Finance for non-finance executives

WELCOME TO THE PROGRAM!

Business


Business as an economic entity

Trading activity
Buying Selling

Manufacturing activity
Buying Processing Selling

Servicing activities
Servicing

Business


Purpose of an economic entity

Wealth creation Wealth management, and Wealth distribution

Objective To lead the revolution and create the best possible values and share them in the equitable manner among all the stakeholders.

Business


Stakeholders in the Business

Investors
 

Equity holders Debt holders including banks and financial institutions

Suppliers Distributors and retailers Employees Customers Community

Business


Proprietary business

Single owner of the business. No difference between the obligations of the business and the obligations of the individual. Two or more owners of the business. No difference between the obligations of the business and the obligations of the individuals.

Partnership firm

Business


Company: Is an artificial person, created by law and has the perpetual existence. Obligations of the company are separate from those of promoters and management.

Private limited company

  

Not more than 50 members Shares are not freely transferable. No invitation to public for subscription.

Public limited company

 

Closely held public limited company Publicly held public limited company

Business


Closely held public limited company

Not a listed company. No invitation to public for subscription.

Publicly held public limited company



A listed company. Held by large number of shareholders. Shareholder have limited liability in Ltd. Companies.

Structure of the businesses

Business

Proprietary

Company

Partnership

Private Ltd.

Public Ltd.

Closely held

Publicly held

Sources of funds


Long term funds

Equity Long term Debts Short term Debts Other short term borrowings

Short term funds

Portfolio mix of the long term and short term funds is called the Capital Structure of the company. This forms the left hand side of the Balance Sheet.

Uses of funds


Fixed Assets Land and building Plant and Machinery Others Working Capital Raw Material Work in progress Finished goods Cash Investments Various avenues of investment

Sources and uses of funds

Match between the uses of funds and the sources of funds:
Long term funds Long term investments

Long term funds Short term funds

 

Short term investments

Long term investments must always be with long term funds. Financing long term assets with the short term funds creates risks mainly the refinancing one. Short term investments may be financed with long term or short term funds. It depends on the attitude of the business managers.

Funds management
Management of the funds Mobilization of the funds Utilization of the funds

Quantum

Source

Cost

time Work. Cap. Investments

Fixed assets

A typical balance sheet

       

Liabilities Authorized Capital Issued capital Paid up capital Preference share capital Long term Debts Other short term borrowings Reserves and surplus Current liabilities

Assets Fixed Assets

Land and building Machinery Others Raw Material Work in progress Finished goods Cash

Working Capital

   

Investments Deferred revenue expenses Intangible assets like goodwill, human resources, brands etc. Accumulated losses

Balance sheet
 Assets would always be equal to the liabilities. Balance sheet would always match (Result of double accounting rule).  It provides readers with the static picture of the business on a specific day. Is it possible to engineer balance sheet to present misleading picture of the state of affairs of business.

Some Balance Sheet items

 

Accumulated losses Intangibles like Goodwill, value of Human Resources and brands etc. For intangibles, equal values are added to the Liability side, in the form of Capital Reserves, to match both the sides of the balance sheet.

Sources of funds - Equity



Equity capital is the risk capital, which facilitates the wider dissemination of the risk and rewards of the business.
 Why

the equity capital is shown as a liability in the books of the company.

Important terms linked to equity

Market value per share and Market capitalization Book value per share = Net worth/ number of outstanding shares. Net worth is equal to the share capital + reserves and surplus other than the Capital Reserves. Earning per share (EPS) = Profit after tax / number of outstanding shares. Dividend per share (DPS) Price earning ratio (P-E ratio) = Market price/ EPS

Sources of funds - Preference shares



Preference shares are called quasi equity. They behave partly like shares and partly like debt instruments. Preference share holders have : Dividend, which is fixed and paid before anything is paid to equity holders. Capital appreciation, if any. Voting right No voting right originally. But acquire the voting rights in certain circumstances.

Important terms linked to preference shares

Claim over the residual assets, at the time of liquidation of the company, before the equity holders and after the debt holders. They behave like debt instruments because they carry fixed dividend rates. They behave like equity instruments because they offer the dividend to the share holders without any obligation on the company.

Sources of funds - Debt

 

Debt provides the business with the capital bearing the fixed cost. Debt owners have :

Fixed Interest Payment of interest is an obligation on the company. No voting right Claim over the assets of the company before the equity holders.

Sources of funds - Debt

 

Both long and short term loans can be secured or unsecured. Different debt owners would have different priority claims on the assets of the company at the time of liquidation.

Important terms linked to debt instruments

     

Face value/ Par value Issue price (at face value or at discount to the face value) Redemption value (at face value or premium to the face value) Terms of the redemption Rate of interest (Coupon) Maturity of the instrument

Important terms linked to debt instruments



Convertible debts

To be convertible into shares of the company. Fixed or the floating prices. Compulsory or optionally convertible. Timings of the conversion may vary a lot. Fully convertible debentures (FCDs) Partly convertible debentures (PCDs)

 

Preference shares can also be convertibles like debt instruments. Bank financing

Short term financing instruments

 

Short term bank loans Commercial papers

Issued at discount Unsecured in nature Generally issued at par Unsecured in nature

Public deposits

   

Inter-corporate deposits Bill discounting Financing against the commercial bills. Factoring Sell of the commercial bills. Forfaiting Sell of the export bills.

Major providers of debt finance

   

Individual investors Banks Financial institutions Specialized institutions

Reserves and Surplus

   

General reserves Created out of retained profits. Share premium reserve premium on allocation of securities is credited to this account. Capital reserves Also called the revaluation reserves. Sinking fund account to meet the specific requirements/obligations of the business.

Main items of the revenues

 

Sales revenue Other income

Dividends and interest Sales of the assets

Lease charges

Main items of the expenses

  

Cost of goods sold. Salary Other expenses

A typical profit and loss account

Revenues from the business Less Cost of goods sold and other expenses Less Depreciation Earning before interest and taxes (EBIT) Less Interest payment Earning before taxes (EBT) Less Taxes Earning after the tax (EAT/PAT)

Items from profit and loss account



Depreciation Straight line method Discounted value method (Change in depreciation methodology to inflate/deflate profits) Deferred revenue expenditure R&D expenses Advertisement expenses Product promotion expenses (expenses are charged as capital expenses and amortized over the period of time)

Cost concepts


Cost of goods sold Direct material Direct labor Direct manufacturing overheads Administrative costs Office rent Salaries Postage and Telegram Other costs Selling and distribution costs Salaries of sales staff Commissions, promotional expenses Advertisement expenses etc.

Cost concepts
     

Fixed costs

Salary and wages, lease rentals etc. Raw material and other related costs

Variable costs

Semi-variable cost Total cost Average cost Opportunity cost

Cost concepts
     

Replacement costs Direct cost Indirect cost Sunk cost Estimated cost Actual cost

A view of profit and loss account



Cash expenses

Raw material, salary and other administrative expenses Depreciation

Non cash expenses

A view of profit and loss account

   

Break even point Is the point of no profit and no loss. Throughput/productivity = output/input Ways to improve the throughput/productivity Economies of scale and scope

A view of profit and loss account

  

Cost leadership Price leadership Market leadership

 

Offer a better product at a competitive price. Offer a competitive product at a better price.

Annual Reports


Auditors report

Profit and loss account Balance sheet Cash flow statement Qualification of auditors

Directors report

Corporate actions


PAT money is available for the equity holders. Following three things can be done with this money:

Distribute to the equity holders as dividend. Retain the whole money and channelize that towards the business, if opportunities exist. Distribute part of the money and retain part of the money.

Corporate actions


Dividend decision

Need of the fresh funds in the company. Long term plans of the company. Expectations of the shareholders. Management philosophy

Corporate actions


Bonus shares

This is another form of paying dividend and so bonus shares are also called the stock dividend. Some fresh shares are given for the existing shares for no extra charges. Stock market prices fall down after the bonus shares. In the books of company, general reserves become the share capital (Capitalizing reserves).

Corporate actions


Split of shares

Shares are split in more number of shares. Par value per share goes down. Stock market prices fall down immediately to adjust for the increased number of shares. In the books of company, there is no impact other than the change in the outstanding number of shares (become more).

Corporate actions


Consolidation of shares

This is exactly opposite to the split of shares. Shares are consolidated and existing shares are exchanged for the lesser number of shares. Par value per share goes up. Stock market prices go up immediately. In the books of company, there is no impact other than the change in the outstanding number of shares (become less).

Corporate actions


Right shares

At the time of raising further capital, first offer is made to the existing share holders by the company. Additional shares are offered to the existing share holders on priority basis to ensure that their shareholding does not get diluted. Shares are generally offered at a discount to the market value of the share. Stock market prices fall down after the offer. In the books of company, capital changes. What about trading of rights on the exchange platforms ?

Corporate actions


Buyback of shares

For treasury operations. For extinction - If the company wants to reduce the share capital, it can do that by buying the shares back.


Fixed price buy back.

Proportionate right is offered to the investors to sell the shares back to the company. Buy back of shares is done generally at a price higher than the market price.

 

Book built buy back Put options approach to fixed price buy back offers.

In the books of company, capital changes (it goes down).

Cost of capital
   

Cost of equity Cost of debt Total cost of funds Weighted Average Cost of Capital (WACC). Rate of return has got to be higher than the WACC for economic business proposition.

Risks in the business

     

Business Risk Financial Risk Default risk Interest rate risk Currency risk Refinancing and reinvestment risks.

Leverage impact
  

More debt creates the financial risk. Companies with the high business risk may not take high financial risk. What about the zero debt companies.

Management of the risks



Management of the risk requires the knowledge of the specialized instruments called derivatives. Major products are :

Forward Futures, and Options

Balance Sheet & financial disclosures

Purpose of Balance Sheet

Describe the purpose of the balance sheet and understand its usefulness and limitations.

The Balance Sheet

The purpose of the balance sheet is to report a companys financial position on a particular date. Limitations:  The balance sheet does not portray the market value of the entity as a going concern nor its liquidation value.  Resources such as employee skills and reputation are not recorded in the balance sheet. Usefulness:  The balance sheet describes many of the resources a company has available for generating future cash flows.  It provides liquidity information useful in assessing a companys ability to pay its current obligations.  It provides long-term solvency information relating to the riskiness of a company with regard to

Balance Sheet

Claims against resources (Liabilities) Resources (Assets) Remaining claims accruing to owners (Owners Equity)

Classification of Assets

Distinguish between current and non-current assets and liabilities.

Identify and describe the various balance sheet asset classifications.

FedEx Corporation Balance Sheet 31-May (In millions) Assets: Current assets: Cash and cash equivalents Receivables, less allowances Spare parts, supplies, and fuel Deferred income taxes Prepaid expenses and other Total current assets Property and equipment, at cost: Aircraft and related equipment Package handling & ground support equipment and vehicles Computer & electronic equipment Other Less accumulated depreciation Net property and equipment Other long-term assets: Goodwill Prepaid pension cost Intangible and other assets Total other long-term assets Total Assets 2004 2003

Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

$ $

1,046 $ 3,027 249 489 159 4,970 $ 7,001 $ 5,296 3,537 4,477 20,311 11,274 9,037 2,802 1,127 1,198 5,127 19,134 $

538 2,627 228 416 132 3,941 6,624 5,013 3,180 4,200 19,017 10,317 8,700 1,063 1,269 412 2,744 15,385

Current Assets
Current Assets

Cash Cash Equivalents ShortShort-term Investments Receivables Inventories Prepayments

Will be converted to cash or consumed within one year or the operating cycle, whichever is longer.

Cash equivalents include certain negotiable items such as commercial paper, money market funds, and U.S. treasury bills.

Operating Cycle Mfg Company

Use cash to acquire raw materials

Convert raw materials to finished product

Deliver product to customer

Collect cash from customer

Non-current Assets
NonNon-current Assets

Investments and Funds Property, Plant, & Equipment Intangibles Other

Not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer

Non-current Assets
Investments and Funds 1. Not used in the operations of the business 2. Includes both debt and equity securities of other corporations, land held for Property, Plant and Equipment speculation, non-current 1. receivables, and cash set Are tangible, long-lived, and aside in the operations of the used for special purposes business 2. Includes land, buildings, equipment, machinery, and furniture as well as natural resources such as mineral Intangible Assets 1. Used in the operations of the business but have no physical substance 2. Includes patents, copyrights, and franchises Other Assets 3. Reported net of 1. accumulated Includes long-term prepaid expenses and amortization any non-current assets not falling in one of the other classifications

Classification of Liabilities

Identify and describe the two balance sheet liability classifications.

FedEx Corporation Balance Sheet 31-May (In milions) Liabilities: Current liabilities: Current portion of long-term debt Accrued salaries & employee benefits Accounts payable Accrued expenses Total current liabilities Long-term debt, less current portion Other long-term liabilities Deferred income taxes Pension, postretirement healthcare and other benefit obligations Self-insurance accruals Deferred lease obligations Deferred gains, principally related to aircraft transactions Other liabilities Total other long-term liabilities Total liabilities 2004 2003

750 $ 308 1,062 724 1,615 1,168 1,305 1,135 4,732 3,335 2,837 1,709 1,181 768 591 503 426 60 3,529 11,098 882 657 536 466 455 57 3,053 8,097

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities as a result of past transactions or events.

Current Liabilities
Current Liabilities Accounts Payable Notes Payable Accrued Liabilities Current Maturities of Long-Term Debt

Obligations expected to be satisfied through current assets or creation of other current liabilities within one year or the operating cycle, whichever is longer

Long-term Liabilities
Long-Term Liabilities Notes Payable Mortgages Bonds Payable Pension Obligations Lease Obligations

Obligations that will not be satisfied within one year or operating cycle, whichever is longer

FedEx Corporation Balance Sheet 31-May (In millions, except shares) Common Stockholders' Investment: Common stock, $.10 par value, 800 million shares authorized, 300 million shares issued for 2004 and 299 million shares issued for 2003 Additional paid-in capital Retained earnings Accumulated other comprehensive loss Less deferred compensation and treasury stock at cost Total common stockholders' investment 2004 2003

30 $ 1,079 7,001 (46) 8,064 28 8,036 $

30 1,088 6,250 (30) 7,338 50 7,288

Shareholders Equity is the residual interest in the assets of an entity that remains after deducting liabilities.

Shareholders Equity
Capital Stock Deferred Compensation

Retained Earnings

Treasury Stock

Accumulated Other Comprehensive Income

Disclosures

Explain the purpose of financial statement disclosures.

Disclosure Notes
Summary of Significant Accounting Policies
Conveys valuable information about the companys choices from among various alternative accounting methods. A significant development that takes place after the companys fiscal year-end but before theor events Transactions financial statements are issued. that are potentially important to evaluating a companys financial statements, e.g., related parties, errors and irregularities, and illegal acts.

Subsequent Events

Noteworthy Events and Transactions

Analysis
Explain the purpose of managements discussion and analysis.

Management Discussion and Analysis

Provides a biased but informed perspective of a companys operations, liquidity, and capital resources.

Managements Responsibilities


Preparing the financial statements and other information in the annual report. Maintaining and assessing the companys internal control procedures.

Audit Report - Content

Explain the purpose of an audit and describe the content of the audit report.

Auditors Report
Expresses the auditors opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles, IFRS etc.

Auditors Opinions
Unqualified

Issued when the financial statements present fairly the financial position, results of operations, and cash flows in conformity with GAAP Issued when there is an exception that is not of sufficient seriousness to invalidate the financial statements as a whole

Qualified

Adverse

Issued when the exceptions are so serious that a qualified opinion is not justified

Disclaimer

Issued when insufficient information has been gathered to express an opinion

Analytical Approach

Describe the techniques used by financial analysts to transform financial information into forms more useful for analysis.

Using Financial Statement Allow financial statement Information users to compare year-toComparative Financial
Statements Horizontal Analysis

Vertical Analysis

Ratio Analysis

year financial position, results of operations, and Expresses each item in cash flows the financial statements as a percentage of that Involves expressing each same item in the financial item in the financial statements of another statements as a year (base amount) percentage of an appropriate corresponding total, or base amount, within the Allows analysts to control same year. for size differences over time and among firms

Risk Assessment
Identify and calculate the common liquidity and financing ratios used to assess risk.

RATIOS
Ratio refers to the arithmetical,Numerical,quantitative relationship between two items of variable.  A ratio is calculated by dividing one item of the relationship with another.  Ratios can be expressed in 3 different ways.  Computing ratios does not add any info not already inherent in the statement


Ratio analysis removes the difficulty of drawing inferences on the basis of absolute figures.  Comparison with related facts is the Basis of financial ratios.  Comparisons are of 3 types:  - Time Series/Trend Analysis  - Inter-Firm/Cross Section  - Standards/Industry analysis..


Ratios can be classified into four broad groups:

Liquidity Ratios  Leverage Ratios  Activity Ratios  Profitability Ratios.



h h h h h h h h

Current Ratio Quick Ratio Debt Equity Ratio Debtors Turnover Inventory Turnover Debt Service coverage ratio Gross Profit Margin Net Profit Margin.

Ratios:current
Current Ratio: Arrived at by : Current Assets / Current Liabilities  Is a ratio of Current Assets to Current Liabilities.  Will not be the same for all businesses.  Ideal is said to be 2:1, but it depends.  Most imp is the trend or movement in the current ratio.  Declining current ratio is an indication of possible liquidity problems

Ratios:Quick
Quick Ratio: Arrived at by : Current Assets Stocks / Current Liabilities.
Idea quick ratio is about 1:1.  Trend or movement is of paramound importance. An increase in Quick ratio indicates a sign of improving liquidity and a decrease in the ratio is a sign of worsening liquidity.

Ratios:Gearing
Debt Equity Ratio(Gearing): Arrived at by : Long term debts / Equity Minus intangible fixed assets in the balance sheet. Measures the stake of the proprietor/owners. A business is said to be low-geared when the ratio is less than 1. There is no ideal level of gearing.

Ratios:Debtors Turnover
Debtors Turnover Ratio): Arrived at by : Annual Credit Sales / Average Debtors. Measures the no of times the debtors have turned over. To arrive at the length of credit allowed: Divide either 12 or 365 by the Debtors turnover ratio: or Average Debtors / Annual Credit Sales X 12

Ratios:Debtors Turnover
This ratio is used to assess: Management efficiency in credit control.  Length of credit given to clients and  The size of the investment by a business in its debtors.  Debtors are an investment,cos,they rep sales by a business on which a profit has been taken into account, for which cash is not received.


Ratios:Debtors Turnover
This ratio is used to assess:


If the average period of credit allowed to clients seems unusually high, it should be asked whether the business is properly controlling the credit it gives, which in turn might suggest that the size of the investment in debtors is too high.

Ratios:Stock Turnover
This ratio is arrived at by: Cost of Goods sold / Average inventory The ratio gives the no of times the stock has turned over. For Eg: If the COGS is 1,800,000 and the average stock is 150,000, the stock has turned over 12 times. Therefore, the period of stock held is: 12months / 12 = 1 month.I.e, the stock remains in store for a month before they are sold.

Ratios:Stock Turnover/receivables on its own This ratio does not mean anything
unless trends are considered and ageing schedule is obtained. Eg: Year 1 months Year 2 3 weeks Year 3 1 month, shows that stock is taking longer to sell and so:
 

Either the sales and p urchases are falling in volume without a corresponding reduction n stock level or Stock volumes have been increased without corresponding increase in sales.

Ratios:Stock/Inventory Turnover
Questions to be asked:
         

Is there unnecessary tying up of funds? Is business investing too much capital in its stock? Is there danger of obsolescence/Out-of-date stock? Is the Price too high? Is the locatin of the business poor? Is the quality of the products poor? Marketing efforts are poor? Advertising and media relations bad? Service is poor? Not in trend or fashion?

Ratios:Profitability Analysis
 

Gross Profit Margin : gross profit / sales X 100 Provides an idea of gross margin which in turn would depend on relationship between prices, volumes and costs. Net profit margin : Net Profit / sales x 100 Reflects managements ability to operate business to recoup all costs & Expenses (including depreciation,interest and taxes) and also provide compensation to owners.

Early Warning Signals

           

Continuous irregularity in Cash Credit/Overdraft accounts. Low Capacity Utilisation (in manufacturing accounts) Profit fluctuations (downward) Downward trend in sales stagnation. High rate of return of goods (Rejection) in sales/manufacturing. Failure to pay statutory dues. Larger and longer outstandings in the bill accoutsn. Longer period of credit allowed on sales. Constant utilisation of cash credit facilities to the hilt. Failure to pay timely instalments & Unterest on term loans and instalment credits. Non-submission of required data in time. Financing capital expenditure out of funds provided for working capital purposes.

Early Warning Signals

       

Rapid turnover of Key personnel. Increasing law suits against a borrower. Sudden and frequent changes in Management whether professional or otherwise and dominated by one or few individuals. Diversion of funds for purposes other than running the Unit. Frequent return of cheques/Bills. Frequent/constant Non-availability of the borrower when visited for meeting. Piling up of stock. Adverse market report.

Case study Liquidity test

1)

Current Ratio

A B 90,000/55,000 = 1.64 119,000/70,000 = 1.7

2)

Quick ratio

30,000/55,000=0.55 35,000/70,000=0.5

Both companies have a fairly low Current ratio. Very low quick ratio. Though quick ratio of Co A is higher than Co B, Co A is in more immediate difficult situation because it has run up against its OD facility, whereas Co B still has 10,000 of its limit to use up.

EXAMPLE Debtors turnover

Year Debtors turnover period (average) 2000 224,000/1460000 X 365 days = 56 days

2001 2002
h h h

h h

264,000/1,606,000X365 ds = 60 days 360,000/1,800,000X365 ds = 73 days The debtors period is lengthening. Suggests a worsening control over the amt of credit allowed by Al Fayha. If the turnover period in 2002 had been the same as in 2000, ie 56 days,the total investment in debtors in 2002 would only need to be appxly: 56/365 X 1,800,000 = 276,000, which is 84,000 less than the actual 2002 outstanding of 360,000. By tightening the control and debt colln, they could have borrowed less!And saved on interest too!

EXAMPLE Profit/Sales ratio

1.

Gross profit/sales Net Profit/Sales

(60/120) =50%(69/140)=49.3% and 81/160=50.6% 30/120=25%; 37/140=26.4%; and 48/160 = 30% +50% +17% +20% +14%

2.

1. 2.

Trend in net profit Trend in Sales Turnover

h h h h

This company, on the basis of only 3 yrs results, showing a trend of improving the profits. Fairly steady ratio of GP to Sales. NP to sales is also improving. Net profit is increasing at a faster rate than sales turnover. The performance of such a company should impress the banker fairlyl.

Financing Ratios
Total liabilities Debt to equity = ratio Shareholders equity Indicates the extent of reliance on creditors, rather than owners, in providing resources Net income + Interest expense + Taxes Interest expense

Times interest earned ratio

Indicates the margin of safety provided to creditors

Introduction to

Depreciation, Capital & drawings

What is depreciation?

Depreciation is the reduction in the value of a fixed asset due to the passage of time, wear and tear or obsolescence over its useful life. The purpose of depreciation is to allocate the full cost of the asset minus any scrap value received at the end of its useful life - over the estimated useful life of the asset. The usual causes of depreciation are:
Wear and tear; Obsolescence; Inadequacy.

What assets are depreciated? For the purpose of depreciation, fixed assets are usually divided into four main categories: 1. 2. 3. 4. Land and buildings; Plant and machinery; Fixtures and fittings; Motor vehicles.

All except land can be depreciated, though `amortisation' as opposed to depreciation, is the term used to describe the writing-off of leasehold premises.

Calculation of depreciation The objective of charging depreciation is to spread the total cost of an asset over its useful life so that each accounting period is allocated a proportion of cost to reflect the benefit it has received from the asset. There are a number of methods for calculating depreciation. The most common methods are two: the straight line method and the reducing balance method.

Straight line method

The straight line method charges an equal amount of depreciation in each year of the asset's life. For example: Van cost Dhs 37,500/Expected life 3 years Estimated residual value Dhs 1,500/Therefore Total depreciation = Dhs 37,500 - Dhs 1,500 = Dhs 36,000/Therefore Annual depreciation = Dhs 36,000 = Dhs 12,000 3 or expressed as a formula: Cost - Residual value = Annual depreciation Number of years of expected life

Reducing balance method

This method applies a fixed percentage each year. For example, rather than depreciate Dhs 12,000/- each year, as in the straight line method, the company may choose to depreciate by 50% each year on the balance remaining.
Cost End year 1 Depreciation 50% Net book value year 1 End year 2 Depreciation 50% Net book value year 2 End year 3 Depreciation 50% Net book value year 3 Dhs 37,500/Dhs 18,750/Dhs 18,750/Dhs 9,375/Dhs 9,375/Dhs 4,687.50 Dhs 4,687.50

In other words, we are reducing the balance by 50% each year. The rate used in the reducing balance method is found by using a complicated formula.

Depreciation
Depreciation Is an Accounting Mechanism to Transform Investment into Annual Expenses Investment is a CASH FLOW but not an EXPENSE "Expenses" are, in accounting terms, amounts that can be deducted from current income to calculate profit Investments simply transform financial assets into another type of capital asset. After making an investment, you presumably have the same capital value you started with. Depreciation is an EXPENSE but not a CASH FLOW. Depreciation is an ACCOUNTING means of reflecting the consumption of a capital asset as it is used

Depreciation Rules
  

The rules will affect profits, net investment (i.e. investment - depreciation), and ROI Changes in the rules can therefore change the value of the company or of a project! What can be depreciated: Tangible or intangible assets that are used to produce income. Have a finite, determinable life > 1 year. Deteriorates from use, natural causes or obsolescence. Are neither inventory nor stock-in-trade. Buildings, machinery, vehicles, computers, ...

Fixed installment or Straight-line method: cost price minus scrap value divided by life of assets  Diminishing balance method or Writtendown value method: used for such assets whose life is comparatively longer; also for assets which are continuously expanded like buildings, plants and machinery


BALANCE SHEET OF DIAMOND SPORTS AS AT 31.12.2007

Fixed assets Premises (cost) Machinery (cost) Less depreciation Motor vehicle (cost) Less depreciation Current Assets Stock Debtors Less provision bad debts Prepayment Short-term investment Cash 140,000 46,000 12,000 --------26,000 5,000 --------15,000 26,000 2,000 -------24,000 500 5,000 5,000 --------49,500 13,000 3,000 20,000 --------34,000

21,000 ---------195,000

Less current liabilities Creditors Accruals Overdraft Working capital Long-term liabilities Loan

36,000 --------13,500

10,000 ---------218,500 ====== 200,000 18,500 ---------218,500 ======

CAPITAL + Net profit for the year

CAPITAL AND DRAWINGS Sole traders cannot draw a salary from their businesses, instead they make drawings from the businesses against the capital invested and anticipated future profits. Drawings are not an expense of the business but a reduction in the owner's capital. Drawings can take three forms:
Cash; Goods or services; Payment of personal bills through the business's bank account.

All drawings are recorded and at the end of the year shown on the balance sheet as a reduction in the owner's capital.

CAPITAL AND PROFIT Sole traders are entitled to all the profits made by their businesses. Net profit is added to the owner's capital at the end of the year and it increases the indebtedness of the business to the owner. Remember: Net profit increases the owner's capital. Net loss decreases the owner's capital.

The net profit of a year can be calculated by comparing the owner's capital in two consecutive balance sheets.
Net profit = Closing capital -- Opening capital + Drawings -- New capital 250,000 = 1,100,000 -1,000,000 + 150,000 -0

CAPITAL AND THE BALANCE SHEET The owner's capital is shown separately on the balance sheet under the assets and liabilities. It is presented as follows: Financed by: Capital Net profit for year Dhs. 1,000,000 250,000 -------------1,250,000 150,000 -------------1,100,000 =========

Drawings Net worth

Financial Forecasting, Planning, and Budgeting

Financial Forecasting
1) Project sales revenues and expenses.

Financial Forecasting
1) Project sales revenues and expenses. 2) Estimate current assets and fixed assets necessary to support projected sales.

Financial Forecasting
1) Project sales revenues and expenses. 2) Estimate current assets and fixed assets necessary to support projected sales.
Percent of sales forecast

Percent of Sales Method

Suppose this years sales will total $32 million. Next year, we forecast sales of $40 million. Net income should be 5% of sales. Dividends should be 50% of earnings.

This year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $8m $16m $24m $4m $4m $1m $6m $15m $7m $2m $9m $24m

% of $32m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Predicting Retained Earnings

Next years projected retained earnings = last years $2 million, plus:

Predicting Retained Earnings

Next years projected retained earnings = last years $2 million, plus: projected sales

net income x sales

(1

cash dividends - net income )

Predicting Retained Earnings

Next years projected retained earnings = last years $2 million, plus: projected sales

net income x sales

(1
x

cash dividends - net income )

$40 million x

.05

(1 - .50)

Predicting Retained Earnings

Next years projected retained earnings = last years $2 million, plus: projected sales

net income x sales

(1
x

cash dividends - net income )

$40 million x

.05

(1 - .50)

= $2 million + $1 million = $3million

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% 12.5% n/a n/a n/a

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% How much 12.5% Discretionary n/a Financing n/a

will we n/a Need?

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% How much 12.5% Discretionary n/a Financing n/a

will we n/a Need?

Next year Assets Current Assets Fixed Assets Total Assets Liab. and Equity Accounts Payable Accrued Expenses Notes Payable Long Term Debt Total Liabilities Common Stock Retained Earnings Equity Total Liab. & Equity $10m $20m $30m $5m $5m $1m $6m $17m $7m $3m $10m $27m

% of $40m 25% 50%

12.5% How much 12.5% Discretionary n/a Financing n/a

will we n/a Need?

Predicting Discretionary Financing Needs

Predicting Discretionary Financing Needs

Discretionary Financing Needed =

Predicting Discretionary Financing Needs

Discretionary Financing Needed = projected total assets projected total liabilities projected owners equity

Predicting Discretionary Financing Needs

Discretionary Financing Needed = projected total assets $30 million projected total liabilities projected owners equity

$17 million - $10 million

Predicting Discretionary Financing Needs

Discretionary Financing Needed = projected total assets $30 million projected total liabilities projected owners equity

$17 million - $10 million

= $3 million in discretionary financing

Sustainable Rate of Growth

Sustainable Rate of Growth

g* = ROE (1 - b)
where

Sustainable Rate of Growth

g* = ROE (1 - b)
where

b = dividend payout ratio (dividends / net income)

Sustainable Rate of Growth

g* = ROE (1 - b)
where

b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or

Sustainable Rate of Growth

g* = ROE (1 - b)
where

b = dividend payout ratio (dividends / net income) ROE = return on equity (net income / common equity) or net income sales ROE = sales x assets assets x common equity

Budgets
Budget: a forecast of future events.

Budgets
Budgets indicate the amount and timing of future financing needs. Budgets provide a basis for taking corrective action if budgeted and actual figures do not match. Budgets provide the basis for performance evaluation.