Commercial
Management:
theory and practice
Chapter 5
Financial Decisions
Learning objectives
•
Understand the nature and purpose of financial
information
•
Be aware of the main user groups and their financial
information needs
•
Understand the content and function of the primary
financial statements
•
Explain the nature and use of some basic accounting
control systems
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Learning objectives
•
Be aware of how to use financial information to make
short-term decisions
•
Be aware of long-term investment appraisal techniques
such as discounted cash flow, and understand how they
are used in the creation of a business case
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Introduction
•
Financial information aids:
•
the stewardship function of management
•
•
to demonstrate how well business resources have been managed
management planning, decision-making and control
•
to provide useful and timely information to help managers make
decisions
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Introduction
•
•
Demand side to assess whether a project:
•
will generate a sufficient return on an investment
•
is affordable in terms of the projected monthly/annual cost
Supply side to monitor/assess:
•
whether a project’s costs are running at the amounts estimated
(and the amount of and reason for any significant differences)
•
the level of return that the project is making on the investment
(together with the ability of the project to make debt repayments
when due)
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature/purpose of financial
information
•
Generated by the accounting function in an enterprise or
organisation
•
The accounting process (providing useful financial information)
involves:
•
the classification and measurement of transactions
•
summarising them for a period of time (a week, a month or a year)
•
communicating and analysing that financial information
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature/purpose of financial
information
•
A major function of accounting is the preparation of
financial statements:
‘The objective of general purpose financial reporting is to
provide financial information about the reporting entity that is
useful to present and potential equity investors, lenders and
other creditors in making decisions in their capacity as capital
providers. Information that is decision-useful to capital
providers may also be useful to other users of financial
reporting who are not capital providers.’ (IASB, 2008,
Paragraph OB2)
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature/purpose of financial
information
•
•
Components:
•
balance sheet – the financial position of a business, frozen at
a point in time
•
income statement – a historical summary of performance over
the past year
•
cash flow statement
Users of accounting information:
•
investors, lenders, suppliers and other creditors, employees,
customers, government and their agencies, the public,
management
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature/purpose of financial
information
•
Desirable qualities of financial information
‘Information provided by financial statements needs to be
relevant and reliable and, if a choice exists between relevant
and reliable approaches that are mutually exclusive, the approach
chosen needs to be the one that results in the relevance of the
information provided being maximised.’ (ASB, 1999)
•
In addition, information needs to be:
•
comparable (implies consistency and the need for adequate
disclosure)
•
understandable
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature/purpose of financial
information
•
Financial reports can be divided into:
•
financial accounting reports – prepared for the purposes of
supplying information to shareholders and other interested
parties; must be prepared according to statutory and other
regulatory requirements in terms of content and format
•
management accounts – concerned with the production of
information in order to facilitate planning, evaluation and control
of commercial activities
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature of financial reporting
environment
•
Varies depending on the way in which a business has
been formed – e.g.:
•
small unincorporated businesses and partnerships are usually
subject to less regulation than
•
larger incorporated enterprises, private or public limited liability
companies – trading as a group (holding company and
subsidiaries)
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Relationship between parent
company and subsidiaries
Extract from Vinci’s Annual Report 2011)
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Nature of financial reporting
environment
•
Financial reporting (by companies) is governed by national
and international regulatory frameworks
•
•
These cover:
•
content, formats and presentation of published financial statements,
including extensive disclosures, permissible valuation methods for items
such as buildings, inventory and financial instruments, and treatments of
specific transactions
•
requirements for directors and in relation to auditors and corporate
governance
The financial reporting environment is dynamic, and subject to
constant change, as reporting issues have become more complex
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
Financial reports include:
•
the balance sheet
•
the income statement
•
the cash flow statement
•
ad hoc reports prepared for special projects
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
Balance sheet – indicates how a company, is funded as
represented by the equation:
Assets − Liabilities = Equity
•
assets – the rights or other access to future economic benefits
controlled by a company as a result of past transactions or events
(non-current and current assets)
•
liabilities – the obligations of a company to transfer economic
benefits as a result of past transactions or events (current and
non-current liabilities)
•
equity – the residual amount found by deducting all of the
company’s liabilities from all of its assets
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
Assets include:
•
non-current assets – used on a long-term basis (that is, over the
course of more than one year) to generate profits
•
•
Examples are tangible items (land, buildings, machinery, motor vehicles,
computers), intangible items (goodwill, leases) and investments
current assets – assets that generate cash within 12 months of
the balance sheet date
•
Examples are inventory (stock), trade receivables (debtors),
prepayments, cash and cash equivalents
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
Liabilities include:
•
non-current liabilities – amounts payable more than 12 months
after the balance sheet date
•
•
Examples are borrowings, deferred tax liabilities, pension obligations and
other provisions
current liabilities – amounts payable within 12 months of the
balance sheet date
•
Examples are bank overdrafts, trade payables, accruals, current tax
liabilities and proposed dividends
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
Equity (also known as capital and reserves or
shareholders’ funds) includes:
•
share capital
•
share premium
•
reserves (including retained profit)
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
The income statement or statement of financial
performance gives a summary of income less expenditure
for the year
•
revenue – the total sales or operating revenue of a company
•
cost of sales –the value of materials and services (including
labour and overheads) bought during the year in order to make the
goods or to provide the services sold
•
distribution costs – costs incurred after production of goods is
completed
•
administrative expenses – the additional costs incurred in
running a company
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
Cash flow statement – shows how cash has been managed
during the period:
•
net cash flow from operating activities – reconciles the
operating profit figure with operating cash flow
•
cash flows from investing activities:
•
•
receipts resulting from ownership of investments or loans to other
companies
•
the sale or purchase of businesses, intangible or tangible non-current
assets and to the sale or purchase of debt instruments of other companies
cash flows from financing activities – payments to the providers
of finance and long-term financing cash flows
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
Difference between profit and cash
•
•
In the income statement:
•
Income is included when it is earned – when a sale is made, not when the
cash is received
•
Expenditure is matched with the income it helps to generate
•
It can therefore be potentially misleading
The cash flow statement (reporting the actual cash inflows and
outflows of the company) is:
•
seen to provide additional relevant and reliable information
•
less open to manipulation than the income statement
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Presentation of financial
statements
•
Financial analysis
•
Financial statements can be used to generate trends
•
Enables providers of finance to monitor debt covenants
•
A return on the investment can be calculated and compared with
the target return
•
Used to produce additional internal information comparing actual
figures to those budgeted and planned for
•
However, financial accounting information can be incomplete, or
subject to creative accounting techniques
•
Financial statements and their analysis can only act as a starting point for
further investigation
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Management accounting
•
Accounting information – individualised to meet the needs of
the specific users
•
Emphasis on the context of the financial information and a
sophisticated analysis of costs and cost behaviour
•
Management accounting information contributes to:
•
strategic planning
•
investment appraisal
•
budget/profit planning
•
financial management
•
communication of financial and operating information
•
financial control
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
•
Cost determination and cost
behaviour
Costing information feeds into:
•
planning decisions – use estimates of future costs, and
include pricing and outsourcing decisions.
•
control procedures are in place to maintain and improve the
efficiency with which resources are employed
•
•
providing timely and accurate feedback on the efficiency and
effectiveness of operations
Understanding cost behaviour is important for decisionmaking, with costs being categorised as:
•
direct or indirect
•
variable, fixed, semi-variable (mixed), or stepped
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Cost–volume–profit analysis
•
Break-even analysis – a useful way to predict costs at
different levels of activity
•
Any product or service that can be sold for more than its variable
cost is making a positive contribution to the fixed costs of the
business
•
contribution – the difference between the selling price and the variable
cost of producing and selling that item
•
profit per unit – the difference between the selling price and the cost of
producing and selling that item
•
unit contribution –equal to selling price less total variable cost per unit
•
Contribution analysis is an important tool in management decision-making
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Cost–volume–profit analysis
•
Break-even point:
•
•
volume of sales at which
•
total contribution is equal to total fixed costs
•
neither a profit nor a loss is made
Break-even analysis – useful for short-term decision-making
•
Graphical display can be provided and sensitivity analysis carried
out
•
Can be used only in certain (relatively straightforward) situations,
and relies on several assumptions
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Total cost to output relationship
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Cost prediction
•
•
Techniques include:
•
engineering methods based on direct estimation of required
production inputs
•
historical cost methods based on the information already in
the accounting system – extrapolated to meet the new position
•
statistical methods such as linear regression analysis
Each method will yield different figures, and experience is
needed to arrive at an appropriate conclusion
•
Understanding cost behaviour will help management make better and
more effective decisions
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Performance measurement
•
Budgets help managers plan for the future in a controlled
way
•
A budget is:
•
•
a formal financial and/or quantitative statement, prepared prior to
a defined period of time, of the policy to be pursued during that
period for the purpose of attaining a given objective
•
the short-term projection of the long-term strategy for managing
projects and project contracts, and will usually be set in terms of
profit targets and a required return on capital
Revenue, expenses, capital and cash budgets
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Performance measurement
The budget is used to evaluate actual performance
•
achieved through a system of budgetary control, which uses
budget data to monitor and control progress
Variance analysis – compares the difference between a
budget estimate and an actual result
•
Investigation and explanation of variances form part of the process
of management control
Flexed budgets adjust the original budget to reflect actual
levels of activity
•
identify separately differences arising from changes in activity and
differences arising for other reasons
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Performance measurement
•
Effective budgeting improves efficiency
•
It demands the following requirements:
•
careful planning and the provision of information/data for management
•
the participation of both managers and other employees
•
coordination and cooperation
•
a sound accounting system
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Performance measurement
•
Effective budgeting improves efficiency
•
It can deliver the following benefits:
•
new trends and inefficiencies are detected at an early stage of the planning and
control process
•
the delegation of duties/authority
•
control by responsibility
•
management by exception
•
a sound evaluation system for comparing/reporting on budgeted and actual
results
•
the motivation of employees
•
good clear communications
•
corrective action by management to remedy adverse conditions
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Performance measurement
Most companies experience
difficulties in implementing the
budgeting process
Management must take care
over the way in which the
budgetary control system is
operated to avoid sub-optimal
problems
•
•
Checking of estimates may be
difficult, and conditions may
change once budgets have been
agreed
•
Management may not be willing
to cooperate, or support may be
inadequate
•
The accounting system may not
be effective to ensure adequate
control
•
There may be deficiencies in the
organisational structures of the
business
Some of the limitations:
•
Staff regard the techniques as
pressure instruments
•
Motivation may be misplaced
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Cash flow management
•
More businesses go bankrupt through lack of cash than
for any other reason
•
Cash flow forecast includes elements of capital and revenue
income and expenditure to help forecast the cash needed to
keep the business solvent
•
Cash flow management is closely related to working capital
control
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Cash flow management
•
•
Cash flow management is particularly important for
implementing commercial project pricing strategies based
on determining monthly charges to customers
•
Ideal strategy will involve a large cash payment at the start of
the project to cover the capital and start-up costs, followed by
monthly rental to cover ongoing personnel and maintenance
costs
•
Any unrecovered up-front charges will be built into finance
charges
Different exit strategies will also affect cash flow
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Capital investment decisions
•
Four main methods of investment appraisal:
•
accounting rate of return (ARR) – calculates the percentage
value of the average annual operating profit divided by the
average investment over the life of the project, and compares it
with a target percentage rate
•
payback period – calculates the amount of time it takes to
recover, or pay back, the initial investment
•
net present value (NPV) – compares the present value of cash
inflows (benefits) with the present value of cash outflows (costs)
•
internal rate of return (IRR) – calculates the interest (discount)
rate whereby NPV equals zero
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Capital investment decisions
•
Major disadvantage with ARR and payback period – both
ignore the time value of money
•
Both NPV and IRR take the time value of money into
account – but IRR demonstrates pitfalls:
•
It ignores the scale of the investment, focusing instead on the
percentage return
•
The IRR rule may disagree with the NPV rule if the project profile
shows cash inflows first, followed by cash outflows at a later date
•
It is possible for a project to show multiple IRRs, if for example
project cash flows change signs over time
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Capital investment decisions
•
NPV is the only investment appraisal measure that ensures
the maximisation of shareholder value
•
•
technique usually used for the preparation of business cases
A further consideration for companies undertaking capital
investment is how to finance that investment
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Summary
•
Commercial managers need a working understanding of
financial reporting
•
•
to ensure that projects are being properly run
Management accounting information helps commercial
managers to plan and control costs, and make informed
business decisions
•
Income and costs can be estimated and combined to produce
budgets (revenue or capital), as part of an overall strategy for
achieving business targets
•
often expressed a percentage return on investment or a percentage profit
on sale
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Summary
•
Cash flow forecasts can be modelled
•
•
•
to assist with estimating borrowing requirements, setting pricing
strategies, or for use in NPV projections
Performance evaluation can be undertaken to:
•
determine areas of good and poor performance
•
identify where and when management action should be taken
Good quality financial information – and some
understanding of how it is produced – underpins effective
decision-making
Commercial Management: theory and practice, First Edition. David Lowe.
© 2013 David Lowe. Published 2013 by Blackwell Publishing Ltd.
Recommended
reading
ISBN-10: 1-4051-24687
ISBN-13: 978-1-4051-24683
Chapter 5
Additional
reading
ISBN-10: 1-4051-2450-4
ISBN-13: 978-1-4051-2450-8
Chapters 5 and 18