1 Robert Uberman Financial Management KA im Frycza

1 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

What is Finance all about? Finance is about three things: n raising money n allocating it n controlling return on money invested n Spreadsheets and Finance Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Course Overview n n n n n Financial statements (1) Revenues and Costs (nonfinancial) (2 -3) Net Working Capital Management (4) Time Value of Money Concept (5) Investment Decisions (6) Responsibility centers and managerial accounting (7) Financial ratios (8) Business Financing (9) Business Modelling and Forecasting (10) Financial Disciplines (11) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Books & Evaluation Rules n Books: n n Brealey Richard A. , Myers Stewart C. : Principles of Corporate Finance. Mc. Graw-Hill, New York, 1996 (or any other edition, incl. Polish version) Shim Jae K. , Siegel Joel G. : Vest Pocket CEO. Prentice Hall, New York, 1992 (a very good Polish edition by ABC, 1999) Atrill Peter, Mc. Laney Eddie: Management Accounting for Decision Makers. Prentice Hall, Harlow, 2007. Evaluation: n n n Written, in- class, closed books Exam, with 3 out of 4 topics to be discussed Near to all topics will require both calculations and assessment of a problem challenged After class assignments not graded at all but instrumental to succeed on the final exam Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session One Topics n General concept of financial statements Balance sheet Accrual vs cash flow approach Profit and Loss (Income) Statement Cash Flow Statement n Brealey, Myers pp. n n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Key financial questions n n n How much does the business own (at present, in the past, in near future)? How much has the business earned (over a given period of time)? How much it will earn in future? The above indicated are key financial questions for every person but also enterprise, institution, government. We will discuss almost exclusively non-financial businesses although some concepts apply to other types, too. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Sheet – key notions to remember n Assets: properties owned (now: or under control and with entitlement to key benefits): n n n Liabilities and equity: n n n Long-term (with useful life over 1 year): laptop. Current (with useful life up to 1 year): enrolment. Tangible: laptop. Intangible: enrolment right. Long-term (due later than within 1 year): Father’s loan and, by definition, equity. Current (due within 1 year): instalments. A Balance Sheet: a statement of properties and sources financing them Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Reasons why assets and liabilities have to be recorded separately n Even if we have a dual entry approach and transactions are not divisible their results are: n if granted a loan to purchase a specific equipment one cannot use the proceedings for other purpose, n n n however when transaction is closed one has to repay a loan regardless the machine purpose and, of no specific arrangements are made, can do whatever it wishes with the equipment. Both relations can be discontinued separately in a different time and circumstances. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Accruals vs cash flow n n In private life we tend to equalize revenues with cash inflows and costs with cash outflows, sometimes recognizing special character of investments (eg. nobody would treat creating a bank deposit as a cost albeit identifying it as a cash outflow). In the least complex business activity it is a handy approach but: n n even in such cases carries certain risk, it would be dangerous in case of complex businesses. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Reasons why not all costs are represented by cash outflows (1) n n Long term assets will loose their value over time and eventually become useless (except for ground plots and some other specific items). The above mentioned process may be long and involve very valuable items (f. e. a car) Consequently we need a mechanisms to allocate expenses incurred to acquire them over pertain time. We say, we „depreciate” them (amortise intangible assets, deplete natural resources) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Reasons why not all costs are represented by cash outflows (2) n n n Commercial credit. Concurrent services (eg. electricity, employment costs). Deferred obligations and revenues (f. e. in construction business). Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Two financial statement addressing the issue of results n n Income (Profit and Loss) Statement Cash Flow Statement Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Income Statement – key notions to remember n n Revenues: Cash inflows or other enhancements of assets (for example acceptance of services delivered) Costs: use of assets attributable directly or indirectly to the revenues recognised n n n cash costs. non-cash costs (DDA) Income (gross): revenues – costs Income tax(es): obligatory levies on income (but not VAT, stamp duties, etc. ) Income (net): Income (gross) – taxes Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cash Flow Statement – key notions to remember (1) n Operational activities : n n n receipts from the sale of goods or services, payments to suppliers for goods and services, payments to employees or on behalf of employees, buying Merchandise some otherwise typically financial items if strictly connected with operational activities (eg. interests on delayed payments for services). Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cash Flow Statement – key notions to remember (2) n Financial activities: n n n dividends paid (with tax if applicable), sale or repurchase of the company's stock, net borrowings, interests paid & other borrowing costs (incl. certain leasing related payments), repayment of debt principal, including capital leases. Investing activities: Payments resulting from purchase or sale of a long term asset (assets can be land, building, equipment, marketable securities, etc. ) n Payments related to mergers and acquisition. n (Under certain regimes) loans made to suppliers or received from customers Robert Uberman, Financial Management, KA im Frycza Modrzewskiego n

2 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Two Topics n n Revenues Management accounting Relevant costs Cost allocation under full absorption Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial vs Managerial Accounting n Financial Accounting: n n n highly regulated independent check of statements accuracy oriented backward perspective generally external use n Managerial Accounting n n n company dependent no direct independent control speed oriented onward perspective generally internal use Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial vs Managerial Accounting FAQ n Financial Accounting: n n n what was the A’s equity at the date of? What was the profit made over a period of? Was the Company solvent at the closing date? n Managerial Accounting n n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego shall we buy/sell a business segment? shall we launch a new product line? shall we increase/decrease prices? is our cost level still competitive?

Financial vs Managerial Accounting relevant costs (items) n Financial Accounting: n n only costs incurred matter almost no estimates allowed full absorption approach no scenario analyses n Managerial Accounting n n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego only future costs matter (sunk costs!!!) estimates widely used marginal costs approach scenario analysis and hybrids (opportunity costs)

A concept of revenue – definition and traps n n Revenue defined as an increase in assets or decrease in liabilities that is caused by the provision of services or products to customers. Under the accrual basis of accounting, revenue is Under the usually recognized when goods are shipped or services delivered to the customer. Under the cash. Under the basis of accounting, revenue is usually recognized when cash is received from the customer following its receipt of goods or services. Revenue vs cash inflow Revenue vs price (rebates, discounts other provisions) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

A concept of cost – definition and use n n Cost defined 1 = monetary value of economic resources used in performing an activity Cost defined (measured) 2 = the amount of cash or cash equivalents paid or the fair value of the other consideration given to acquire an asset at the time of its acquisition (IAS 16) Cost vs expense (very close to the second definition of a cost) Cost vs price (quantity of payment or compensation given by one party to another in return for goods or services) n Cost vs investment (money committed or property acquired for future income) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Typical costs items by origin n n n Remuneration (salaries, wages, fringe benefits) Raw materials Energy External services Taxes and duties allocated to costs (real estates tax, stamp duties but neither VAT nor excise tax Depreciation, Depletion & Amortisation Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost absorption n n Cost of goods sold General costs (period costs) Logically there should be no costs left after allocation (orphan costs) since ultimately every dollar spent has to be covered The problem is that share of direct costs (naturally allocated) decreases while the one of general costs growths rapidly and in some most advanced and valuable businesses gets dominance Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost absorption n n Profit = Revenues – costs Revenues (excl. bounded sales) are always direct and objective Costs must be fully allocated to products & services sold Cost allocation is always to some extend subjective According to various studies indirect costs account between 30 -42 % of the total costs (Laney, Atrill, p. 316) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Use of the full absorption approach n n n Long -term pricing Long-term resource allocation Financial accounting Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – types of costs n n Direct vs indirect costs Direct vs variable costs n n n raw material wages Indirect vs fixed costs n office rent Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – targets n n n Products (individual, group) Business segments Customers (individual, segments, markets) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Typical manufacturing processes n Job order n n order batch assembly Process process (often with joint products issue) n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – job order n Cost pools n n n Overheads For one-factory firm: typically two levels: factory shared services + supporting activities For international corporations: multilayer structure Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – job order n Cost drivers: n Typically related to the time used e. g. machine hours (production lines) n e. g. employees’ working hours (services) n n n A need for standardized (normative) costing: otherwise forecasting ability non-existent Process costing skipped as too complicated at this level Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – exercises n n Atrill Activity 10. 5 Atrill Exercise 10. 6 (Homework) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – Critique of conventional costing n n Not a tool to analyse overheads: a growing portion of total costs Inability to provide analytical background in responding key strategic and operational questions: n n shall we enter a new market (say Ukraine)? shall we keep servicing this very group of customers (say students? ) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

3 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Three Topics n n Fundaments of ABC costing Applications of ABC costing Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – Rising share of overheads Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – A(ctivity) B(ased) C(osting) n Fundamental questions underlying ABC n n What activities are being performed? What resources are used in these activities? How much do these resources cost? What really drives these costs (activity drivers)? Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC vs. conventional costing – cost drivers Conventional costing Number of machine hours becomes: ABC Number of set ups Number of shifts Number of O&M interventions Number of working hours per shift Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC vs. conventional costing – Example (1) An inbound warehouse employs 12 people with the total cost (not limited to labour cost) of 20 000 USD: first stage cost driver = number of employees receiving parts – requires 6 employees so cost is 10 000 USD; second stage allocation basis is number of shipments of purchased parts (250 per month) receiving raw material – requires 3 employees so cost is 5 000 USD; second stage allocation basis is number of shipments of raw materials (50 per month) distributing material – requires 3 employees so cost is 5 000 USD; second stage allocation basis is number of production runs (200 per month) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC vs. conventional costing – Example (2) Stage 2 Remove costs from activity cost pools and assign to products using second stage cost drivers: receiving purchased parts 10 000 USD/250 = 40 USD per shipment receiving raw material 5 000 USD/50 = 100 USD per shipment distributing material run 5 000 USD/200 =25 USD per run For product A, the 100 produced require 200 purchased part shipments, 40 raw material shipments and 100 production runs. The direct labour requirement is 2 000 hrs. For product B, the 2 000 produced require 50 purchased part shipments, 10 raw material shipments and 100 production runs. The direct labour requirement is 3 000 hrs. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC vs. conventional costing – Example (3) If we use this information to compute conventional cost allocation, we see the following results: Warehouse (indirect) cost is 20 000 USD allocated to 5 000 hrs gives 4 USD/hr, what translates into: for product A: 2000 hr/100*4 USD = 80 USD/unit; for product B: 3000 hrs/2000*4 USD = 6 USD/unit If we use this information to compute the ABC cost based, we see the following results: A Parts receipt 200 * 40 USD = 8 000 USD Raw material receipt 40 * 100 USD = 4 000 USD Distributing material 100 * 25 USD = 2 500 USD 14 500/100 = 145 USD per unit B Parts receipt 50 * 40 USD = 2 000 USD Raw material receipt 10 * 100 USD = 1 000 USD Distributing material 100 * 25 USD = 2 500 USD 5 500 USD/2000 = 2, 75 USD per unit Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC – sources of differences to conventional costing n n Complexity (more operations – more costs) – an example of newspapers attachments Volume (large vs. small batches) Size of products – an example of packaging line Value of fixed assets used Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC – advantages for services n n Minimal level of variable and small of direct costs Focus on customers rather than on products Products definition very complex, flexible and customized High operational gearing Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

ABC – advantages for services This enabled managers to examine indirect cost in more detail. For example, consider this example from an order processing department: Using the traditional costing system, the question that managers would ask was: Why was £ 74, 000 spent on travel? Using ABC, the new question is: Why was £ 35, 000 spent on resolving problems? Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – Homework Exercise 11 -1 in Excell Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cost allocation – exercises Buccaneers Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

4 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Four Topics n n n Net Working capital Current assets and liabilities Balancing NWC management Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

(Net) Working Capital: Introduction to n Revenues (accrual) not settled turn into accounts receivables n n Supplies (of labour, raw materials) received but not settled turn into accounts payable n n other accounts receivables are f. e. advances paid for supplies. other accounts payable are f. e. advances received. Raw materials, semi - products & products not sold turn into stock. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Net Working Capital on a balance sheet Assets Long term assets Short term assets, incl. : Liabilities & SE $ 10, 000 Short term liabilities, incl. : $ 7, 000 Accounts payables Accounts receivables $ 3, 000 Overdraft Inventory $ 3, 000 Long term liabilities Short term notes $ 1, 000 Shareholders’ Equity $ 17, 000 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego $ 3, 000 $ 2, 000 $ 10, 000 $ 4, 000 $ 17, 000

NWC ratios Cost of Goods Sold (COGS): (merchandise) $ 9, 000 Accounts receivables collection period: 3, 000/20, 000 *365 = 55 days Overheards $ 9, 000 n Gross profit $ 2, 000 3, 000/9, 000 *365 = 122 days P & L for the 200 x Revenues Tax (paid) n $ 20, 000 $ 500 Net profit: $ 1, 500 Stock conversion holding Accounts payables settlement period 2, 000/18, 000 *365 = 40 days n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Cash Conversion Cycle n Cash cycle receivables’ collection period + stock holding period payables’ settlement period = cash conversion period n For the example used: 55 + 122 – 40 = 137 days Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

NWC ratios calculations - tips n n Accounts receivables collection period is always calculated against revenues. However some of short term receivables themselves may not result from sales. Stock holding period can be calculated either in relation to COGS (for trading businesses) or to revenues (for manufacturing companies) Accounts payables are calculated in relation to cash costs (DDD excluded) Simplification are often used and allowed if applied consistently. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

(Net) Working Capital n Short - term assets vs Working Capital n n capital which costs (interests bearing liabilities) liquidity approach - confusion n Exxon vs Metro (MS Excell Spreadsheet) n Net assets vs Short-term assets Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Sheet basic analysis (Net) Working Capital n n Industry and business position context critical while analysing Exxon vs Metro (MS Excell Spreadsheet) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

5 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Five Topics n n Introducing time concept Discounting money streams Key problems with proper discounting Brealey, Myers: the chapter titled: “Present Value … “ (pp. 11 -56) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Time Value of Money n n 1 USD today does not equal 1 USD tomorrow! FV = PV * (1+r)n where: n n n r represents a return n represents number of periods (quite often years) PV = FV/ (1+r)n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Theoretical fundaments of relation between time and value n n Risk of a return different from the planned one (Mind you: also bigger !!!) Liquidity: investor converts cash, which is the most universal value transponder into less liquid assets (Opportunity Cost of Capital), Purchasing Power: universal (inflation, see Brealey, Myers, pp. 642 -645), individual (ultimate goal in investing) Intrinsic value of money (per se): – J. M. Keynes’ theory. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Capitalisation n FVt – Future Value of a given sum CF 0 – present value of a given sum rt – interest rate in period t (most often annual) t – capitalisation period n Brealey, Myers pp. 11 -56 n n n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Capitalisation rate n n The most common way of expressing a capitalisation rate is an annual one, marked with r letter without index t However quite often a real capitalisation period is different – interests are added to a capital after each month, quarter or so. Then the previously mentioned equitation is converted into: Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Key equations Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Various approaches to set an interest (discount) rate n There is a huge variety of theories and models covering the issue. The list below indicates a subjective selection of most commonly used ones: n n n n n Alternative capital cost Risk-free alternative Debt cost WACC Historical rate of return Risk Adjusted Discount Rate (RADR) Hurdle rate Social rate of return Discount rate quite often is presented as: risk-free rate + risk adjustment Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Concept of risk n n Financial and insurance meaning of risk Individual attitudes towards risk: n n n averse, neutral, Seeker. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Risk – coin tossing game (1) n Game A: Head + head = 40 % gain n Head + tail = 10 % gain n Tail + head = 10 % gain n Tail + tail = 20 % lose Expected return = 0, 4*0, 25+0, 1*0, 25 -0, 2*0, 25 = 10% n n Game B: Head + head = 70 % gain n Head + tail = 10 % gain n Tail + head = 10 % gain n Tail + tail = 50 % lose Expected return = 0, 7*0, 25+0, 1*0, 25 -0, 5*0, 25 = 10% n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Risk – coin tossing game (2) n Game A: Return Deviation Squared deviation Probability P * SD + 40 + 30 900 0, 25 225 + 10 0 0 0, 50 0 - 20 -30 900 0, 25 225 Variance = 450 - Sq. Dev. = 21 n Game B: Return Deviation Squared deviation Probability P * SD + 70 + 60 3600 0, 25 900 + 10 0 0 0, 50 0 - 50 -60 3600 0, 25 900 Variance = 1800 - Sq. Dev. = 42 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Present Value as dependence on a discount rate Discount rate 8% 10% Discounting Period 12% 15% 20% Value in k USD PV, 25 yrs 747 635 549 452 346 PV, 238 yrs 875 700 583 467 350 PV, infinity 875 700 583 467 350 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Homework n n If the PV of 150 USD to be paid in one year is 130 USD, what is a discount rate? (Brealey, Myers, Chapter 2, Q 2) You have come to a bank in order to make 1000 PLN deposit for 5 years, with 7% interest and half-year capitalisation (period). An financial advisor has stepped in with an offer of shares which over last 5 years period brought 40 % return. What would be your decision? Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

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Session Six Topics n n n Investment vs Capital Budgeting Decisions I(nternal) R(ate of) Return NPV PI Payback (discounted) Brealey, Myers: Chapter titled “Why Net Present Value Leads to Better Investment Decisions …” (pp. 85 -112) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Investment vs. Capital Budgeting Decisions n n n Investment = money committed or property acquired for future income Capital budgeting is planning capital outlays for purchasing new fixed assets to get additional profit thus it means planning investments Intra-corporate investment process is usually much more complicated ro evaluate than financial investments (share, bonds) since cash flows are not easily defined Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Examples of Capital Budgeting Decisions n n Equipment selection decision. Plant expansion aimed at: n n increase in sales; backward integration. Equipment replacement decision caused by aging machine park. New equipment purchase aimed at cost reduction. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Commonly used measures of investment efficiency n n n Payback (straight) I(nternal) R(ate of) Return NPV PI Payback (discounted) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Payback (period) n n The payback period estimates the time required to recover the principal amount of an investment. It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Payback (example) n A&B Enterprises is trying to select the best investment from among three alternatives. Each alternative involves an initial investment of $100, 000. Their cash flows follow: Year A B C 1 $ 10, 000 $ 50, 000 $ 25, 000 2 $ 20, 000 $ 40, 000 $ 25, 000 3 $ 30, 000 $ 25, 000 4 $ 40, 000 - $ 25, 000 5 $ 50, 000 - $ 25, 000 Which investment will you select using the payback method? Why? (Brealey, Myers) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Payback – key issues n What is an investment? n n Capital expenditure Increase in NWC Other How one defines a pay back itself? n n Net profit Net cash flow Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Payback - limitations n The payback period method ignores: n n any benefits that occur after the investment is repaid the time value of money risk-free cost of money n risk n n Therefore payback period: is useless for ranking purposes n can be used only in relation to near certain flows n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

IRR n n IRR vs Yield to Maturity IRR algorithm IRR use Disadvantages of IRR Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

IRR - definitions n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

NPV and IRR n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

NPV n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

IRR vs NPV n IRR: n n can be calculated only if a cash flow break even only once – which is typical for many simple investments; is directly comparable to benchmarks like interests on deposits; can be used as a ranking tool but with attention to various traps (see Brealey, Myers, pp. 94 -101. NPV n n n in practice it is calculated to get IRR; it can be applied to streams not to be assessed using IRR; it can not be used as a ranking tool (unless all investments are equal) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

PI (Profitability Index) n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Discounted Payback (Period) n n n The discounted payback period estimates the time required to recover the principal amount of an investment but applying discounting. It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment with consideration of time value of money concept. It is quite often used as an indicator of a risk level Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Homework n An owner of a successful retail business of a traditional handmade wool clothes in Krynica considers opening a new outlet in Warsaw. There are two options as far as location is concerned and they can be characterised as stated below in terms of key economic parameters. Please select the most efficient one using measures presented before. Apply 15 % discount/hurdle rate when needed. Location (PLN) Cost/ month Monthly turnover Mark up Days in stock Days payable Initial investm ent Premium 10 000 50 % 30 60 90 000 Subarbian 6 000 35 000 30 % 45 60 30 000 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

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Session Seven Topics n n Responsibility Centers Fundamental Income Statement analysis Budgeting and control tools and processes Other performance measurement concepts Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Responsibility centres n Cost centres cost only Revenue centres n revenues (usually combined with some costs) Profit centres n revenues and costs but no capital expenditures n n Investment centres n n all three: rev. , costs, and CAPEX measured by ROI, NPV, EVA(Residual Income) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

CVP analysis n Cost structures - variability: n n n fixed costs variable costs other types: semi variable n stepped costs n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

B(reak) E(ven) P(oint) analysis n n n BEP formula BEP as a measure of companies’ risk exposure Variable costing (USA) vs. marginal costing (UK) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

BEP concept Company B, likely: metal industry, mining Company A, likely: FMCG retail Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Contribution concept n n Contribution = Revenues - Variable costs Contribution – ways of presenting: n n Value/unit or per tone % of sales revenues Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

BEP and pricing decisions n n Full absorption vs variable costing Pressure on price Allocation of fixed costs Opportunity costs – limited resources issue – fixed costs as representation of limited resources Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Pricing – most widely used methods n n Cost + method Mark-up vs Margin Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Variance analysis in the control process n Volume and price variance Budgeted amount = budgeted price * budgeted quantity n Actual amount = actual price * actual quantity n n n Variances’ tree Atrill Example 13. 1 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Variance analysis in the control process – practical issues n Huge number of calculations: n n 1500 products* 3 -4 major costs components*time frame Delay in time – actual data available when decisions are taken Dynamic environment Benchmarking issue Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Value creation measures n ROCE n n n Return = Net profit Capital Employed = Equity + Debt = Net Working Capital + Fixed Assets EVA (RI) n n EVA = Net profit - Capital Charge = CE * cost of capital Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Investment measures n n Hurdle rate as a cut-off point Shell to find 4 billions USD as ‘lazy assets’ - underperforming with ROCE less than 13 -15% (FT. com. , 22 December 2003) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Budgeting and Control n n n Budget as the key tool in any controlling process Budget vs plan Levels of budgeting: n n n strategic operational managerial Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Budgeting - purpose + general remarks n n Resource allocation Congruence with strategy Master budget vs. operating budgets Monetary budgeting vs budgeting in natural units Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Budgeting - typical structure n Revenues Variable costs n Fixed costs = OPEX n n n Other Investment costs Capital Expenditures (CAPEX) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Scorecard as a nonfinancial performance measure n n Customer Perspective Business Processes Perspective Organisational learning (Development) Perspective Financial Perspective (RI) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Budgeting - typical processes n Top -down (authoritarian) n Bottom up n n n participation consultation Role of K(ey) P(erformance) I(ndicators) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Budgeting – KPI of Netia Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

8 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Eight Topics n n n n Introducing ratio analysis Short-term solvency (liquidity) Long-term solvency Working Capital Ratios (see Session Four) Financial efficiency Using ratio analysis Brealey, Myers: Chapter “Analyzing Financial Performance” (pp. 765 -773) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Liquidity ratios n Current ratio: n current assets/current liabilities mind you: in this case (as oppose to NWC) a short term debt is included Quick ratio (ACID - test) n n n Cash + short term securities + receivables/ current liabilities: n mind you: sometimes it is said that the only difference lays in not including inventories – in many cases it’s true but often misleading Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Solvency ratios n Gearing (debt/equity) ratio: n Debt, including leases /equity mind you: various authors exclude short-term debt (Brealey, Myers including) – in US practice it is reasonable but in many cases short term debt is very important Interests coverage n n n EBIT (Earnings Before Interest and Taxes)/ interests & other debt related costs: n mind you: banks charge provisions and other which are not disclosed as interests but other financial costs – on the otehr side financial costs may include net results on currency rates Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial Efficiency Ratios n Gross Margin: n EBIT (if possible before overheads)/revenues mind you: sometimes quite difficult to be established directly from P&L Return on assets n n EBIT/ total assets Return on equity n Net profit/ equity Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial efficiency n n n The second Du. Pont formula ROE = Net profit/Equity (average) ROA = (EBIT – Tax)/Total Assets (average) Therefore: ROE=ROA*(Total assets/equity) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Du. Pont Formula Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Comprehensive Financial Ratio Analyses Ratios: Sources: Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

9 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Nine Topics n n n Business financing overview Debt financing – financial markets Debt financing – banks Equity Other sources of financing Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Sheet basic analysis Sources of finance n Structuring criteria: n n n duration form of remuneration providing entity legal form Long term vs short term Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Sheet basic analysis Sources of finance n Remuneration: n n n (Accounts) payables ---> cost included in price/cost of the original item Loans (and overdrafts, receivables discounting), debentures (bonds), leases --- > interests Equity ----> profit (dividends + growth) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Balance Sheet basic analysis Sources of finance n Providing entity: n Shareholders stock n preferred stock n subordinated loans n n Financial institutions (mainly banks) loans n overdraft n trade receivables discounting n n Special category: Bonds Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial markets n Bonds, especially quoted on regulated financial markets: n n n Other forms: n n Accessible for renowned companies or investors Issued with different maturities (short-term are named notes) Usually very liquid Common in US and UK but gaining importance elsewhere Private placement Preferred stock Financial markets usually do not seek high interests but insist on security (exception: junk bonds) Brealey, Myers pp. 640 -62 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Maturity & Yield to Maturity n n Maturity is a period for which a loan (or other form of financing is granted) Yield to maturity is nothing else but a rate of interest paid (price, cost) for obtaining a financing Z – bond: a zero coupon bond = does not pay interest Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Yield to Maturity with interest paying bonds n When an interest (coupon) is to be paid the yield has to be calculated as both coupons and a principal are actually equal to zero -coupon bonds – different payments * -The second method is valid on the following two conditions: (1) purchasing price = principal (2) all coupons are equal Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Banks n Asset based financing: n n n Other forms: n n Leasing (based on fixed assets) Factoring (based on receivables) Credit notes Loans Banks usually do not seek high interests but try to reinforce sales of other services Brealey, Myers pp. 640 -62 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Equity n n Financing provided by owners (although owners may also use debt financing but always additionally): Residual value of all assets remaining after satisfying all liabilities (including debt paid back to owners) The most risky and volatile form of financing Essential for business existence Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Equity vs Debt Financing (1) n Miller-Modigliani Preposition I: n n n Miller-Modigliani Preposition II: n n A firm cannot change it’s value through changing a financial structure thus investment decision have to be taken disregarding financing methods There are no taxes & financial markets are perfect Expected yield on shares rises as share of debt-financing increase Tax credit favours debt Increasing debt drives risk up Brealey, Myers pp. 450 -457 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Equity vs Debt Financing (2) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Homework Calculate: a) yield to maturity on 7 percent, 8 -year bond selling at 74, 5; b) price of 7 percent, 9 -year bond yielding 10 percent; c) price of 8 percent, 12 -year bond yielding 14 percent; (Brealey, Myers, Chapter 23, Q 4, use either Table 23 -1 or a spreadsheet) n Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

10 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Session Ten Topics n n Creating a Financial Model Forecasting Interpretations and application of financial modelling Brealey, Myers: Chapter “Approaches to Financial Planning” (pp. 794 -809) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Fundaments of Financial Planning n n n There is nothing like precise financial planning. If your actuals match exactly the financial plan it means only that one column in excel has been mistakenly copied. Any financial plan in fact reflects authors’ understanding of the business in consideration but helps substantially to deepen it. Consistency is more important that results obtained. Financial planning shall not start with numbers but end with them. All three statements has to be completed: P&L, BS and CF. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Basis of financial modelling n n n Existing businesses usually start from past statements. New businesses typically start with crunching revenues. Good planners start with goods/services volumes expressed as KPIs: n n Say, in case of a restaurant one should start rather with number of lunches and dinners served than with sales value. Some key assumptions have to be defined upfront and followed consistently: n primary currency, n inflation, n time frame and structure. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Creating a Financial Model (1) n n There are many financial models available on shelf. They offer many useful functions form consistently check up to very advanced iconography. It is nothing wrong with using them however they will not understand the business instead of managers. My advice: first develop the model yourself from scratch. n n n this will check your business understanding, allows you to focus on important issues (many models are in practice full of “zeros” since aiming at wide audience they have to incorporate many rarely used items, will really help you run a business. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Creating a Financial Model (2) n n n Use plain Excell Sheet (or similar software) In case of continuing business follow the sequence: the coming period P & L, BS and then CF – while completed go to next periods. In case of start ups start with the forecast of the first full capacity year (P&L and BS only), then make previous years P&Ls and BSs and finally close CFs. Define revenues in volume terms using KPIs. Remember VAT issue. Use ABC costing widely & wisely. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

VAT issue n n In principle VAT, Value Added Tax, is imposed on final consumers. All other entities paying VAT in procurement of goods and services can deduct the amount paid from VAT imposed on their customers. In ideal world enterprises shall not be bothered with it. Based on this principle ISAB requests VAT exclusion from P&L. Technically VAT works like a sales tax but with a profoundly complicated calculation process. Enterprises are ultimately responsible and financially liable for it’s collection and payment to a proper tax office. Therefore if you grant all customers 30 days payment period with flat sales instead of 30 days ARCP expect longer (36 days if 20 % VAT is applied). The same rule refers to APSP. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Financial Models in Big Corporations n Complexity issue: n n no of responsibility centers can exceed 1 000 easily, no of currencies involved can reach 100 with no dominant one (say USD, EUR and Chinese Remnibi could weight substantially enough not to allow for simplifications), no of business lines can exceed 1, 000 with more than 5 really important ones, no of substantially different accounting regulations might be applied on local level forcing numerous translations and corrections. MNCs usually develop their own financial planning models (often with support of service providers) and stick to them for long times. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Forecasting n n Forecasting is in fact not a part of Finance. One applies model/methodologies relevant forecasting areas. Focus on a few key items, crucial for the business, typically: n n 1 -2 shaping revenues; variable costs per unit; 1 -2 shaping fixed costs. and elaborate on them extensively and carefully. Use benchmarks or official sources or seek for external solutions in other areas: say, ask tax expert to calculate taxes. Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

11 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Finance vs Accounting n Financial Accounting n n Tax Accounting n n n driven by state regulations; strictly regulated. Managerial Accounting n n historically the first to described and normalized officially; oriented towards stakeholders not directly involved into operations; primary data source for all mentioned below. oriented towards managers and other people directly involved into operations; based on certain standards but not regulated. Corporate Finance Banking & Financial Markets Insurance Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Exercise n An owner of a successful retail business of a traditional handmade wool clothes in Krynica considers buying the house he runs his business in. The landlord expects an offer around 500, 000 PLN. At present the monthly rent is 1, 000 PLN and does not include any maintenance. On the upper floor there is an apartment rented for 800 PLN/month net. Since there is a high risk of cancellation of rent in case a third party buys in the owner identified another location to be rented for 800 PLN, though slightly less attractive. Location (PLN) Cost/ Month (excl. rent) Monthly turnover Mark up Days in stock Days payable Initial investm ent Present 4 000 30 % 15 60 0 New 3 500 25 000 30 % 15 60 20 000 Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Additional exercises (1) n n You have been offered 2 years bonds: zero coupon, 100 GBP nominal value, for 91 GBP Now a bank pays you 4, 5 % on a semi-annual deposit. What is your decision? Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Additional exercises (2) n n n n You have considered investing up to 2 million PLN somewhere (your bank offers you 6 % per annum) Since You owned a plot nearby the city centre one obvious idea was to construct an office building. A property agent contacted has a client willing to pay 2, 5 millions for the building desired providing it becomes available in 2 years. The agent also pointed out that he would be willing to buy this plot onto his own account for 400 thousands PLN The agent provision is 4 % Your colleague, running a construction company offered to construct this building on a turn-key basis for 1 500 thousands, and expects his consideration in three equal instalments (500 thousands each) Robert Uberman, Financial Management, KA im Frycza Modrzewskiego

Additional exercises (3) Comapany X has budgeted the following for the coming month: Production Product A Product B 5000 units 15000 units Direct material Product A Product B 25 GBP/unit Product A Product B 4 hrs/unit 2 hrs/unit Direct labour rate 10 GBP/unit Overheads Total no of activities Total 750 000 Machine set-ups Quality inspections Production orders 115 000 320 000 90 000 GBP GBP Machine hours worked Material receipts 175 000 50 000 GBP A B 5 000 8 000 900 3 000 5 000 300 2 000 3 000 600 25 000 5 5 000 20 000 3 Prepare conventional based and ABC based cost forecast for product A and B Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Product