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ACCOUNTING STEP BY STEP

CLE - CREATIVE LEARNING EXERCISE

MINI-AGL - EVA & FINANCIAL MANAGEMENT OF WORKING

CAPITAL

Draft for correction before final publication 2012

Dr. Bob Boland & Team FCA, CPA, DBA, ITP (Harvard)

Editions in English (UK/USA), French, German, Spanish, Italian, Portuguese, Zulu, etc.

Source: EW et aliaAudio: freely available in www.crelearning.comHelp: [email protected]: RGAB/1

mailto:[email protected]

http://www.crelearning.com/

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DEDICATION

This is a fun programme, is dedicated to memory of the of all hard working accountants (and auditors), who have always been the respected traditional honest man in the tough game of business, but have been relegated to the relatively humble job of scorekeepers.

In revenge the accountants keep the score, in such a complex way, that nobody other than skilled accountants, can know what the score really is ... was ... or will be ...

We believe that the programme will provide you with confidence, humour and motivation to learn well, about the wonderful world of accounting, which started with a book on debits and credits in 1425 ... and is still progressing.

Each year accountants find new, ever more creative ways, of keeping the score, such that, a manager with an MBA from a major international business school. who was CEO of a major (bankrupt) public company in USA (which shall be nameless), confessed to a US Congressional Committee, that he had no idea what the real score was.

However we still put our trust in the Professional Accountants and Auditors who always try to serve us well, and in new increasingly powerful International Accounting Standards, as the hope of the future. See also our new book: Ethics of Business – in 2007.

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INDEX

Item Page No

PART I - EARLY MORNING

Sect. 1 - Introduction 3

Sect. 2 - Key Learning Points 4

Sect 3 - Study - Financial Management I 11

Sect. 4 - Study - Financing Expansion 19

Sect. 5 - Review 24

PART II - LATE MORNING

Sect. 1 - Study - Creative Accounting 33

Sect. 2 - Case Studies 43

Sect. 3 - Study - Financial Management II 49

Sect. 4 - Key Learning Points 56

Sect. 5 - Learning Maintenance 56

APPENDICES:

A - Glossary 57

B - Quiz 70

C - Exercise 87

D - AGL 89

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PART I - SECTION 1 - INTRODUCTION

1. OBJECTIVES

The learning objectives are to

(a) Understand accounting language and concepts of financial management.

(b) Recognize the need for financial forecasting of cash, funds, income statements and balance sheets.

(c) Develop practical skills in using financial data to manage working capital effectively.

(d) Recognize "creative accounting" in financial reporting, despite IAS (International Accounting Standards).

(e) Motivate further study in the future

2. SYLLABUS

The syllabus of the program introduces the basic concepts of financial management and EVA (Economic Value Added) as motivators to EVERY manager to take reponsibility for the management of working capital.

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PART I - SECTION 2 - KEY LEARNING POINTS

1. OBJECTIVES OF THE COURSE

(a) Introduces the basic concepts of financial management and EVA (Economic Value Added).

(b) Motivate EVERY manager to take reponsibility for the management of working capital.

2. FINANCIAL MANAGEMENT NEEDS

Key objective is to increase the long term value of the business (the "Market Capitalization") with EVA and SVA.

Knowledge, skills and appropriate attitudes - for creativity in solving financial problems.

Good audited, timely (4 days monthly/40 days annually) financial data of the current financial position (treat "delay" with great suspicion).

Reliable alternative forecasts of the future: cash flow. funds flow, income statements, balance sheets. etc.

Benchmarking and EVA/SVA data. Limited EI (emotional investment) so that all alternatives may be fairly evaluated.

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3. FINANCIAL STATEMENTS

Objective is to be useful and credible.

Follow general accepted accounting principles and only be "creative" if absolutely necessary. Accounting principles, company law and tax law, affect the way companies present financial statements.

The Chief Executive and not the auditor determines the profit disclosed each year. Creativity may achieve higher profit this year but lower profit figure next year ... but let's get there first ...

4. AUDITORS

Auditor is a professional "honest man" (with professional standards).

Auditor's opinion is based on random tests, not detailed checking of all transactions.

Auditor's reputation is vital to his business ! Check auditor's name. fee and independence to evaluate the quality of his audit and reliability of the financial statements.

Most auditors will "bend", if pushed hard enough; small auditing firms often "bend" more easily than big international public accountants. Conservatism is NOT usually regarded as manipulation.

5. ACCOUNTING VALUES

The valuation of assets in the books, affects all financial ratios and the total validity of the financial statements.

When assets are substantially under or over-valued then adjust the ratios accordingly.

Asset values at: cost, selling price. or liquidation are all different.

Value changes over time; "true and fair" values are impossible; seek "useful" values!

Usefulness within credible standards is reasonable.

With inflation of greater than 30% per annum, financial statements become unreliable and working capital management is critical to survival.

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6. FINANCIAL MANAGEMENT OF WORKING CAPITAL

(a) Determine whether a business has a short term or long term financial need.

(b) Recognize that increased investment in WC must bring a return above the CoC (Cost of Capital). Check out the importance of receivables and inventory to the total assets employed; sometimes they are more than the fixed assets!!

(c) Evaluate past performance in relation to the industry averages; then forecast the future based upon assumptions.

(d) Check the validity of assumptions underlying the forecasts;

(e) Manage cash, receivables, inventories and payables. Seek all alternatives and determine appropriate risk levels before decision making.

(f) Ensure that solutions to immediate short term problems will not create even bigger long term problems in the future.

[g) Keep relationships and alternative sources of finance continually open as "Life-line" against possible disaster.

(h) Avoid unlimited rapid expansion which leads to excessive risk of failure ... recognize the stages to move from:

1. Maximizing sales2. Maximizing net profits3. Maximizing cash flow4. Maximizing SVA ...

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7. CONCLUSIONS

(a) Careful diagnosis must determine whether financial problems are short or long term, and how they relate to: OCF, CoC, EVA and SVA.

(b) Use the past for diagnosis but insist also on future forecasts of cash and funds, income statements and balance sheets; but always check the underlying assumptions.

(c) Seek all alternatives available before developing financial policies at appropriate risk levels.

(d) Good relationships with banks, suppliers, customers, shareholders. etc. facilitate effective financial management.

(e) Manipulation of financial statements is relatively easy, despite accounting principles, auditing standards etc. Be particularly skeptical about deferred assets, contingencies, or profits and losses charged to reserves.

(f) Different financial statements are prepared for different purposes - bank, tax and management.

(g) Consolidated accounts are vital to evaluate companies with major investments in subsidiaries.

(h) Financial management seeks not merely profit but an increase in the long term value and (continuing) financial health of the business.

(i) Audited statements are neither true nor fair, but they should be useful.

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7. CONCLUSIONS (continued)

(k) Financial management is essentially a creative activity involving knowledge, skills and above all appropriate attitudes.

(l) Recognize that short term financing is for normal operations, but long term financing problems may require outside specialist assistance.

(m) Manage the cash effectively; make it move quickly; don't let it lie idle earning nothing; control the timing of the cash flows; no business ever failed because of too little inventory!

(n) ApprecIate that all financial problems are essentially problems of human relationships not merely technical analysis.

(o) Financial management language and concepts are particularly effective when combined with intuitive business skills.

(p) To avoid financial manipulation, set clear financial policies as to how accounting principles may be used and may not be abused.

(q) Only ONE large financial mistake is needed to ruin years of good financial management.

(r) "Materiality" is the key concept of financial management .... ... worry about the big things ... the "coconuts" ... and not the "peanuts" ...!

(s) Watch out for unexpected contingent liabilities from: FOREX, legal claims, environmental issues etc. Be careful with "derivatives" unless you ... fully understand them ... and are lucky too ...

(t) Watch out for "off-balance sheet financing" with extensive leasing obligations as the cost of an improving the E:D ratio.

(u) Always do a "PFD" before actually implementing major decisions ...

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7. CONCLUSIONS (continued)

(v) Benchmark to set better WC standards - you may be surprised what other companies have accomplished.

(w) Recognize the key financial management objective of EVA/SVA of which working capital is one of seven drivers.

(x) Many companies control investment in fixed assets very rigorously but seem to regard increased investment in working capital a "natural result" of doing business, so manage the working capital or it will manage itself ... very badly.

(y) Appreciate that all financial data is an estimate and so avoid excessive pseudo-accuracy - concentrate on materiality (coconuts not peanuts!).

(z) Use Dupont charts to "decompose" ROA (Return on Assets) into its main components and help EVERY manager to "own" the problem of working capital management. For each manager OP/NAE must exceed CoC!!

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8. LEARNING PATTERNS

1. EVA/SVA

2. OPERATING CASH FLOW

3. COST OF CAPITAL

4. SEVEN & EI & PFD

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PART I - SECTION 3 - STUDY - FINANCIAL MANAGEMENT I

1. METHOD

Read aloud, listen and respond verbally to any questions.

2. FINANCIAL MANAGEMENT

a. Deals with four major problems:

1. Size - what size should the firm be?

2. Growth - what rate of growth of sales, assets, profits. etc.?

3. Financing - how should the firm be financed, and at what risk?

4. Investment - what kind of assets should be acquired, and at what rate?

b. Most important is ... CASH FLOW and SURVIVAL ... to increase the long term value of the business for ALL of the "stakeholders": customers, shareholders, employees, managers, suppliers, banks, communities, government, trade unions, environmental groups etc.

c. To achieve EVA (Economic Value Added), then in each division of the company:

OP/NAE times 100% must exceed CoC

OP = Operating profit after taxNAE = Assets less current liabiltiesCoC = Cost of Capital

d. With EVA, company mmanagement can achieve SVA (Share Value Added). In 1995, shareholders may be powerful pension funds, insurance companies and mutual funds, who require Management to provide SVA with both dividends and increased share value ... or move over ...

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3. OBJECTIVE. METHOD AND SKILLS

a. Objective - increase the long term value of the business with EVA (Economic Value Added) and SVA (Share Value Added).

b. Method - raise money and use it effectively to achieve standards of financial performance

c. Skills - risk evaluation, raising cash, using time effectively, control, maintaining relationships with: suppliers, customers. bankers, employees, financial markets. government, auditors, etc., AND developing appropriate attitudes towards risk and reward.

4. SHORT AND LONG TERM FINANCIAL MANAGEMENT

a. Diagnosis to determine whether business has a short term or long term need for funds

b. Short term:

1. Investment in cash, receivables (debtors) and inventory (stock)

2. Finance from payable (creditors). advances. bank loans. etc.

c. Long term

1. Investment in fixed assets, acquisitions, R&D. etc.

2. Finance from long term loans or equity.

Note: Net working capital is current assets less current liabilities.

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5.FINANCIAL ANALYSIS

Use the LAPP system to evaluate the health of a business:

Liquidity & Gearing - Rough Standard

Quick assets : quick liabilities 1/2 : 1 Current assets : current liabilities 2:1Equity : debt 2:1 or 1:1

Activity -

S/A (times turned over) 1+

Cost of goods sold/Inventory 2+

Profitability -

Gross profit/sales x 100% improving Net profit/sales x 100% improvingNet profit/owners equity x 100% improving

Operating profit after tax/netcapital employed x 100% above CoC

Note:

Rough standards are not adequate! Relate ratios to industry averages. Look at past trends, compare with target; forecast forward to see the future effect of operations!

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6.FORECASTING FUNDS

Funds flow shows source and use of funds.

Sources are: profit, depreciation, new capital and loans.

Uses are: fixed assets, dividends, working capital.

Funds flow statements reveal key management decisions - past and future.

Forecast forward to provide funds as required 1 - 5 years ahead.

7.FORECASTING - CASH

Arrange now for the cash required in the future.

Cash flow is the cash (received and paid) in the shorter term.

Continually re-forecast monthly for 12 months ahead to be sure cash is available when required; some businesses need weekly or even daily cash forecasting and control due to seasonal fluctuations of the industry.

Review the past cash flows against target, and plan future cash flows.

Look for peak requirements and duration - watch seasonal and monthly effects.

Don't keep too much cash in hand earning nothing.

Debt capacity (equity: debt relationship) is real key to liquidity. The quick ratio and current ratio are only part of the story! Debt capacity - is the ability to borrow more cash!

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8.MANAGEMENT OF WORKING CAPITAL

(a) Manage the assets and sources of finance.

(b) Assets:

Cash - reduce amount on hand, get it to the bank faster!

Inventory - reduce inventory or get suppliers to hold it!

Receivables - reduce by credit control, expediting payment, cash discounts, change of customers, deposits, factoring, etc.

(c) Liabilities:

Suppliers - "stretch" but don't miss discounts; get longer credit terms; seek alternative suppliers?

Banks - borrow more from the same or several or different banks?

Leasing - lease rather than buy fixed assets to release cash for working capital.

Watch out for contingent liabilities for: FOREX, legal and environment claims, lease payments etc.

(d) Cash is vital - so many businesses that go bankrupt are making a profit - they just run short of cash. Cash needs vary at different times both within the month and the season.

(e) Plan for sustainable positive OCF (Operational Cash Flow) which is: net profit, plus depreciation and interest, less working capital changes, less normal capital expenditure. A positive OCF makes cash available for new profitable investments that give EVA.

(f) "Benchmark" with other companies to set new performance standards and to get ALL managers (production, marketing and finance) to "own" the working capital problem!

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9.CHECK LIST ON ANNUAL REPORTS

Be skeptical about company's annual reports; evaluate reports using a check list:

(a) Cash(b) Orders and activity(c) Profitability(d) Prospects and resources (e) Long term finance(f) Shareholders(g) Management(h) Exceptional transactions(i) Notes to the financial statements(j) Secret reserves(k) Contingent liabilities for leasing, legal and environmental

claims etc.(l) Reconciliation of the net profit with IAS.

10. SIMPLIFIED - COST OF CAPITAL, EVA, VALUATION AND SVA

(a) These are all complex concepts. In very simple terms, the Cost of Capital (CoC) is the WEIGHTED (E:D) average after-tax cost of raising long term funds for the business.

(b) Such funds can be either from long term debt (liabilities) or equity. Normally debt (say 8%) costs less than equity (say 16%).

(c) Hence the E:D ratio set by Management (2:1 or 1:1 or 1:4) can affect the average Cost of Capital (say 13.3% or 12% or 9.3% - can you check these computations?).

(d) EVA (Economic Value Added) is produced when the net assets employed (A-CL) produce an OP (operating profit after tax, say 11%) which is greater than the Cost of Capital (say 9.3%).

(e) Valuation of a company or share, relates not to profits but to future cash flows. It may be simply computed as:

V = OCF/(r - g), where:

OCF = Operating Cash Flow (100)r = Cost of Capital (say 9.3%)g = Growth Rate (say 5.3%)V = 100/(0.93 - 0.53) = 250

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(f) SVA (Share Value Added) is produced when the sustainable cash flows and dividends lead to increased short term and long term share value, as related to the share index by the Beta coefficient.

(g) Most companies control capital expenditure well but fail to

control investment in working capital, which is part of NVE (net assets employed) and therefore critical to achieving EVA and EVA.

11. OVERALL

Plan short term cash and long term funds.

Set financial management objectives.

Manage the working capital or it will manage itself - badly!

Seek seven alternatives before setting financial policies.

Ensure that short term plans have good long term effects.

Watch for daily, weekly, monthly and seasonal fluctuations in cash needs!

Seek creative not merely routine financial management.

Always use good financial forecasts 1-3 years ahead ... with the key underlying assumptions clearly outlined.

Note:

There are always SEVEN alternatives ... for every financial problem ... so, seek them out ... before ... you make that final decision ... and ... do a PFD (Provision for Disaster) ... before ... you finally ... implement your decision!

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12. LEARNING PATTERNS - REVIEW


SIZEGROWTHFINANCINGINVESTMENT ......................... FOR EVA/SVA

2. WC MANAGEMENT

ASSETS - C, R and ISOURCES - P and I

3. FINANCIAL ANALYSIS

L & GAPP

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PART I - SECTION 4 - LECTURE ON FINANCING EXPANSION

1. METHOD

Read aloud, listen and respond verbally to any questions.

2. PLANNING FOR THE FUTURE

Need to plan the size, growth and profit stability of the company.

Funds flow is the key to long term financing.

Cash flow is the key to short term financing.

Forecast forward both cash and funds to determine whether financial needs are short term or long term.

3. RISK AND THE CRITICAL FEW

Decide upon "critical few" factors which really make for profit in the particular business. Analyze the industry, economy, size of the business and finally the personal values of the chief executive.

Determine the risk level the company will accept. Evaluate the risk of various possible disasters. Set financial policies to deal with the "critical few" profit-making features at the appropriate risk level.

4. EFFECT OF EXPANSION

Expansion of sales leads naturally to expansion of current assets (receivables, inventory and the minimum cash balance).

Management of receivables and inventory is the cheapest "source" of finance, i.e. reduce the investment.

Suppliers provide cheap finance after cash discounts are lost (or not offered). Loss of cash discount is costly - i.e. 2% 10 days net 30 days is 2% for the extra 20 days of credit or 36% per annum!!

Alternative sources of short term finance include: suppliers, factoring, loans. customer deposits, banks, etc. Get suppliers to give 2% 30 days or take 9 months to pay or change suppliers?

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5. BANK RELATIONSHIPS

Commercial banks serve customers by financing current business (not like merchant banks which provide long term capital).

Key to bank financing is the mutual confidence between banker and customer.

Bankers like: short term financing which turns over regularly; they like "accounts" that are actively going from red to black to red, etc.

Banks provide a widening range of services today; they believe that "the customer does not have to tell us all the truth but he must never deliberately lie or be irresponsible".

Commercial banks have associates that do merchant banking.

6. CRITERIA FOR BANK FINANCE

Commercial banks lend not just against physical security but on the following criteria:

(a) person-relationship with banker(b) purpose(c) profitability(d) payback (is it possible?)(e) security.

Bankers may say "all loans are repayable on demand" if the "rules" are broken, but in reality they never demand it unless in danger.

Banks hold security in the hope of never having to use it. Banks give information to each other in a special code which is discreet and

confidential.

Relationship with the bank manager is the key!

Banks sometimes insist that "equity base" be increased as a condition for further loans. Banks are normally conservative and tough!

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7. CONTROL OF WORKING CAPITAL

Frequent (monthly) reporting with reliable financial statements to all managers (production, marketing, finance etc.) to get them ALL to "own" the WC problem.

Regular and effective forecasting of peak and duration of cash needs. Timely financial data for ALL managers. Forecast forward the income statements, balance sheets, cash and funds and then evaluate risk.

Never go to the banker when you need money; go when you don't need money and arrange to have it available when you want it. ("I need 500,000. Can you handle it or should I deal directly with your general manager?")

8. CONTROL OF RECEIVABLES

Make frequent aging of receivables to identify slow payers and assess DOS (days of sales) performance.

For external causes: visit selected customers to identify the reasons for delay which may include: incorrect documentation, invoice errors, order errors, credit claim delays, non-delivery, quality issues, etc.

For internal causes: investigate, slow invoicing, pricing complexities, credit note delays, shipment errors, poor expediting, discount errors, failure to drop poor accounts etc.

Benchmark with other companies, in collaboration with marketing,

production, quality, finance managers to jointly "own" the problem, set targets and monitor progress.

9. CONTROL OF INVENTORY

Make frequent aging of inventories to identify slow moving high value items and to assess DOP (days of purchases) and DOS (days of sales) performance.

For external causes: visit selected suppliers to identify the reasons for high inventory which may include: excess order quantities, long delivery lead times, poor standardization, lack of JIT systems etc.

For internal causes: investigate delayed usage, excess storage, lack of standardization, poor design specification, failure to control high value items daily, excess storage space and costs, lack of JIT systems, poor supplier selection etc.

Benchmark with other companies, in collaboration with production,

marketing, quality, finance managers to jointly "own" the problem, set targets and monitor progress

.

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10. INFLUENCE OF THE CHIEF EXECUTIVE

Age. experience, reputation, skills, attitudes and knowledge of the chief executive are key factors in the decision to finance expansion by banks. suppliers or merely reduce the working capital investment.

Overall expansion of sales involves increase in assets employed in the business; financing of those assets is a management decision; but there are many alternatives.

"Bridging" of long term needs by short term finance is acceptable provided the risk is clearly recognized and there is an achievable long term plan to recover financial health.

May accept temporary high risk, and unhealthy financial position provided:

high profits. planned recovery of health. planned reduction of risk to "normal" level.

Note:

1. Before every financial negotiation, always make other personal contacts to work out what you could do WITHOUT the other party ... and then negotiate (gently) from strength ... not weakness ... because you ALREADY have good alternatives ... without him ...

2. In 1995, many "quoted" public companies have major shareholders (pension funds, insurance companies etc. whio are better informed and more powerful than the small shareholders of the past.

3. Management may have a high "ego" priority to use "excess cash" for expansion and diversification projects. By contrast such shareholders may have priority for EVA targets in terms of dividends and SVA.

4. Thus the shareholders may insist that unless new acquisitions or mergers can achieve EVA, then the excess cash is better be returned to shareholders as dividends or share buy-back (equity capital reduction).

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1. BANK FINANCING

P P P P & S

2. CONTROL OF R & I

INTERNAL

EXTERNAL

3. CEO

CHIEF EXECUTIVE OFFICER

WITH NEW PRIORITIES: CUSTOMERS, EMPLOYEES & OWNERS

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PART I - SECTION 5 - REVIEW

A. CASES

1. ELIZA MANUFACTURING COMPANY

The 1995 financial forecasts indicate a doubling of sales but a stable inventory and a gross profit increasing from 32 to 37%. Is this a reasonable expectation? Why?

2. POTTER PRODUCTION

Financial director insists that he needs ECU 500,000 loan from the bank for working capital. What alternatives could be investigated?

3. BERTON INC.

CEO of the company is concerned with the increase in accounts receivable. List ten ideas for improvement.

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A. CASES - ANSWERS


No.Cannot expect inventory to remain stable when sales double. Need to justify such low inventory levels by operatIons research studies. Gross profit increase by 5% Also requires specific justification in terms of prices. costs. customers. etc. Overall financial forecast is difficult to accept without considerable explanation?

2. POTTER Production

Alternatives to a bank loan are as follows:

(a) Reduce investment in inventory. receivables and cash. (b) Stretch the suppliers.(c) Factor receivables. (d] Get suppliers to hold the inventory and deliver and invoice as required. (e) Lease rather than buy fixed assets. (f) Get long term loan or mortgage. (g) Expedite receivables wi'~ better credit policies, discounts and credit

control. Reduce cash reserves. Get customer deposits.

3. BERTON INC.

Ten suggestions for reducing accounts receivable:

1. Age receivables to locate slow payers. 2. Visit selected customers to identify causes of late payment. 3. Reduce invoice errors. 4. Speed up credit note processing. 5. Audit credit control procedures. 6. Improve documentation required by customers before payment. 7. Benchmark with other companies. 8. Involve marketing and production managers int he problem. 9. Check up on discount policies and compliance.10. Control sales expansion with better customer selection.

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B. SUMMARY LECRTURE


(a) Deals with four major problems:

1. Size - what size should the firm be?

2. Growth - what rate of growth of sales, assets, profits. etc.?

3. Financing - how should the firm be financed, and at what risk?

4. Investment - what kind of assets should be acquired, and at what rate?

(b) Financial health of the business depends upon both its resources, the environment in which it operates and its financial policies. Financial management is dynamic and depends upon SUSTAINABLE flows of cash and funds not a static situation.

(c) Most important is ... CASH FLOW and SURVIVAL ... to increase the long term value of the business for ALL of the "stakeholders": customers, shareholders, employees, managers, suppliers, banks, communities, government, trade unions, environmental groups etc.

(d) To achieve EVA (Economic Value Added), then in each division of the company:

OP/NAE times 100% must exceed CoC

OP = Operating profit after taxNAE = Assets less current liabiltiesCoC = Cost of Capital

(e) With EVA, company management can achieve SVA (Share Value Added). In quoted companies, shareholders may be powerful pension funds, insurance companies and mutual funds, who are highly skilled in finance; they may require Company Management to provide both dividends and increased share value ... or move over ... thus in 1995, SVA (Share Value Added) is becoming a key financial objective!

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2. OBJECTIVE. METHOD AND SKILLS

(a) Objective - increase the long term value of the business (EVA - Economic Value Added) and to achieve SVA (Share Value Added).

(b) Method - raise money and use it effectively to achieve standards of financial performance

(c) Skills - timing to balance risk and reward

3. SHORT TERM/LONG TERM FINANCING

(a) Short term finance used for: cash, receivables, inventory. prepayments, etc.

(b) Sources of short term finance: payables, banks, factoring, leasing, or reduction of the need for cash, receivables and inventory.

(c) Long term financing deals with long term assets and the financing of those assets by proportions of equity and debt.

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4. FORECASTING

(a) Cash forecasting used to provide cash resources up to one year ahead; concentrate on the duration and peak need within: weekly, monthly, yearly, seasonal, etc. periods.

Distinguish:

1. CF - Cash Flow - net profit plus depreciation

2. EBIT - Earnings before interest and taxes

3. OCF - 0perating Cash Flow - cash flow plus interest, less working capital changes less capital expenditure. Often called "Free Cash Flow" because it is cash available for new profitable investment opportunities.

(b) Funds flow reveals the key financial decisions of past and future.

Sources of funds: profit, depreciation, new equity and long term loans.

Uses of funds: fixed assets, dividends, repayment of long term loans and working capital.

Net working capital is: current assets less current Liabilities.

(c) Forecasted income statements and balance sheets reveal future financial health.

(d) Materiality is the key!

5. BANK RELATIONSHIPS

(a) Relationship with the banker is key to the management of working capital.

(b) Criteria for bank loans: person, purpose, profitability, payback, and then security.

(c) Many alternatives available to bank finance (they may cost more): factoring, deposits. loans, leasing. stretching creditors, other banks, etc.

(d) Old bank customers normally get better treatment than new ones Cultivate a relationship with your bank manager.

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6. FINANCIAL ANALYSIS

(a) LAPP system of financial analysis: liquidity (and gearing), activity, profitability, potential.

(b) Need to forecast cash and funds and provide adequate flows to finance assets acquired and required.

(c) Be creative in seeking and using financial alternatives.

(d) Avoid "emotional investment"

7. CONTROL OF WORKING CAPITAL

(a) Frequent (monthly) reporting with reliable financial statements, to ALL managers (marketing, production, finance etc.) so that they all "own" the working capital. Dupont charts may help managers to recognize how they an impact financial management.

(b) Regular and effective forecasting of peak and duration of cash needs. Timely financial data. Forecast forward the income statements, balance sheets, cash and funds and then evaluate risk.

(c) Never go to the banker when you need money; go when you don't need money and arrange to have it available when you want it. ("I need 500,000. Can you handle it or should I deal directly with your general manager?")

8. CONTROL OF RECEIVABLES

(a) Make frequent aging of receivables to identify slow payers and assess DOS (days of sales) performance.

(b) For external causes: visit selected customers to identify the reasons for delay which may include: invoice errors, order errors, late credit note claims, non-delivery, quality issues, incorrect documentation etc.

(c) For internal causes: investigate, slow invoicing, pricing complexities and errors, credit note delays, shipment errors, poor expediting, discount errors, failure to drop poor accounts etc.

(d) Benchmark with other companies, in collaboration with

marketing, production, quality, finance managers to jointly "own" the problem, set targets and monitor progress.

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9. CONTROL OF INVENTORY

(a) Make frequent aging of inventories to identify slow moving high value items and to assess DOP (days of purchases) and DOS (days of sales) performance.

(b) For external causes: visit selected suppliers to identify the reasons for high inventory which may include: excess order quantities, long delivery lead times, poor standardization, lack of JIT systems etc.

(c) For internal causes: investigate delayed usage, excess storage, poor standardization, poor design specification, failure to control high value items daily, excess storage space/costs, lack of JIT systems, poor supplier selection etc.

(d) Benchmark with other companies, in collaboration with production, marketing, quality, finance managers to jointly "own" the problem, set targets and monitor progress.

10. SIMPLIFIED - COST OF CAPITAL, EVA AND SVA

(a) These are all complex concepts. In very simple terms, the Cost of Capital (CoC) is the WEIGHTED (E:D) average after-tax cost of raising long term funds for the business.

(b) Such funds can be either from long term debt (liabilities) or equity. Normally debt (say 8%) costs less than equity (say 16%).

(c) Hence the E:D ratio set by Management (2:1 or 1:1 or 1:4) can affect the average Cost of Capital (say 13.3% or 12% or 9.3% - can you check these computations?).

(d) EVA (Economic Value Added) is produced when the net assets employed (A-CL) produce an OP (operating profit after tax, say 11%) which is greater than the Cost of Capital (say 9.3%).

(e) Valuation of a company or share, relates not to profits but to future cash flows. It may be simply computed as:

V = OCF/(r - g), where:

OCF = Operating Cash Flow (100)r = Cost of Capital (say 9.3%)g = Growth Rate (say 5.3%)V = 100/(0.93 - 0.53) = 250

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(f) SVA (Share Value Added) is produced when the sustainable cash flows and dividends lead to increased short term and long term share value, as related to the share index by the Beta coefficient.

(g) Most companies control capital expenditure well but fail to

control investment in working capital, which is part of NVE (net assets employed) and therefore critical to achieving EVA and EVA.

11. DIAGNOSIS AND DECISION

(a) Recognize that every industry and trade and country has a special tractional environment and standards of financial management.

(b) Knowledge, attitudes, and skills force the financial manager to be creative.

(c) Diagnosis helps the financial manager to distinguish short term from long term problems.

(d) Ensure that short term financial policies arc consistent with long term goals.

(e) Provide for both short term and long term financial health at appropriate risk levels.

(f) Manage the WC or it will manage itself - very badly!!

(g) Always seek the seven alternatives before making a financial commitment!

Note: Past attitudes may sometimes deter new financial policies for reducing assets or increasing sources of finance.

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S (size), G, F & I .... CASH FLOW .... EVA/SVA

2. COST OF CAPITAL

WEIGHTED AVERAGE COST OF EQUITY AND DEBT (LIABILITIES)

HURDLE RATE FOR EVA

3. OPERATING CASH FLOW

NET PROFIT PLUS DEPRECIATION PLUS INTEREST LESS CHANGES IN WORKING CAPITAL AND CAPITAL EXPENDITURE

PROVIDES CASH FOR: NEW PROFITABLE INVESTMENTS

INCREASED WC IS AN INVESTMENT!

4. EVA/SVA

OP/NAE TIMES 100% - MUST BE GREATER THAN CoC

VALUE = OCF/(r - g)r = Cost of Capitalg = Growth Rate

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PART II SECTION 1 - CREATIVE ACCOUNTING

1. FINANCIAL STATEMENT OBJECTIVES

Financial statements are : income statements profit and loss accounts), balance sheets and funds flow statements.

Objective - not scientific accuracy, not "correct", but rather "useful credible estimates for all parties concerned". Must be credible.

Financial statements for banks, shareholders, management, suppliers and tax authorities may differ. Company may have several different balance sheets but the auditor normally signs only one.

2. ACCOUNTING PRINCIPLES AND TAX LAWS

Financial statements affected mainly by accounting principles but also by company and tax laws.

Accounting principles that help us to translate records into financial statements are: cost, conservatism, consistency, true and fair, comparability, accounting period, entity, matching and materiality.

Matching means associating the relevant costs and revenues in the same accounting period.

Materiality is the key accounting principle. Big amounts are important; small items are not significant! Don't bother about small amounts or minor accounting errors; "don't polish peanuts, however "satisfying" that may be. Look for the "coconuts" ...

Although influenced by company and tax law, are mainly the work of professional accounting institutes; they enable financial statements to be "reasonably" true and fair.

In managing working capital we have to use financial statements and therefore we must understand (just how "true and fair" they may or may not be ... and "financial statements prepared in accordance with the company law" ... means ... ALMOST NOTHING as regards IAS ...

I.A.S. (International Accounting Standards) bring some consistency to varying national accounting principles, rules and standards. Always ask for the profit according to IAS!!

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3. COMPANY AND TAX LAWS

Company law sets provisions for a minimum disclosure of information in published financial statements; often very little useful data is disclosed!

Financial statements "in accordance with law" are not necessarily "true or fair" or even useful to management.

Management needs the "real figures".

Competitors may get more information from other sources than from financial statements e.g. suppliers.

Company law eventually follows some generally accepted accounting principles, but may he grossly conservative ... especially in Suisse ...!)

Tax law sometimes requires transactions to be recorded in the books to qualify for tax relief; this leads to poor accounting principles and distorted financial statements. (Watch out for it in the notes to the financial statements).

Many companies maintain separate books and financial statements for tax purposes and thus avoid distortion of the management accounting. Be careful when there are several sets of books ... one for the bank. one for the tax people. one for my partner, and one for me ...

4. CREATIVITY (MANIPULATION)

Myth is that financial statements are "correct" - reality is that they are normally manipulated in some way.

Manipulation means "adjustment" in accordance with accounting principles which gives most useful result for the purpose required; not illegal but may be unethical!

People who manipulate never call it "manipulation"; they say it is "being realistic" or "being conservative" or "being practical" or the only thing we could do".

Generally accepted accounting principles provide a wide scope for manipulation since mere disclosure of changes in notes to the financial statements often satisfies the Auditors who (still!) assume that all readers are expert accountants.

Excessive inconsistencies and changes in accounting principles, however. compel the Auditor to "qualify" his report; auditors seldom actually do so because they may thereby lose a client.

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5. CREATIVE TECHNIQUES

Manipulation within accounting principles may be achIeved in many ways. but the general rule ie: don't manipulate the profit unless you really have to

To increase the profit of the year therefore:

(a) Defer costs - treat costs as balance sheet assets rather than

expenses. i. e. R & D, advertising, pre-pre-production costs.

(b) Minimize accrual for liabilities - don't provide for all potential losses.

(c) Release reserves into the income statement or charge losses to reserve. Revalue capital assets to create~ capital reserves against which to charge special losses.

(d) Fixed assets - "capitalise" as much as possible; depreciate over long "horizons" to reduce the annual depreciation charge.

(e) Consolidated financial statements - but don't consolidate subsidiary making heavy losses because it will "distort the position". Alternatively arrange for such subsidiaries to be less than 51% owned at the year end. Acquire and consolidate profitable subsidiaries.

(f) Careful treatment of exceptional losses - charge losses to reserve or accumulated profit rather than to the income statement to "avoid distorting the profit of the year".

(g) Timing - sell assets now at a profit or defer selling them at a loss and thus increase the profits of this particular year.

(h) Inventory - be optimistic! Don't be too conservative; don't write off too much obsolete inventory yet ...

(i) Profit - take profit on uncompleted contracts.

(j) Forex - take profits, but defer losses and contingent liabilities, which are so difficult to identify and evaluate.

Note: Conversely to reduce the profit this year ...

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6.0 DETECTION OF CREATIVITY

To detect manipulation, study the notes to the financial statements very carefully for inconsistencies in accounting principles and watch for:

(a) Deferred and intangible assets which cannot be justified.

(b) Changes in inventory valuation and investment values.

(c) Charges of profits or losses not to the income statement but

to reserves or accumulated profit.

(d) Release of reserves into profit without specific disclosure.

(e) Accruals noted but~not actually provided for.

(f) Vague reserves which are not clearly equity or debt.

(g) Investments in subsidiaries not consolidated. (Why?)

(h) Increased amounts for "goodwill" in the balance sheet, which

are not being written off over five years.

(i) Forex profits and losses.

(j) Pension fund provisions.

(k) RECONCILE THE PROFIT WITH IAS!!

(l) Search for extra-ordinary contingent liabilities for FOREX (foreign exchange), derivatives, legal and leasing commitments which may be "material" (significant) !!

Note: Ignore the "peanuts" ... look for the "coconuts" ...

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7. ROLE OF THE AUDITORS

In theory the Auditor is employed by the shareholders under the law to protect the interests of the shareholders; in reality he is hired by the management to satisfy the law and add credibility to published financial data; as an "honest professional public accountant"; he protects his own interests but "bends occasionally to meet the reality of the situation".

Auditor charges an appropriate fee for making a report on the financial statements; he merely tests the records and does not guarantee their accuracy or the absence of fraud.

Professional standards of auditors in United States, Holland, England, UK, New Zealand, South Africa, Canada, etc. are much stronger and sometimes very different from (so-called) auditors in other countries.

Auditor who is not independent, not a professional public accountant and has no public reputation cannot always be expected to give an unbiased opinion.

An Auditor not satisfied with financial reports must persuade client to change financial statements by appropriate notes or finally he must qualify his report.

Auditor is "flexible" to changes in accounting principles when the tax law changes; particularly concerned with not overstating the financial position but happy for it to be understated without comment. In some countries financial statements are expected to be very conservative and not necessarily at all true or fair.

Evaluate the auditor's work not by his professional qualification alone but by his name, reputation, fee, independence and local financial norms!

Note:

A delay of more than 2 months in publishing professionally audited financial statements must ALWAYS ... be a "financial danger alarm bell" ... alerting you to look carefully for signs of ... creativity ... contingent liabilities ... off- balance sheet financing" ... FOREX losses ... environmental legal claims ... or even missing funds ... and other financial disasters ... everywhere ... and especially in developing countries ...

because so often ... the "auditors" ... who appear to be reliable ... may in reality ... NOT BE ... as professional ... as independent ... as IAS oriented ... or as adequately paid ...

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so be careful ... and put the audit credibility .. into in your PFD ...

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8. DECEPTIONS IN FINANCIAL REPORTING

Figures for a purely normal year may be reported by the Chairman as "exceptionally good" by employing the following devices:

(a) Quote the amounts of differences without indicating the - relative difference to the whole.

(b) Quote small difference amounts in terms of large percentage changes.

(c) Quote aspects of transactions that are improving and avoid the depressing aspects.

(d) Choose a bad prior year as a standard of comparison such that the present year appears to be a substantial improvement (compared with the carefully selected bad prior year).

(e) Attribute profit increases to good management.

(f) Attribute losses to "consolidation for the future, "unfair competition", the "depressed economy" or "government policy".

(g) Point out exceptional profits and losses only if they support the case.

(h) Similarly conceal losses by charging capital reserve or accumulated profit (not the income statement).

(i) Improve capital reserve by revaluing certain fixed assets and then charge off the losses to capital reserve.

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8. DECEPTIONS IN FINANCIAL REPORTING

(j) Quote all figures but only compare certain of them with prior performance.

(k) Show only those financial ratios that appear to indicate improvement over the past years; ignore others; choose a basis to compute the ratios that suits the case.

(l) Release secret reserves by changes in policy for inventory and investment valuation, depreciation and contingencies.

(m) Quote profits before or after income tax as appropriate.

(n) Quote employee numbers; increases result from "expansion" decreases result from more efficient operations".

(o) Increase the volume of information in the annual report: add more maps, graphs and pictures!

(p) Consolidate or do not consolidate subsidiaries.

(q) Continually point out that financial statements have been prepared so as to avoid distortion of figures which could mislead the shareholders.

(r) Make a restructuring charge and blame the retiring CEO ... and announce a recovery for next year ...

Key Note:

1. Profit at the front of the Annual Report may "disappear" in the small print of the notes to financial statements.

2. Always check the reconciliation of the net profit figure with IAS, and you may sometimes be AMAZED ...!!

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9. PRACTICAL APPROACH TO ACCOUNTING PRINCIPLES

(a) If current year's profit is adequate. be conservative and:

1. Charge off all losses to the income statement either as operating or non operating costs.

2. Charge off all R & D, advertising and deferred costs as soon as possible.

3. Take all profits into the income statement either as operating or non operating income.

4. Don't change accounting principles unless absolutely necessary.

(b) If current year's profit not adequate, be less conservative:

1. Defer costs or charge them to reserve

2. Take profits on working process to date

Note: Keep "credibility gap" to the minimum but if you HAVE to HAVE A LOSS ... AND IT IS ... "inevitable" then make a it a "big one" ... with "restructuring" ... and announce a "recovery in the current year" ... immediately ... with a new CEO ...

10. FINANCIAL POLICIES

Need for financial policies to provide for EVA/SVA with sustainable cash flow and profit which provides for the health and continuity of the business.

Financial management does not avoid risk. It balances risk and return.

Strategy, TIMING, knowledge, ATTITUDES and skills of the financial manager are critical in setting successful financial policies .

Financial statements must occasionally be manipulated ("window dressed", "adjusted within the law". "modified in accordance with accounting principles", "creative". "practical" etc.)

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11. FINANCIAL ETHICS

Answer the following questioned in your notebook:

(a) Should financial statements for shareholders always be true

and fair and disclose reality? Even when (possible) disclosure of a dangerous position could lead to a disaster which might be avoidable?

(b) Can several alternative financial statements all be equally true

and fair?

(c) Would you legally "creative" in a financial statement to gain

time for your company's survival?

(d) Who really decides what profit is shown in each year's financial statements? Accountants? Auditors? Management?

(e) Who knows best what to do with "excess" cash? Management? Or major Shareholders?

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1. CREATIVE ACCOUNTING

TAX LAWSCOMPANY LAWSGAAPIASAUDITING STANDARDS ...... BUT STILL ... CA

2. FINANCIAL POLICY

BALANCING RISK AND RETURNTIMING IS THE KEY

FOR EVA ... AND SVA

3. CASH FLOW

CASH IS A FACT!PROFIT IS JUST AN OPINION!!

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PART II - SECTION 2 - CASE STUDIES 1. ELIZA MANUFACTURING COMPANY

The 1997 financial forecasts indicate a doubling of sales but a stable inventory and a gross profit increasing from 32 to 35%. Is this a reasonable expectation Why?


Financial director insists that he needs ECU 500,000 loan from the bank for working capital. What seven alternatives could be investigated?

3. REES DEVELOPMENT INC

A bank loan of ECU 100.000 was requested but the bank refused. Chief Executive suggests changing banks immediately! What difficulties and opportunities would this give my company?

4. GLADSTONE BAG COMPANY

Old established company has a policy of paying all suppliers before time and never borrowing anything from anyone. Management is convinced that this is the way to do business and good financial management. Do you agree?

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10. MINICASES - QUESTIONS

5. DOUGLAS COMPANY

Banker with whom company had an account in credit balance for many years responds to request for a small loan by immediately demanding security. What to do? Why?

6. MERVILLE HOLDING

Management insists that to achieve increased sales, the inventory and receivables must increase substantially. What can be done to manage inventory and receivables?

7. PROFELD COMPANY

Company needs more credit from suppliers to provide substantial financing and requests guidelines as to how creditors may be "stretched" (seven ideas).

8. ZONDI COMPANY

Company's profit is low this year and management seeks to manipulate it higher to avoid complaints from the shareholders. What methods could the company consider which are in accordance with accepted accounting principles? (seven methods)

9. OUALO COMPANY

Due to sale of an investment, the company suffered major loss this year which will upset shareholders and cause the share price to fall. No capital reserve available but company buildings are undervalued. What can be done to avoid showing a loss this year?

10. WILLIAMS BANK

Client with large loan sends monthly reports to its bank six to eight weeks late because "the auditors are in. and no information is available for two months". Reasonable?

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PART II - SECTION 2 - CASE STUDIES (cont.)

11. HOLMES WATSON COMPANY

Auditor insists that no one in the company should use green ink and, further. that company must make 27 small adjustments each for under ECU 100 so that the books are "totally accurate". What can management do?

12. TIM TOM COMPANY

Profit will be well over budget and company wishes to reduce the profit disclosed this year, so as to keep "a little in hand for the future". Chief Executive suggests acquiring another company which is losing money and then consolidating the figures. Is this acceptable? What alternatives available?

13. GILLIE GOLF COMPANY

Bank requires company to submit financial forecasts to justify application for substantial bank loans. Company insists that the position is so uncertain that forecasts would not be useful. What is your opinion

14. LATE CHRISTOPHER COMPANY

Company owned by its executives seeks a small loan from the bank. Bank insists that in addition to normal company security. each executive should sign an unlimited indefinite personal "joint and several guarantee" to me bank for the loan. Is this reasonable? Should they agree?





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17. DOUGLAS COMPANY

Banker with whom company had an account in credit balance for many years responds to request for a small loan by demanding security. What to do? Why?

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PART II - SECTION 2 - CASE STUDIES - ANSWERS

4. SUTHERLAND COMPANY

Ten suggestions for reducing inventory:

1. Aging of the inventory. 2. Identify high value items.

3. Identify slow moving items. 4. Dispose of obsolete items. 5. Standardization to reduce the number of parts. 6. Operations research inventory computations. 7. JIT systems. 8. Reduce production volume. 9. Benchmarking with other companies.10. Get production, marketing and finance to own the problem.

5. MARC COMPANY

Expansion can be financed with increased, thus the E:D ratio could move from 2:1 to 1:4. But the risk of failure is higher and the Cost of Capital would change.

6. MERVILLE HOLDINGS

Increased sales will probably require some WC expansion ahead of the sales ... but he might ... manage the inventory investment by: operations research, better purchasing, JIT, getting suppliers to hold inventory until required ... and he might manage better receivable investment by: factoring, credit control, customer selection, cash sales, quicker billing, expediting customers, deposits. etc.

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PART II - SECTION 2 - CASE STUDIES - ANSWERS (cont.)

7. PROFELD COMPANY

Suppliers may be stretched as follows:

(a] Pay each supplier a little regularly and keep him happy with "extra orders" promise.

(b) Insist that as an old and loyal customer. supplier must give better credit terms.

(c) Tell supplier that his competitors are offering longer credit terms.

(d) Place large orders on condition that extra credit terms are granted.

(e) Ask supplier to supply copy invoices and thus delay payment.

(f) Query the prices and amounts thus delay payment.

(g) Take unreasonable discounts and take time negotiating so as to complicate the account thereby making it difficult lo expedite.

(h) Pay the wrong amount on invoices and statements thereby confusing the supplier accounting system.

8. ZONDI COMPANY

Manipulation (creative accounting) for a higher profit may be achieved by various methods:

(a) High (less conservative) inventory values. (b) Capitalise heavy maintenance a fixed or deferred asset. (c) Depreciate fixed assets over longer "horizons" (working lives),

certified by engineers.

(d) Defer advertising, R & D and other expenses. (e) Keep accruals and reserves to the minimum. (f) Release reserves into profits.

(g) Charge losses to reserve or accumulated profits.

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(h) Acquire profitable subsidiaries and consolidate. (i) Sell fixed assets and investments a profit and take it in the income

statement.

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PART II - SECTION 2 - CASE STUDIES - ANSWERS (cont.)9. QUALO COMPANY

Revalue the building in the books and credit the difference in value to capital reserve; then charge the loss on the sale of the investment to capital reserve thereby not reducing the profit of the year. Make a note in the financial statements to indicate the change to reserve and explain that it "avoids distorting the figures for the year".

10. WILLIAMS BANK

Do not accept that the auditors are responsible; insist upon regular timely reports. Auditor is often used as an excuse to expedite payment or delay information on poor results.


Point out that the auditor is working for the company and the key accounting principle is materiality. not "peanut polishing". Buy him a bottle of yellow ink. Let him "note the adjustments" but refuse to make them in the books. Refute the idea that the financial statements are accurate and insist that they are only useful estimates. Allow the auditor to qualify his report if he dares ....!!! He won't!!!

12. TIM TOM COMPANY

Manipulation of the profit this year could be achieved by acquiring a loss company; the other methods are also useful

(a) Reduce the inventory value by being more conservative.

(b) Set up reserves and accruals for every conceivable loss.

(c) Postpone the sale of a fixed asset (at a profit) or sell it sooner (if it makes a loss).

(d) Charge all losses to income statement and not to capital

(e) Expense small fixed assets (and even larger ones).

(f) Reduce the working life (horizon) of fixed assets so as to increase the annual depreciation.

(g) Write to the lawyer to find out about possible legal liabilities for damages or claims; accrue for them in the books.

(h) Write down the value of investments or any assets which are

53

over-valued and charge the loss against profits.

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Forecasts are especially necessary when the financial position is so uncertain. Suggest alternative forecasts of high, low and probable estimates, so as to give some idea of the range of risk. Financial forecasts are always useful as part of financial decision-making. They are no substitute however for good business experience and intuition.


Normal for banks to require personal guarantees when they lend money , to companies owned by their own executives. However, ensure that the guarantees are for specific limited amounts over specific time periods. Avoid unlimited indefinite guarantees. Donate assets to wives and other relations to avoid total personal loss should the guarantors be called upon to pay (and beware of divorce!) Remember guarantor of a debtor can always sue the debtor if he feels his liability is in jeopardy.

15. REES DEVELOPMENT INC.

Changing banks provides financial flexibiLity but batter alternative V Is to keep both banks and play off one against another. Old bank will give us better service as an existing client, but the new bank may seek to get our business and thereby force the old bank to give us more. Keep relationships with both bankers in a healthy condition despite the competitive situation. Keep both accounts active. Never let a bank account lie idle.


Paying suppliers before time ias never justified. Pay early to get discount. Otherwise don't pay until required to pay. Company probably has excessive equity. Failure to use "debt capacity" is not good financial management.

17. DOUGLAS COMPANY

Banker is unreasonable although the company has failed to establish a "track"' record of borrowing and successful repayment. Insist upon a small overdraft without security other than the integrity of the company name~ Arrange alternative finance with another bank. then return to the first bank with this information and request him once again to make the loan. Alternatively suggest to assistant manager that you need a loan

55

and ask "can you handle it or should I deal with the General Manager"

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PART II SECTION 3 - FINANCIAL MANAGEMENT II

1. FINANCIAL MANAGEMENT AND RISK

Financial management plans the sources and uses of funds to achieve objectives.

Key objective is to increase the long term value of the business. Share value depends upon seven key drivers: sustainable cash flow, sales growth, operating profit margin, tax rate, working capital, fixed assets, cost of capital and the growth duration period.

Financial management takes risk in a balanced way. Risks include economic risk. marketing risk. production risk, technological risk and, above all in international business. political risk. All risks end up as financial risk.

Before making a financial decision. seek all available data. Analyze to seek out all possible risks and measure the extent of those risks. Seek all alternatives and avoid "emotional investment in traditional financial practices". Financial management is creative not defensive!

2. TECHNIQUES OF FINANCIAL MANAGEMENT

Financial techniques aid management but are no substitute for business acumen and an intuitive feeling for business problems.

Techniques include:

Ratio analysis (LAPP system) Forecasting of funds flows and cash flows.Forecasting of income statements and balance sheets Capital investment and cost of capital analysisEVA/SVA analysisEarnings per share analysis (EPA)Break-even analysis Creative accounting (manipulation) concepts. Intuitive assessment of potential contingent liabilities (leasing, environment etc.)

Note:

The key technique in financial ANALYSIS is simply to compare the large amounts with past, budget and industry by amount and ratios, to check that they are "internally consistent" and to fully investigate reasons for differences.

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3. CONTROL

Control of a company is not merely 51% of the shares. but the ability to influence the Board of Directors; may arise from as little as 8% of shares outstanding.

Control by influence in good times changes rapidly when disaster strikes.

Effective financial management provides earnings, growth and dividends which shareholders need and thereby ensures management control for the future.

"Poison Pills" are management schemes to prevent "take-over" of a quoted company. In practice they may deter a "take-over" in the short run and give management time to change its policies from unprofitable "expansion and diversification" to the key priority for EVA/SVA.

4. SHORT TERM FINANCING

Determine whether the financial need is really short term rather than long term. i.e. that funds are adequately available in the long term.

Look for the peak and duration of short term requirements.

Plan for cash flow and for OCF that provides cash for new investment opportunities. The key OCF drivers are: trading profit, sales growth, WC management, fixed asset management and tax law.

Make financial projections that look for "daylight ahead", i.e. profitability and financial health now and in the future.

Be creative in seeking sources of finance. Set financial strategies that reflect management's attitude towards risk.

Personal relationships in the financial community are the real key to financial success - not what you know but who you know ... that will provide cash when you really need it.

Be skillful in financial forecasting but be skeptical about the result. Question the underlying assumptions and make alternative computations.

Search out the possible disasters and meet them as part of the normal planning process.

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5. APPROACH TO WORKING CAPITAL MANAGEMENT

May involve:

Getting all of the managers involvedInvestment in cash, receivables and inventory -Managing cash. receivables and the inventoryGetting suppliers to hold inventories and invoice laterGetting customers to order and pay better

JIT as appropriate

Sources of funds -

Stretch the suppliers Bank loans

Leasing Factoring

Field warehousingGrey market operations (borrowing from financial markets but not through the banks!).

Note:

"Get a favorable "track record" of borrowing and repayment as a financial lifeline for the future".

6. BANK AND BORROWER OBJECTIVES

These are not the same.

Bank tries to be reasonably conservative in selecting alternative uses for its limited money.

Borrower seeks to take risk by using borrowing (debt) as financial leverage and thus increase profitability of his equity.

Banks do more for old clients than for new ones because risk seems to be lower.

Banks prefer borrowers to have only one source of funds (the lender) whereas borrowers prefer to have multiple sources.

Non-bank lenders often make substantial loans if they get not only interest but "a piece of the action" (some equity participation).

Note: Always set up a good alternative ... BEFORE negotiating with the bank manager ... negotiate from strength ...

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7. LIQUIDATION

Default on borrowing makes a company liable to liquidation (as one of SEVEN alternatives ...).

Liquidation values are low because trade buyers normally "step back and wait for values to fall".

Generally compared with book values, fixed assets (except real estate) produce about 40%, inventory about 25% receivables about 60%,thus leading to substantial losses.

For this reason many lenders avoid actually liquidating a defaulter.

Secured creditors get paid first and unsecured creditors may get little on liquidation.

The "easy" alternative of continuing the business may be costly since overheads continue and losses often increase very substantially before recovery.

If a bank sells a defaulting business, it can often offer special financing to a strong buyer and thereby get a good price.

"Company doctors" succeed in reviving poor businesses not merely by financial skills but also by the reputation and the debt capacity they bring with them.

Assessed tax losses may be an "asset" of the business.

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8. EQUITY AND DEBT

a. The equity:debt relationship of a company is a measure of risk, debt capacity, leverage and ability to borrow.

b. There are various way of computing the E:D ratio:

1. A simple computation relates Equity to Total Liabilities.

2. An alternative ratio is to relate Equity to only Long Term Debt.

3. Another alternative ratio is to relate Equity to only Net Long Term Debt (debt less cash and marketable securities).

c. In simple computation an E : D of 2:1 is always very strong but

attracts "cash hungry" take-over bids. A ratio of 1:1 is reasonable, but some industries or companies accept an E:D of 1:4 quite happily. It depends upon norms of the industry, the financial community and the country!

d. Attitudes towards profit and risk depend upon the personal values and experience of the Chief Executive. The timing of the risk-taking seriously affects its success or failure. Timing is the key!

e. A company may take a higher risk with E:D of 1:4 to finance expansion; the smaller equity base is a lower cushion to protect creditors; a temporary poor E:D ratio enables "bridging" until longer term finance is available - a risk of failure.

f. Long term assets should normally be financed with long term money, but they may be "bridged" from short term funds if long term financing is more easily available, later or if equity or retained profits become available later.

g. Leasing of long term assets saves cash but may distort the financial statements, since assets and liabilities may not always be shown on the balance sheet. Thus then E:D looks better ... but is NOT!!!

h. This "OFF BALANCE SHEET FINANCING" may have to be revealed by capitalising the lease as an asset and a liability, as well as a note to financial statements. It may be a "Material" contingent liability!! And it is usually expensive!!!

h. Similarly refinancing long term liabilities with "derivatives" to reduce interest rates has become a normal financial technique, which always requires careful investigation.

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9. THE FINANCIAL MANAGER

a. The financial manager needs not only knowledge and skills in accounting and finance, but also the "right" attitude towards risk-taking. Timing is the key!

b. Understand the effect of increased activity on assets required and the importance of planning cash flows.

c. Seek all "seven" alternatives before making any major financial decision. Do a PFD (provision for disaster) brain-storming, just to be sure that you have considered everything that could go wrong ... always useful to check that the underlying assumptions will CONTINUE to be valid for the future ... especially in developing countries ...!!

d. Financial risk in the 1990's may come more from politics, FOREX and technological change than from "normal" marketing and production operations.

e. Need to develop changing financial polices that anticipate change ... not merely react to it ...

Note:

Remember: FOREX and inflation are "normal", and thus "debt" (payables) may be a "hedge" against risk and an opportunity to ... benefit ... from it. Rethink carefully the continuing validity ... (or not) ... of the assumptions underlying your ... (very reasonable) ... financial policies and forecasts ... they may be 80% wrong!!

Remember: every financial community and country has its own "norms" of what is ... "financial health" ... what are ... "financial ethics" ... and they may differ very widely indeed ... and the law may take no action at all!!

Remember: a basic familiarity with company and tax law may enable the financial manager to make more effective use of ...

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"expert" financial advice ...

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1. LIQUIDATION VALUES

LOW LOWER ... LOWESTTIMING IS THE KEY

2. EQUITY : DEBT

SIMPLE - EQUITY : TOTAL LIABILITIES

ALTERNATIVE - EQUITY : LONG TERM DEBT

NET ALTERNATIVE - EQUITY : NET LONG DEBT (LTD-C)

3. FINANCIAL ETHICS

TIME?PLACE?LOCAL LAW?INTERNATIONAL LAW?CULTURE?CUSTOM?ECONOMY? PRESSURE?

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PART II SECTION 4 - KEY LEARNING POINTS

See Part I Section 2

PART II SECTION 5 - LEARNING MAINTENANCE

Quiz - see appendix

Learning maintenance program

1. Objective - to ensure that learning from the course is both maintained and reinforced.

2. Help - discuss problems arising with your local Controllers, and for any outstanding questions, do not hesitate to FAX us for whatever assistance may be needed.

3. Routine -

a. Play the LRT (Learning Recall Tape) several times to reinforce the your learning recall, achieve deeper understanding of EVERY aspect of the course, and to identify the learning materials that will require extra study time.

b. Study the WSJ for at least 20 minutes daily. Use the special note

provided, to interpret the more difficult technical sections.

c. Review all course learning materials.

d. From day 15 onwards, study the text book - Corporate Financial Analysis (CFA) (Harrington).

e. On day 34, complete the quiz of 100 questions (open book) and return it to the Organizer with your mature feedback on the course content and its direct application to your area of responsibility.

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APPENDIX A - GLOSSARYSHORTHAND

ENGLISH OTHER LANGUAGE

A assetsAP accounts payableAR accounts receivableBS balance sheetCA current assetsCA:CL current assets:current liabilitiesCF cash flowCGS cost of goods soldCGS/I cost of goods sold/inventoryCoC cost of capitalCOS cost of salesCL current liabilitiesD debt (liabilities)EVA economic value addedEX expensesE equity (owners equity)EBIT earnings before interest and taxesFA fixed assetsGP gross profitI inventoryIAS International accounting standardsIS income statementL liabilitiesLAPP liquidity, activity, profitability, potentialLTL long term liabilitiesNP net profitNWC net working capitalOA other assetsOCA other current assets (except cash)OCF operating cash flowOE owners equityQA quick assetsQA:QL quick assets:quick liabilitiesQL quick liabilitiesS salesS/A sales/assetsSVA share value addedWC working capital

NOTE: Please note symbols are a shorthand for learning ...

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MAIN GLOSSARY

ACCOUNTING PRINCIPLES - Generally accepted accounting principles set by public accounting institutes to facilitate"fair" financial statements. Not the same as tax or company laws. Accounting principles are usually confusing and contradictory so that manipulation of financial statements is possible. Principles include: cost, consistency, conservatism,accounting period, entity, going concern, profit realization,matching, and materiality. Key principle is materiality.Changes in the principles must be noted in the financial statements.

ACCUMULATED PROFIT - Retained earnings, revenue reserve, earned surplus, surplus retained in the business. Profit of previous years accumulated in the business and not yet distributed as dividends. Often used instead of current year's income statement to charge special losses (this is poor accounting practice!) Charges to accumulated profit are not reflected in earnings per share (EPS). Not capital surplus or capital reserve.

AGENCY THEORY - Concept that Management must make the shareholders "happy" (with SVA) or at least "happier" than some take-over management. For quoted companies major shareholders (pension funds, insurance companies, mutual funds etc.) may not be "passive" and may demand EVA and SVA performance to industry standards.

ALTERNATIVES - All financial problems have alternative solutions many of which are never considered because they do not comply with the personal attitudes and values of the parties concerned. Seek all alternatives before making financial decisions.

ASSET - Valuable things owned by a business must be reasonably valued in financial statements. Excessive under/over valuation distorts financial statements and makes all financial ratios misleading.

ASSUMPTIONS - Fundamental facts about the environment which underlay all financial forecasts. Need to be skeptical to seek out alternative assumptions, evaluate their reality and possible effects. Prepare alternative financial forecasts on different assumptions to test the sensitivity of the results.

AUDITORS - Appointed to give an opinion on the annual financial statements of a company. Usually professionally qualified public accountants. Appointment depends upon the law and company regulations. Should be independent, qualified and adequately paid for effective work to acceptable auditing standards. Anglo-Saxon public accounting firms have high professional standards. Strongly influenced by the norms of the local business community. See Qualified Report.

AUDITING STANDARDS - Professional standards for testing accounting records before giving opinion as to their fairness. Related to company law but normally more stringent. Failure to comply with auditing standards leaves the auditor

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liable to be sued for damages

BANK - See Commercial Bank and Merchant Bank.

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BANK FINANCE - Generally short term (overdraft) loans and in theory repayable on demand". In practice banks seldom require repayment unless the account is in jeopardy; many short term loans become semi-permanent working capital for the bank's clients.- Key factor is relationship of banker with client. Criteria for a loan include: personal reputation, purpose, payback, profitability, security. Bank finance may also be long term by special agreement including restrictions on capital expenditure, dividends, mortgages, etc. Commercial banks prefer short term financing but have associates who provide every sort of financial service.

BANK RELATIONSHIP - Key to bank financing is confidence of banker in his client. Visit the banker before the need for cash arises. Never make false statements to a banker but decide how much to tell him.

BANK SERVICES - Commercial banks provide an increasing range of services from receiving deposits, making advances, custody of important documents and assets, managing investments, commercial intelligence, exchange control, import export financing, and through associates all merchant banking activities. BETA FACTOR - Relationship between change in a share price and changes in the share market index. Beta of 1.0 indicates a consistent relationship. Use in the computation of share value.

BRIDGING - Finance of long term needs by short term money until it is more convenient or less expensive to raise appropriate long term finance,

CAPITAL EXPENDITURE - Technical accounting term meaning new investment in long term fixed assets, equipment, investments, etc. CAPITALISE - Technical accounting term meaning to carry forward as an asset in the balance sheet rather than charge to expense.

CAPITAL RESERVE - Capital surplus; special reserve in the equity part of the balance sheet arising from share premium or revaluation of assets, Not available for dividend but often used to write off special losses and thus provide opportunities for manipulation.

CASH - Cash in hand but mainly in the bank. Cash forecasting and planning is essential for financial management; cash is more important than profit especially in difficult times. Need to continually plan well ahead to have cash available at right time and at right price. Cheapest cash is suppliers money (once discounts have been lost) then bank finance, factoring, etc.each becoming more expensive. Cash forecasting and control is the key to business survival.

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CASH FLOW - General term meaning cash "throw off" computed as net profit plus depreciation. Also used to mean cash forecast, Cash flow "drivers" are: trading profit, sales growth, WC management, fixed asset management and tax rates. Distinguish:

1. CF - Cash Flow - net profit plus depreciation

2. EBIT - Earnings before interest and taxes

3 OCF - 0perational Cash Flow - cash flow plus interest, less working capital changes less capital expenditure. Often called "Free Cash Flow" because it is cash available for new profitable investment opportunities.

CLEAN SURPLUS CONCEPT - Concept that all profit and losses, operating and non-operating, should be charged through the income statement of the year and not concealed by charging accumulated profit or reserves. Ensures that profit manipulation is minimized Not always followed by some major companies, but becoming compulsory in U.S.A. U.K., etc.

COMMERCIAL BANK - Normal bank taking deposits and lending shorter-term money. Not a merchant bank.

COMPANY LAW - Legal framework for companies including accounting records and disclosure in financial statements. Sets the minimum standards for disclosure in financial statements and in the long run follows accounting principles. Financial statements "in accordance with the law" may not be true nor fair. Excessive conservatism is often permitted by the law - this could be manipulation!

CONSOLIDATION - Technical accounting term for financial statements prepared for a holding company and its subsidiaries together showing all the assets. Vital to evaluate financial health of the "holding company".

CONTINGENT LIABILITIES - Possible liabilities not provided for in the financial statements e.g. financial obligations, environmental damage, legal claims etc. May be a material factor in assessing financial health of a company. See FINANCIAL INSTRUMENTS.

CONTROLS - Financial control depends upon timely and useful financial statements. Good audited statements are essential for dealings with outside parties. Difficult for the lender to control the borrower without continuous personal contact."Membership of the board" alone may not provide control.

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COST OF CAPITAL - Complex concept. Simplified, the WEIGHT (E:D) average after tax cost, of financing from long term debt or equity. If debt costs say 6% after tax and equity say 12%, then with and E:D of 1:1, the average cost of capital would be say 9%. Thus for increasing EVA/SVA new investments must return more than say 9% after tax. Depends strongly upon the E:D ratio set by management. Cost of capital is the "hurdle rate" for new investment to ensure EVA; thus ALL managers should be able to relate CoC in all business activities.

COST OF DEBT - Complex concept. Simplified, the cost of debt is part of the Cost of Capital computation; it is the annual long term interest rate (after tax), weighted by the E:D ratio. See also NET DEBT TO EQUITY RATIO.

COST OF EQUITY - Complex concept. Simplified, the cost of equity is part of the Cost of Capital computation. Equity is not "free" because shareholders have expectations of dividends and SVA (added share value). Generally higher than the cost of debt. Various computation techniques available which involve the "Beta" coefficient and weighted by the E:D ratio. Most methods compute the cost of equity as: risk free rate plus a risk or growth rate.

COST OF GOODS SOLD/INVENTORY - Measure of activity. Times inventory is "turned over" in the cost of sales. Depends upon Industry norms. Excessive turnover is "over trading"; poor turnover is stagnation.

CREATIVE ACCOUNTING - See MANIPULATION.

CURRENT RATIO - Ratio of current assets to current liabilities. Test of liquidity; normally strong 2:1, weak at 1:2, but depends upon the industry norms and averages in different countries. Less significant than the quack ratio or the ratio of equity: debt.

DAYS OF PAYABLES - Measure of activity and control. Number of days of purchases or cost of sales in the payables; computed as payables divided by cost of goods sold (or purchases) x 365 days. Compare with credit terms to determine if all available cash discounts are being taken; cash discounts lost are expensive money. Compare with days of receivables. Useful for forecasting.

DAYS OF RECEIVABLES - Measure of activity and control. Number of days sales in receivables; computed as receivables divided by sales x 365 days. Compare with credit terms to determine the effectiveness of credit control. Compare days allowed to receivables with days allowed by suppliers. Useful for forecasting balance sheets and cash requirements.

DEBENTURES - Long term finance often secured on property. Debt not equity. En titled to interest not a share of the profit. Strictly a loan evidenced in writing with or without security. DEBT-CAPACITY - Ability of the company to borrow more debt because its E:D ratio is healthy. High debt-capacity encourages "take-over bids"; low debt

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capacity risks bankruptcy.

DECEPTION - Method of making one year's financial data appear to be "good" by choosing appropriate standards and comparing only parts of the data against standard.

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DEBT - Term used to mean liabilities. More often applied to long term liabilities. See Equity:Debt Ratio.

DEFERRED ASSET - Cost carried forward in the balance sheet as asset, justified by "matching cost to future profits'. Enables costs to be carried forward and expensed against future profits. Examples include: research and development,advertising, pre-production costs, etc. More conservative accounting treatment is to expense immediately but such costs may be carried forward when profits are low provided the costs do have a definite "future benefit". Often used to manipulate. Auditors require certification by management before they agree to deferred assets.

DERIVATIVE - Complex financial instrument to reduce risk and avoid loss. See HEDGING. DISCLOSURE - Must be adequate for financial statements to be fair, Changes in accounting principles or exceptional transactions must be disclosed. Auditor must be satisfied that adequate disclosure has taken place otherwise he "qualifies" his report.

EBIT - Earnings before interest and taxes; used to measure the reward of long term financing from equity and debt.

ECONOMIC VALUE ADDED - See EVA.

EFFECT OF EXPANSION - Sales expansion generally involves expansion of assets employed. Receivables and inventory usually increase faster than sales. Suppliers may be "stretched" to provide necessary increase in working capital. In the long term retained profits or new equity are required to finance the higher level of activity Dividends must not use up all the profits at times of expansion thus causing a cash shortage.

EMOTIONAL INVESTMENT - Biased prejudice in favor of one particular solution,project or approach to business problems. Makes more information and rational argument irrelevant. Seek alternatives early to avoid it! Highly emotional. Not objective. Do a PFD to try to avoid it.

EQUITY: DEBT RATIO - Test of liquidity and financial health. Indicates the extent to which assets are financed by owners equity or debt(liabilities). There are various way of computing the E:D ratio. A simple computation relates Equity to Total Liabilities. An alternative ratio is to relate Equity to only Long Term Liabilities.

In simple computation an E : D of 2:1 is always very strong but attracts "cash hungry" take-over bids. A ratio of 1:1 is reasonable, but some industries or companies accept an E:D of 1:4 quite happily.

Depends upon the industry averages and norms. Measures debt capacity 1. e. the ability of a company to raise more cash by debt; is a more significant measure of immediate liquidity than the quick or current ratio. Equity base is

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the cushion to protect the creditors against loss.

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EQUITY BASE - Equity of a company including capital and reserves; "cushion" for creditors against loss. A low equity base is a high risk (high leverage), high profitability situation; a high equity base leads to a lower return on owners equity.

EVA - Economic Value Added. Financial technique for measuring performance not merely by increased profits, but by increased market value (market capitalization) of the company. The value of the business is the PV (Present Value) at the Cost of Capital (CoC) rate (%), of all future sustainable cash flows.

Value may be simply computed as:

V = OCF/(r-g), where:

OCF = Operating Cash Flow (100)r = Cost of Capital (say 9.3%)g = Growth Rate (say 5.3%)V = 100/(0.93-0.53) = 250

Economic Value Added is achieved by each division of a business, when it's: Operating Profit after tax (say 11m)/Net Assets Employed (A-CL) (say 160m-60m) times 100%, produces a return (say 11%) which is greater than the Cost of Capital (say 9.3%).

Economic Value Added is also achieved when the Operating Cash Flow (OCF) of the business is positive. OCF may be simply computed as: Net profit plus depreciation plus interest less working capital changes less "normal" capital expenditure. OCF is often called "Free Cash Flow" because it is cash available for new profitable investment opportunities.

EVA "drivers" include: cash flow, sales growth, operatingprofit margin, tax rate, working capital, fixed assets, costof capital, growth etc.

EVA (continued) - EVA is maintained when new capital expenditures (including increase in working capital) MUST produce a return exceeding the Cost of Capital (CoC). Thus CoC is not merely a tool for finance managers; it is the "hurdle rate" for justifying investment or disinvestment of business assets, which must be known and used by ALL managers of the business (production, marketing, finance etc.) if they are to achieve EVA. See Cost of Capital.

FACTORING - Short term financing of receivables whereby factor pays the amount due from the customer immediately, and collects on trade terms from the customer May involve a range of credit and billing services. Normally more expensive money than bank finance. Justified if margins are good because increase in sales requires little increase in receivables. Not always considered financially respectable, but becoming more so!

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FINANCIAL ANALYSIS - Technique for evaluating the health of accompany using forecasts of cash, funds, income statements,balance sheets and the LAPP system of financial analysis.

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FINANCIAL DISASTER - Need for financial planning to forecast possible disasters including: death or illness of managers,market decline, product obsolescence, technological obsolescence, economic decline, labor disputes, accounting control failures, etc. Provide for possible failure by planning to avoid excessive risk. Always do a PFD (Provision for Disaster) brain-storming to identify EI and invalid assumptions, before implementing key financial management decisions.

FINANCIAL ENGINEERING - Risk Management through the use of derivatives for: foreign exchange, interest rates, commodities and equity values.

FINANCIAL FLOOR PLAN - Bank financing of inventory on the floor of a dealer whereby the bank loan repaid as the inventory is sold.

Financial HEALTH - Evaluation of the health of a company- in financial terms including: liquidity & gearing, activity, profitability and potential. Company should be both profitable and financially healthy. Excessive risk is not consistent with health.

FINANCIAL INSTRUMENTS - Various techniques for "hedging"(providing for) risk of loss on FOREX and interest on long term debt, including: options, futures, forward transactions, derivatives etc. May sometimes involve high risk. See CONTINGENT LIABILITIES, REFINANCING and FOREX.

FORECASTED FINANCIAL STATEMENTS - Forecast of income statements and balance sheets using: estimated sales, ratios and estimates of dividends and capital expenditure. Several years ahead may be forecast relatively easily with simple assumptions. Alternative forecasts are necessary where assumptions are doubtful. FORECASTING OF CASH - Estimates of future cash receipts and payments to determine the peak and duration of cash requirements. Often done weekly or monthly in detail for 12 months ahead to ensure cash available when required. Depends upon underlying assumptions which must be justified. May be necessary to prepare high, middle, low level estimates. Cash planning is vital for financial management.

FORECASTING OF FUNDS - Future funds flow indicating the major sources and uses of funds. Sources are normally: profit, depreciation, new long term loans and capital, sale of fixed assets. Uses are normally fixed assets, dividends, repayment of long term loans and working capital. Normally five years ahead to indicate longer term planning of finance and the management decisions. See Funds Flow.

FORECASTS - Financial estimates based upon assumptions. Includes forecasts of income statements, balance sheets, cash flows or funds flows. Vital for financial planning. If assumptions poor, need to do alternative forecasts. Key assumption is sales,

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FOREX - Management of foreign exchange risk in international business transactions. May involve high risk if not controlled. Very complex instruments now available not always fully understood by non-professionals. See FINANCIAL INSTRUMENTS.

FUNDS FLOW - Source AND use of funds either past or future.

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GOODWILL - Asset of a business. Excess of purchase price of a business over value of assets actually acquired. Valuation doubtful. Better written off to income statements over five years, but sometimes written off over forty years! Useful for creative accounting.

GREY MARKET - Borrowing of mainly short term financing through intercompany lending rather than the banking system. Funds often raised by lenders through bills of exchange which are discounted on the financial markets. Grey Market borrowings tend to be "turned over" (renewed) regularly thus providing longer term finance.

GROSS PROFIT TO SALES - Ratio of gross profit to sales computed as Gross Profit/Sales x 100%. May be compared with budget, the past or industry averages to determine the causes of good or poor performance. Possible causes of poor gross profit include: inventory losses, poor purchasing, poor pricing, failure to take discounts pilferage, etc.

GUARANTEE - Undertaking by one party to pay the debt of another, if the debtor fails to pay. Banks lending to owner-operated businesses often require personal guarantees from the owners (who should attempt to limit the guarantee both in time and amount and possibly "donate" assets to wives or other parties to avoid total loss, subject to divorce). Banks use guarantors to put "pressure" on the original debtors to pay up or at least to agree to settlement terms.

HEDGING - Using financial instruments to reduce the risk of loss on FOREX and interest payments etc. Instruments include a wide variety of: options, forward transactions, futures, derivatives etc. See FOREX. I.A.S. - See International Accounting Standards.

INCOME STATEMENT - Common international name for a profit and loss account. Earnings statement.

INDUSTRY AVERAGES - Ratios indicating "normal" health in terms of: liquidity, activity and profitability for the industry. Separate figures often provided for small, medium and large sized businesses; measure of efficiency; may be misleading unless related to the actual size and type of business.

INTERNATIONAL ACCOUNTING STANDARDS - I.A.S. Accounting principles specially defined which have international acceptance as evidence of good accounting practice. Similar to GAAP. Always insist that the net profit according to national law and practice, be reconciled with I.A.S. which is more reliable measure of profitability.

INVENTORY MANAGEMENT - Control of inventory investment by getting suppliers to hold inventory, or reducing sales to reduce inventory requirements, or standardization of inventory, or stretching of payables, or Operations Research methods, etc.

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LAPP - System of financial analysis including:

Liquidity & Gearing - measured by: quick ratio, current ratio, equity:debt ratio.

Activity - measured by: sales/assets, cost of goods sold/ Inventory, days of payables, days of receivables.

Profitability - measured by: gross profit/sales, net profit/sales, net

profit/owners equity.

Potential - in terms of product, market, facilities, finance and management.

LEASING - Renting of assets as an alternative to purchase. Difficult to quantify because of complex contracts and DCF computations. Major benefit is reduction of cash requirement. Some leases must be "capitalised" as asset and liability in the balance sheet; others can merely be noted. Extensive leasing may make the balance sheet misleading. All leases should be explained in the notes to financial statements. Cost of leasing is not always relevant because companies may HAVE to lease when cash is not available. DCF analysis must use loan rates rather CoC.

LEVERAGE - Extent to which long term finance includes debt rather than equity. Judge risk in relation to industry and national averages Equity:debt of 2: 1 is strong financial position and poor leverage, low risk, low profitability. Equity:debt of 1: 4 is weak financial position, higher leverage, higher risk, higher profitability.

LIQUIDATION VALUES - Value of assets when sold quickly on winding up of a business. Often less than 25% of book value since buyers tend to wait for values to fall Not related to normal trading values.

LONG TERM FINANCE - Finance by equity or debt for normally more than one year. Used to finance long term assets and also part of working capital. Need to plan long term finance by funds flow for five years ahead to determine whether the need is really short term or long term. Profits can provide an increased equity base if not withdrawn in dividend. Analysis techniques include: funds flow, and forecasted income statements and balance sheets.

MANIPULATION - Creative Accounting. Techniques for adjusting the profit of a company to achieve objectives of various parties. Methods include: deferred expense, capitalised expense, change in depreciation rates, losses charged to reserve or accumulated profit, timing special profits or losses, acquisition of profit-making or loss subsidiaries, consolidation adjustments, accruals or contingent liabilities etc. Must be in accordance with accounting principles acceptable to the auditor; conservative manipulation is often regarded as reasonable practice. Often noted in financial statements,

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MERCHANT BANK - Specialist bank, often associated with a commercial bank. Provides special advice on all financial problems including long term financing arrangements. Does not normally provide overdrafts but will arrange short term finance. May take equity participation in its clients.

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MORTGAGE: - Long term loan normally secured on property or other assets.

NET DEBT TO EQUITY RATIO - Alternative method of computing the E:D ratio. Instead of measuring equity against total liabilities, or against long term debt, it measures equity against "Net long term debt"; this is defined as long term debt less available cash and near-cash (marketable securities). Only significant when the company holds large cash or near-cash funds in hand.

NET PROFIT/OWNERS EQUITY - Ratio of net profit to owners equity in the balance sheet. Compare with the budget, the past, industry averages to measure return on investment. Question the valuation of the assets If assets are substantially undervalued, then the ratio appears to be much better than it really is.

NET PROFIT/SALES - Ratio of net profit to sales for comparison with past, budget and industry averages Determine the cause of any difference against the standard. Pay particular attention to operating as apart from non-operating profits and losses.

NOTES TO FINANCIAL STATEMENT - The balance sheet and income statement frequently don't provide enough information on the underlying accounting concepts that were used. Full disclosure is made of relevant information in "notes to financial statements" including: depreciation, changes in reserves,goodwill, exceptional profits and losses, consolidation adjustments, capital expenditure commitments, contingent liabilities, etc. The notes are part of the financial statements

OFF-BALANCE SHEET FINANCING - Techniques for selling off the assets for immediate cash, and leasing them back for annual rental. Contingent liability may be "material" (significant). Improves E:D ratio but increases the risk of failure.

OR - OPERATIONS RESEARCH - Technique applying scientific method to business problems and planning.

OPERATING CASH FLOW - OCF. See CASH FLOW.

PFD - See PROVISION FOR DISASTER.

PROFESSIONAL ACCOUNTING BODY - Public accountants association which sets professional standards of auditing and accounting principles. Vital for fair financial reports. PROVIDE FOR - Technical accounting term meaning to accrue liability for an expense or a loss.

PROVISION FOR DISASTER - PFD. Brainstorming technique to discover all possible disasters that could result from a key financial decision. Identifies EI and false assumptions. Allows time to modify the financial plans to avoid such disasters.

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QUALIFIED REPORT - Auditor normally reports that financial statements are in accordance with accounting concepts, etc. i.e. "true and fair". When he is not satisfied he "qualifies" his report to indicate exactly why the financial statements are unacceptable. Qualified reports are rare since auditors normally argue the company into adequate disclosure of vital information in the notes to the financial statements.

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QUICK RATIO - Ratio of quick assets (normally cash, receivables and marketable securities) to quick liabilities (normally payables due within a month) indicating the immediate liquidity. Shows whether company can pay its bills this month. Rough measure is 12: 1 but the norm depends upon the industry averages and the cash flow of the company. For example, supermarkets often have a high cash flow during the month and a difficult cash position at the end of the month. Excess quick ratio indicates too much funds in the business.

RECEIVABLES MANAGEMENT - Investment in receivables may be managed by: credit control, discount policy, market selection, billing, expediting, factoring, etc.

REFINANCING - Techniques for "hedging" (providing for) risk of interest rate or FOREX changes. Debt may be re-financed at lower rates. See CONTINGENT LIABILITIES.

RISK MANAGEMENT - Technique to identify, measure and assess limits to acceptable financial risk, which an organization may, at reasonable cost, defray or reduce, using available market instruments. There are basically four risks for which RM has been extensively applied: interest rates, foreign exchange, commodity prices and equity prices.See Financial Engineering and Derivatives. SALES/ASSETS - Measure of activity; times the assets are "turned" over in the sales. Compare with the past, the budget and the industry average. Big companies normally turn over assets 1 to 1 1/2 times depending upon the industry. Smaller companies may turn over the assets two or three times.Excessive turnover is over trading; less than once per annum is probably stagnation.

SECURITY - Property or investments or even the "reputation of the borrowers" necessary to raise any finance. Liquidation value of the security often very doubtful. Lender acquires it as a safeguard but actually hopes never to use it. SHARE VALUE ADDED - See SVA.

SHARE BUY-BACK - Repurchase of shares by the company as an investment to achieve better SVA. Better to buy-back shares when excess cash cannot be invested to return more than the CoC.

SHORT TERM FINANCE - Finance of working capital normally for up to one year. Net working capital is current assets less current liabilities. Normal sources of short term finance include:suppliers, banks, short term loans, factoring of receivables etc. Plan short term finance by cash forecasting. Risky to use short term finance for long term assets except for a "bridging" operation.

SIGNALING THEORY - Concept that Management public announcements may be re-interpreted by the share market as signals to hidden assets and

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potential e.g. a news bulletin indicating increased R & D may tend to increase the share price.

STRETCHING SUPPLIERS - Technique for obtaining extra finance from suppliers. Methods include: paying little and often, promising big orders, quoting competitive better terms, taking discounts, complicating the accounts so that expediting becomes difficult

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SVA - Share Value Added. Complex concept, Simplified, SVA is a key financial objective. SVA is produced when the sustainable cash flows and dividends lead to increased short term and long term share value, as related to the share index by the Beta coefficient. Directly related to EVA. TAX LAW - Regulations for computing the tax due by a business. Not necessarily good accounting principles but often followed in many countries. Sets the rules for computing profit in terms of taxable income and allowable deductions. Companies comply with tax regulations to minimize the tax liabilities. Not the same as generally accepted accounting principles. Some companies adopt tax regulations in the books and thus produce distorted financial statements. Not necessary to follow tax rules into the company records ! ! Keep separate records for tax purposes.

VALUE - Vague term meaning either: book value, sales value, liquidation value or opportunity value. Real value of an asset only known when it sold.

WORKING CAPITAL - Current assets minus current liabilities is net working capital. Normally cash, receivables and inventory financed by suppliers and banks. Working capital expands with sales. Normally working capital needs to be managed because it manages itself rather badly!

WRITE OFF - Technical accounting term meaning to charge to expense or to the income statement, or to reserve, or to accumulated profit.

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APPENMDIX - B - QUIZ

1. The key objective in financial management is to increase the:

(a) liquidity of the business(b) amount of outside finance(c) long term value of the business(d) bonus of the CEO

2. Effective financial management is indicated by the:

(a) overall health of the company(b) weight of the financial controller(c) profitability(d) high cash balance

3. For a "quoted" company, the key objective of financial management must always be to increase:

(a) cash flow(b) return on equity(c) operating cash flow(d) SVA

4. Lack of creativity in financial management normally results from management's:

(a) attitude(b) lack of skills(c) marital inexperience(d) lack of knowledge

5. The financial manager deals with risk by:

(a) avoiding it(b) providing for it at the level required by the chief executive(c) off-balance sheet financing(d) ignoring it

6. Control of working capital is the responsibility of the:

(a) accountant(b) trade unions(c) all managers(d) finance manager

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7. Critical profit making factor of a business are important in financial management because they affect the:

(a) sources of finance(b) morale of the accountants(c) industry standards(d) key financial policies

8. The critical skills of financial management are mainly:

(a) accounting and pessimism(b) timing, relationships and creativity(c) accuracy and honesty(d) forecasting and astrology

9. The horizon of a CAPITAL INVESTMENT ANALYSIS project is normally:

(a) the economic life of the project(b) the technical life of the project(c) simply a matter of management judgment(d) the tax life of the major asset

10. New investment in ... is usually very poorly controlled by management:

(a) working capital(b) fixed assets(c) R & D(d) subsidiaries

11. Creative Accounting:

(a) a method of accounting used in the advertising industry(b) a description given by chartered accountants to accounts prepared

by anybody else(c) a work of classic art(d) an American expression for manipulating figures

12. To maintain credit from suppliers, a liquidity crisis:

(a) pay on delivery(b) pay a little regularly to key suppliers(c) simply refuse to pay up(d) bring in the auditors, and blame them

13. Fixed assets are best financed by:

(a) long term finance(b) equity(c) someone else

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(d) bank loans

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14. The cheapest form of finance for working capital is normally:

(a) field warehousing and theft(b) bank overdraft(c) convertible debentures(d) suppliers when discounts lost

15. Investment in inventory is high, therefore the financial manager must:

(a) depend on the situation(b) cut the inventory(c) cut sales(d) defer payables

16. Extensive leasing of assets:

(a) reduces costs(b) is a high contingent liability(c) is cheaper than purchase(d) makes the E:D ratio look worse

17. The equity: debt ratio:

(a) must always be at least 2 : 1(b) depends on the attitude of the chief executive(c) indicates the "cushion" against loss by the creditors(d) is the same as the industry average

18. When sales expand:

(a) more assets are not required with good WC management(b) generally more assets required(c) everybody is delirious(d) profits increase

19. In financial management what is more important, analysis of the past or forecasting of future cash flows:

(a) analysis of the past(b) both equally(c) forecasting of future cash flows(d) neither

20. Factoring of receivables does not:

(a) provide immediate cash flow(b) improve credit control(c) reduce profit margins(d) always damage company image

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21. By not taking discount offered by suppliers on 2/10 days nett 30 day terms the cost of money is about:

(a) 24%(b) 36%(c) 8%(d) 2%

22. Money borrowed short term until some form of long term finance is arranged is:

(a) bridging finance(b) subordinated debt(c) a scam(d) a form of debenture

23. For management purposes, given only the following options, which would you choose:

(a) profit figures three months old,(b) profit figures of recent origin prepared under pressure of time and

accuracy(c) sales figures and bank account which are up to date(d) daily output in both physical and money terms

24. Operational cash flow is:

(a) net profit plus depreciation(b) Earnings before interest and taxes (EBIT)(c) sales less cost of sales(d) EBIT less taxes and less changes in working capital and capital

expenditure

25. For most companies, the health of a financial ratio is best related to:

(a) financial managers(b) the weather(c) international standards(d) industry averages

26. SVA depends mainly upon:

(a) reduced WC(b) the weather(c) dividend policy(d) new investment producing more than the cost of capital.

27. In financial management the cash balance is:

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(a) the unnatural result of doing business(b) the key to liquidity(c) the result of working capital management(d) too low

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28. Cash forecasting is designed to show the:

(a) cash balance in five years time(b) same as the balance sheet(c) peak and duration of cash requirements(d) impossibility of surviving in the modern world

29 The key overall test of liquidity is measured by the ratio of:

(a) equity to debt(b) current assets to current liabilities(c) quick assets to quick liabilities(d) stocks on cash or credit

30. Equity base of a company should be kept:

(a) as low as possible(b) as high as possible(c) higher than the payables(d) as a cushion for creditors against loss

31. Financial statements are more reliable when they are:

(a) audited(b) absolutely correct(c) three years late(d) prepared for tax purposes

32. "Sales increase but inventory stays at about same level" . This is:

(a) true(b) always false(c) not usually true(d) irrelevant to WC management

33. Cost of capital is the:

(a) cost of equity minus debt(b) arithmetic average of cost of equity and cost of debt(c) long term interest rate(d) weighted average of cost of equity and cost of debt

34. When you are asked to examine a set of annual accounts with a view to making a valuation for acquisition purposes - the first thing to do is:

(a) find out who audited the accounts, and(b) ask yourself - why does the other guy want to sell(c) see how much cash is in the bank(d) order a check on all the assets, and make a judgement on the quality

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of profits

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35. Annual cash flow is:

(a) the decrease in bank borrowings over the year(b) retained profits plus depreciation,(c) the amount of new cash received during the year(d) a Xmas party bonus

35. EVA is achieved when:

(a) OCF is positive(b) Cost of Capital is low(c) Cost od Capital is high(c) OCF is negative

37. Balance Sheet

Liabilities & AssetsOwner's Equity

OE 10 FA 20LTL 2 OCA 1CL 10 Cash 1

22 22

Which statement is the most appropriate:

a) current assets are too highb) equity is too highc) liquidity is poord) fixed assets are too high

Note:OCA = Inventories and Accounts ReceivableFA = Fixed AssetsCA = Current AssetsLTL = Long-term LiabilitiesOE = Owner's EquityDRS = Debtors (receivables)

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38. Balance Sheet


Yr.1 Yr.2 Yr.1 Yr.2OE 60 100 FA 40 50LTL 20 20 Inv. 30 30CL 20 40 Drs. 20 80

Cash 10 -

100 160 100 160


(a) the material increase is in fixed assets(b) there is probably poor control of debtors(c) sales manager is sick(d) there is poor use of long-term funds

39. EVA is a:

a) new tax on added valueb) concept similar to cost of capitalc) measure of value created by a businessd) measure of return on equity

40. Which of the following is not a key EVA driver?

a) operating profit marginb) working capitalc) cost od capitald) level of inflation

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41. Balance Sheet


Cash 2 CL 2OCA 2 LTL 18FA 18 OE 2

22 22


a) current liabilities are to lowb) owners equity is too lowc) long-term liabilities are adequated) fixed assets are too high for the other current assets

42. Balance Sheet

Assets:

Yr.1 Yr.2

FA 4 18OCA 5 5Cash 1 1

10 24Less:

CL (2) (4)LTL (2) (4)

OE 6 16


a) increase in current assets is financed by liabilitiesb) increase in fixed assets is financed by liabilitiesc) increase in fixed assets is financed by receivablesd) increase in fixed assets is financed by owners equity

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43. Balance Sheet


Yr.1 Yr.2 Yr.1 Yr.2OE 6 13 FA 4 4LTL 2 2 OCA 5 22CL 2 12 Cash 1 1

10 27 10 27

Profit and Loss AccountYr.1 Yr.2

Sales 20 40GP 10 20NP 4 7


a) stock and debtors increase is financed by liabilitiesb) stock and debtors increase is financed by equity and liabilitiesc) stock and debtors increase is due to sales expansiond) profit margins are increasing

44. Balance Sheet ... have a care now ....!

AssetsYr.1 Yr.2

FA 4 5OCA 5 10Cash 1 1

10 16Less:CL (2) (10)Net assets 8 6

OE 6 6LTL 2 -

Financing 8 6

Which statement is the most appropriate

a) sales increase led to an increase in debtors and stockb) cash balance is too lowc) liabilities are too high in relation to salesd) significant increase in fixed assets is financed by liabilities

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45. Balance Sheet

Liabilities & AssetsOwner's Equity OE 22 FA 10LTL - OCA 11CL - Cash 1

22 22


a) current assets are too highb) SVA is too highc) owners equity is too highd) fixed assets are too high

46. Balance Sheet


OE 10 FA 18LTL 2 OCA 2CL 10 Cash 2

22 22


a) long-term liabilities are too low for the cashb) a FOREX or a DUREX problemc) liquidity is satisfactoryd) owners equity is too low for fixed assets

47. Balance Sheet (Careful!)

Assets Liabilities &Owners Equity

Cash 1 CL -OCA 20 LTL 20FA 1 OE 2

22 22


a) liquidity is OKb) Owners equity is too lowc) current liabilities are well managedd) LBO is the answer

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48. In the capital asset pricing model (CAPM) the Beta coefficient measures the:

a) bankruptcy risk of the companyb) dividend yieldc) relative volatility of the company share price in relation to the stock

market index.d) ratio of market value to book value

49. Balance Sheet


Yr.1 Yr.2 Yr.1 Yr.2OE 6 8 FA 4 5LTL 2 2 OCA 5 10CL 2 8 Cash 1 3

10 18 10 18

Operating StatementYr.1 Yr.2

Sales 20 21GP 10 10

NP 2 2


a) stock and debtors are too high in relation to OEb) stock and debtors are too high in relation to gross profitc) margins are improvingd) stock and debtors are too high in relation to sales

100

50. Balance Sheet

Liabilities & AssetsOwner's Equity Yr.1 Yr.2 Yr.1 Yr.2OE 60 60 FA 40 180LTL 20 140 Stock 30 20CL 20 40 DRS 20 30

Cash 10 10 100 240 100 240

Income StatementYr.1 Yr.2

Sales 100 150GP 40 60NP 20 30

The material change between year I and II is:

a) increase in salesb) increase in fixed assetsc) SVAd) reduction in profit margin

51. Balance Sheet

Liabilities & AssetsOwner's Equity Yr.1 Yr.2 Yr.1 Yr.2OE 60 65 FA 40 50LTL 20 20 Stock 30 100CL 20 95 DRS 20 20

Cash 10 10 100 180 100 180


a) increase in fixed assets is financed by equityb) increase in SVAc) increase in stock is mainly financed by liabilitiesd) increase in sales is mainly financed by the workers

52. Which of the following is never good security for a banker:

(a) bills receivable(b) inventory(c) goodwill and reputation(d) accounts payable

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53. In responding to a loan request, the bank's first attention is whether the:

(a) client is an old one or a new one(b) amount is too high(c) security is adequate(d) purpose is legal

54. In practice the main security for the bank loan is the:

(a) cash in hand(b) face of the client(c) reputation of the customer(d) size of the safe

55. Banks do not like to lend to companies making losses because;

(a) they are inefficient(b) its bad for their image(c) they can't afford high interest rates(d) they may soon have higher losses

56. The best reason for not using a bank to finance the purchase of a fixed asset is because:

(a) it is not ethical(b) the interest rate is too high(c) the bank may require payment if conditions broken(d) the bank will ask repayment "on demand"

57. Liquidation values are:

(a) dependent upon the way assets are sold(b) more than book values(c) always stable but low(d) the same as book values

58. "If the company cannot repay the loan on demand then the bank has practical alternative but to liquidate the company". This statement is:

(a) always true(b) generally true(c) not possible(d) false

59. A "company doctor" is a man who:

(a) gives medical treatment to staff(b) treats the chief executive for financial ulcers(c) is under contract for legal services

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(d) something else

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60. If a banks sells a defaulting company it will often get a good price because it:

(a) can afford to wait(b) can finance the purchase(c) knows the buyer's reputation(d) is on INTERNET

61. In inflation the important factor for the banker in considering a bank loan increase is:

(a) payback(b) "gilt edge" security(c) age of the chief executive(d) government fiscal controls

62. Net profit plus depreciation is:

(a) cash flow(b) operating cash flow(c) funds flow(d) cost of capital for the year

63. Visit the bank manager when:

(a) you need a lot of money(b) you don;t need money yet(c) no-one else will lend the money you need(d) you need money desperately

64. If a company needs 80,000 but the bank lends only 40,000, then the bank is:

(a) unwise(b) conservative and mean(c) forgetful(d) wise

65. A large increase in payables is a:

(a) source of funds(b) source of worry(c) decrease in cash(d) usually a good thing

66. "The difference between sources and uses of funds, usually results in an increase or decrease in working capital". This statement is:

(a) true

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(b) unethical(c) meaningless(d) false

105

67. Which of the following is not a source of funds:

(a) expanded credit from suppliers(b) sale of shares or stock(c) increase in "excess of the cost of investment in subsidiaries over its

net book value"(d) borrowing from a bank

68. Cost of capital is:

(a) SVA(b) hurdle rate for new investment(c) EVA(d) cost of equity

69. In year I the net profit was 1000 (after depreciation of ;200). In year 2 the net profit was 950 (depreciation 300). The change in the source of funds from profits in year 2 was:

(a) plus 1000(b) plus 50(c) minus 50(d) no change from year 1

70. Cash flow is the key to all except:

(a) SVA(b) cost of capital(c) EVA(d) liquidity

71. Funds flow is used in financial management to show:

(a) sources and uses of cash(b) what to do now(c) key management decisions on fund sources and uses(d) needs for the next month

72. Cash flow forecasting is normally:

(a) shorter in time than funds flow(b) briefer than funds flow(c) easier than funds flow(d) detailed

73. A difficult problem in financial management is to determine if the cash need is:

(a) exactly right

106

(b) short term or long term(c) short term(d) unreasonable

107

74. How should we safely finance a long term capital project where profitability fluctuates considerably:

(a) supplier long term credit(b) off-shore companies(c) equity(d) bank loans

75. The parties who might be interested in financial reports are limited to:

(a) management and shareholders (b) management, government and Commercial Crime Unit(c) management, government and bank(d) even more parties

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QUIZ ANSWERS

1. c a d a b 6. c d b a a 11. d b a d a 16. b c b c d 21. b a b a d

26. d c c a d 31. a c d b c 36. a a b c d 41. b b a b c46. d b c b d

51. c d a c d 56. c a d d b 61. d a b a a 66. a c b b c 71. c a b c d

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APPENDIX C - EXERCISESEXERCISE NO.1 - EFFECT OF TRANSACTIONS: For a manufacturing company show the effect of each of the transactions listed below as of the time the event described takes place: cash, current assets, net working capital (current assets less current liabilities), net profit for the current period. In the spaces provided enter: plus sign (+) to indicate an increase, or minus sign (-) to indicate a decrease, or zero (0) to indicate no effect at all. Item No. 0 is given as an example.

Example: Cash CA NWC NP0. Wages earned by employees during

the period were paid in cash and charged to expense - - - - 1. Materials purchased for cash and

charged to inventory

2. Some of the above materials (ininventory) were used up and sold for cash at a profit and the costwas charged to cost of goods sold

3. Capital (share) stock was issued for cash

4. Depreciation for the period wasestimated and recorded in the books

5. Money was borrowed from the bank on a

30-day note payable (disregard interest) 6. Equipment (fixed asset) was purchased

for cash (ignore depreciation)

7. Equipment was purchased on long termcredit (ignore depreciation)

8. An account (creditor) payable wasreduced by a cash payment

9. Dividends were paid in cash andcharged to accumulated profit

10. Wages accrued in a prior accountingperiod were paid in cash

11. A fixed asset sold for cash at a profit

12. A fully depreciated asset was scrappedfor no value

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Score: /48

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APPENDIX C - EXERCISES

EXERCISE NO.2 - SOME IDEAS TO THINK ABOUT:

WRITE SOMETHING DOWN ON:

1. How do accounting concepts vary in different countries?

2. How reliable is a financial audit without IAS?

3. What is "creative accounting"?

4. What does a long delay in preparing financial statements indicate?

5. How to judge the reliability/creativity of a financial budget/forecast?

6. How relevant are FOREX and DERIVATIVES to working capital management? Are payables and debt useful hedges?

7. Where to get the current financial ratios for your particular industry?

8. How to judge the reliability of unaudited financial reports with such questions as: Who did it? Why? Who for? When? What assumptions? How validated? Checked by whom? Compared with what standard? What record of reliability in the past? Related to which industrial associations, banks, credit agencies?

9. How to get the best out of the Wall Street Journal?

10. How relevant are CoC and WC management to your personal business performance?

11. How to use the INTERNET (NETSCAPE, WWW, DOW, HARVARD etc.) for further study of finance?

12. How to use/abuse Risk Managment?

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AND THEN CHECK YOUR IDEAS WITH YOUR FINANCIAL COLLEAGUES ...

113

APPENDIX D - AUTOMATED GROUP LEARNINGAGL NO. 10 - EVA & FINANCIAL MANAGEMENT OF WORKING CAPITAL

A 2/3 DAY TRAINING PROGRAM FOR MANAGERS AND DIRECTORS

BRIEF BROCHUREPROGRAM:

The program is designed to provide managers and directors with the opportunity to achieve a deeper understanding of financial management of working capital as a key responsibility of EVERY manager.

This broadening of knowledge, skills and attitudes, will enable them to capitalise on new business opportunities and to accelerate their professional development.

SPECIFIC OBJECTIVES:

The learning objectives are to

(a) Understand accounting language and concepts of financial management.

(b) Recognize the need for financial forecasting of cash, funds, income statements and balance sheets.

(c) Develop practical skills in using financial data to manage working capital effectively.

(d) Recognize "creative accounting" in financial reporting, despite IAS (International Accounting Standards).

(e) Motivate further study in the future

SYLLABUS

The syllabus of the program introduces the basic concepts of financial management and EVA (Economic Value Added) as motivators to EVERY manager to take reponsibility for the management of working capital.

METHOD:

The AGL method is designed to achieve rapid individual learning using special material and the stimulus of group activity without formal teaching. The groups use the material to find the answers to all problems and questions. The program provides the full cycle of pre-learning, learning and learning maintenance activity.

TIME:Two days or three days.

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FACULTY:Dr Andre van de Merwe and Dr. Bob Boland of the European Institute

(Geneva).FURTHER INFORMATION:Tel/Fax 33-50-40-89-82/33-50-40-92-49.

115

README FIRST MINI-AGL PROGRAMS A MORNING WITH DR. BOLAND AND FRIENDS

1. CONCEPTS

The programs are developed from established AGL courses by ex-professors from INSEAD/IMD/GSB, as efficient and effective four hour learning experiences, based on new theories of conscious and non-conscious learning.

2. PRINTING FOR LEARNING MAINTENANCE

Find the file marked "LMM and print it out directly as ASCII text or WP51 Times Scalable 12 point.

3. LEARNING

Three "learning aids" are helpful for the morning: a. A partner - to provide positive encouragement.

b. Text book for further study.

c. The WSJ (Wall Street Journal).

4. RUNNING THE PROGRAM

a. You may use Windows but not Word or Excel or Wordperfect or any similar system. Simply, insert the diskette into an IBM compatible computer drive A or B. Copy it to a NEW directory on your computer (once only).

b. If possible, do the learning routine (four hours) in one morning; otherwise do two sessions of two hours each. Do the Learning Maintenance" afterwards to reinforce the learning. Then a week later ... relax ... repeat the morning ... make it fun .. and ... surprise yourself ...

c. When running the program on IBM compatible computer, type any of the following:

Flash - for the morning routine - first two hours. Flash2 - for the morning routine - second two hours. Quiz - for a large multiple choice quiz Glossary - for a glossary exercise Exercise - for learning maintenance exercises

116

NOTE: THE PROGRAM WORKS MUCH FASTER ... WHEN YOU COPY IT TO YOUR HARD DISK ... IN A SPECIAL DIRECTORY

117

5. PROGRAMS AVAILABLE

Mini-agl (morning) programs currently becoming available at July 1995 include:

AGL 1 Accounting Reports AGL 2 Cost Control AGL 8 Communication for Effective Management AGL 10 EVA and Financial Management of Working Capital AGL 11 Forex and Risk Management AGL 20 Business Strategy 1999 AGL 40 Environmental Audit

For special clients, customized versions can be developed with company cases with about two week of intensive supported effort.

Dr. R.G.A. Boland (FCA, CPA, ITP (Harvard), DBA, former professor INSEAD/UCT/Columbia) 10.2.1996 Tele/Fax 3350408982/3350409249

A. CASES


The 1995 financial forecasts indicate a doubling of sales but a stable inventory and a gross profit increasing from 32 to 37%. Is this a reasonable expectation? Why?


Financial director insists that he needs ECU 500,000 loan from the bank for working capital. What alternatives could be investigated?

3. BERTON INC.

CEO of the company is concerned with the increase in accounts receivable. List ten ideas for improvement.

PART II - SECTION 2 - CASE STUDIES 1. ELIZA MANUFACTURING COMPANY

The 1997 financial forecasts indicate a doubling of sales but a stable inventory and a gross profit increasing from 32 to 35%. Is this a reasonable expectation Why?


Financial director insists that he needs ECU 500,000 loan from the bank for working capital. What seven alternatives could be investigated?





10. MINICASES - QUESTIONS

5. DOUGLAS COMPANY

Banker with whom company had an account in credit balance for many years responds to request for a small loan by immediately demanding security. What to do? Why?

6. MERVILLE HOLDING

Management insists that to achieve increased sales, the inventory and receivables must increase substantially. What can be done to manage inventory and receivables?

7. PROFELD COMPANY

Company needs more credit from suppliers to provide substantial financing and requests guidelines as to how creditors may be "stretched" (seven ideas).

8. ZONDI COMPANY

Company's profit is low this year and management seeks to manipulate it higher to avoid complaints from the shareholders. What methods could the company consider which are in accordance with accepted accounting principles? (seven methods)

9. OUALO COMPANY

Due to sale of an investment, the company suffered major loss this year which will upset shareholders and cause the share price to fall. No capital reserve available but company buildings are undervalued. What can be done to avoid showing a loss this year?

10. WILLIAMS BANK

Client with large loan sends monthly reports to its bank six to eight weeks late because "the auditors are in. and no information is available for two months". Reasonable?

PART II - SECTION 2 - CASE STUDIES (cont.)


Auditor insists that no one in the company should use green ink and, further. that company must make 27 small adjustments each for under ECU 100 so that the books are "totally accurate". What can management do?

12. TIM TOM COMPANY

Profit will be well over budget and company wishes to reduce the profit disclosed this year, so as to keep "a little in hand for the future". Chief Executive suggests acquiring another company which is losing money and then consolidating the figures. Is this acceptable? What alternatives available?


Bank requires company to submit financial forecasts to justify application for substantial bank loans. Company insists that the position is so uncertain that forecasts would not be useful. What is your opinion


Company owned by its executives seeks a small loan from the bank. Bank insists that in addition to normal company security. each executive should sign an unlimited indefinite personal "joint and several guarantee" to me bank for the loan. Is this reasonable? Should they agree?





17. DOUGLAS COMPANY

Banker with whom company had an account in credit balance for many years responds to request for a small loan by demanding security. What to do? Why?

PART II - SECTION 2 - CASE STUDIES - ANSWERS

4. SUTHERLAND COMPANY

Ten suggestions for reducing inventory:

1. Aging of the inventory. 2. Identify high value items.

3. Identify slow moving items. 4. Dispose of obsolete items. 5. Standardization to reduce the number of parts. 6. Operations research inventory computations. 7. JIT systems. 8. Reduce production volume. 9. Benchmarking with other companies.10. Get production, marketing and finance to own the problem.

5. MARC COMPANY

Expansion can be financed with increased, thus the E:D ratio could move from 2:1 to 1:4. But the risk of failure is higher and the Cost of Capital would change.

6. MERVILLE HOLDINGS

Increased sales will probably require some WC expansion ahead of the sales ... but he might ... manage the inventory investment by: operations research, better purchasing, JIT, getting suppliers to hold inventory until required ... and he might manage better receivable investment by: factoring, credit control, customer selection, cash sales, quicker billing, expediting customers, deposits. etc.


7. PROFELD COMPANY

Suppliers may be stretched as follows:

(a] Pay each supplier a little regularly and keep him happy with "extra orders" promise.

(b) Insist that as an old and loyal customer. supplier must give better credit terms.

(c) Tell supplier that his competitors are offering longer credit terms.

(d) Place large orders on condition that extra credit terms are granted.

(e) Ask supplier to supply copy invoices and thus delay payment.

(f) Query the prices and amounts thus delay payment.

(g) Take unreasonable discounts and take time negotiating so as to complicate the account thereby making it difficult lo expedite.

(h) Pay the wrong amount on invoices and statements thereby confusing the supplier accounting system.

8. ZONDI COMPANY

Manipulation (creative accounting) for a higher profit may be achieved by various methods:

(a) High (less conservative) inventory values. (b) Capitalise heavy maintenance a fixed or deferred asset. (c) Depreciate fixed assets over longer "horizons" (working lives), certified by

engineers.

(d) Defer advertising, R & D and other expenses. (e) Keep accruals and reserves to the minimum. (f) Release reserves into profits.

(g) Charge losses to reserve or accumulated profits.(h) Acquire profitable subsidiaries and consolidate. (i) Sell fixed assets and investments a profit and take it in the income

statement.

PART II - SECTION 2 - CASE STUDIES - ANSWERS (cont.)9. QUALO COMPANY

Revalue the building in the books and credit the difference in value to capital reserve; then charge the loss on the sale of the investment to capital reserve thereby not reducing the profit of the year. Make a note in the financial statements to indicate the change to reserve and explain that it "avoids distorting the figures for the year".

10. WILLIAMS BANK

Do not accept that the auditors are responsible; insist upon regular timely reports. Auditor is often used as an excuse to expedite payment or delay information on poor results.


Point out that the auditor is working for the company and the key accounting principle is materiality. not "peanut polishing". Buy him a bottle of yellow ink. Let him "note the adjustments" but refuse to make them in the books. Refute the idea that the financial statements are accurate and insist that they are only useful estimates. Allow the auditor to qualify his report if he dares ....!!! He won't!!!

12. TIM TOM COMPANY

Manipulation of the profit this year could be achieved by acquiring a loss company; the other methods are also useful

(a) Reduce the inventory value by being more conservative.

(b) Set up reserves and accruals for every conceivable loss.

(c) Postpone the sale of a fixed asset (at a profit) or sell it sooner (if it makes a loss).

(d) Charge all losses to income statement and not to capital

(e) Expense small fixed assets (and even larger ones).

(f) Reduce the working life (horizon) of fixed assets so as to increase the annual depreciation.

(g) Write to the lawyer to find out about possible legal liabilities for damages or claims; accrue for them in the books.

(h) Write down the value of investments or any assets which are over-valued and charge the loss against profits.



Forecasts are especially necessary when the financial position is so uncertain. Suggest alternative forecasts of high, low and probable estimates, so as to give some idea of the range of risk. Financial forecasts are always useful as part of financial decision-making. They are no substitute however for good business experience and intuition.


Normal for banks to require personal guarantees when they lend money , to companies owned by their own executives. However, ensure that the guarantees are for specific limited amounts over specific time periods. Avoid unlimited indefinite guarantees. Donate assets to wives and other relations to avoid total personal loss should the guarantors be called upon to pay (and beware of divorce!) Remember guarantor of a debtor can always sue the debtor if he feels his liability is in jeopardy.

15. REES DEVELOPMENT INC.

Changing banks provides financial flexibiLity but batter alternative V Is to keep both banks and play off one against another. Old bank will give us better service as an existing client, but the new bank may seek to get our business and thereby force the old bank to give us more. Keep relationships with both bankers in a healthy condition despite the competitive situation. Keep both accounts active. Never let a bank account lie idle.


Paying suppliers before time ias never justified. Pay early to get discount. Otherwise don't pay until required to pay. Company probably has excessive equity. Failure to use "debt capacity" is not good financial management.

17. DOUGLAS COMPANY

Banker is unreasonable although the company has failed to establish a "track"' record of borrowing and successful repayment. Insist upon a small overdraft without security other than the integrity of the company name~ Arrange alternative finance with another bank. then return to the first bank with this information and request him once again to make the loan. Alternatively suggest to assistant manager that you need a loan and ask "can you handle it or should I deal with the General Manager"

A. CASES - ANSWERS


No.Cannot expect inventory to remain stable when sales double. Need to justify such low inventory levels by operatIons research studies. Gross profit increase by 5% Also requires specific justification in terms of prices. costs. customers. etc. Overall financial forecast is difficult to accept without considerable explanation?

2. POTTER Production

Alternatives to a bank loan are as follows:

(a) Reduce investment in inventory. receivables and cash. (b) Stretch the suppliers.(c) Factor receivables. (d] Get suppliers to hold the inventory and deliver and invoice as required. (e) Lease rather than buy fixed assets. (f) Get long term loan or mortgage. (g) Expedite receivables wi'~ better credit policies, discounts and credit control.

Reduce cash reserves. Get customer deposits.

3. BERTON INC.

Ten suggestions for reducing accounts receivable:

1. Age receivables to locate slow payers. 2. Visit selected customers to identify causes of late payment. 3. Reduce invoice errors. 4. Speed up credit note processing. 5. Audit credit control procedures. 6. Improve documentation required by customers before payment. 7. Benchmark with other companies. 8. Involve marketing and production managers int he problem. 9. Check up on discount policies and compliance.10. Control sales expansion with better customer selection.

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