How to Understand Business Finance Robert Cinnamon, Brian Helweg-Larsen and Paul Cinnamon Second Edition Publisher’s note Every possible effort has been made to ensure that the information contained in this book is accurate at the time of going to press, and the publishers and authors cannot accept responsibility for any errors or omissions, however caused. No responsibility for loss or damage occasioned to any person acting, or refraining from action, as a result of the material in this publication can be accepted by the editor, the publisher or any of the authors. First published in Great Britain in 2002 by Kogan Page Limited entitled If You’re So Brilliant… How Come You Don’t Understand Your Accountant? Reissued in 2005 entitled How Come You Don’t Understand Your Accountant? Reissued in 2006 entitled How to Understand Business Finance Second edition 2010 Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced, stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers, or in the case of reprographic reproduction in accordance with the terms and licences issued by the CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the undermentioned addresses: 120 Pentonville Road 525 South 4th Street, #241 4737/23 Ansari Road London N1 9JN Philadelphia PA 19147 Daryaganj United Kingdom USA New Delhi 110002 www.koganpage.com India © Robert Cinnamon, Brian Helweg-Larsen and Paul Cinnamon, 2002, 2006, 2010 The right of Robert Cinnamon and Brian Helweg-Larsen to be identified as the authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN 978 0 7494 6020 4 E-ISBN 978 0 7494 6021 1 The views expressed in this book are those of the authors, and are not necessarily the same as those of Times Newspapers Ltd. British Library Cataloguing-in-Publication Data A CIP record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Cinnamon, Robert. How to understand business finance / Bob Cinnamon, Brian Helweg-Larsen. -- 2nd ed. p. cm. ISBN 978-0-7494-6020-4 1. Business enterprises--Finance. 2. Financial statements. I. Helweg-Larsen, Brian. II. Title. HG4026.C526 2010 658.15--dc22 2009045602 Typeset by Saxon Graphics Ltd, Derby Printed and bound in India by Replika Press Pvt Ltd eBook by Graphicraft Limited, Hong Kong Contents Acknowledgements Introduction 1 So why do you want to know more about finance? Learning A tale of two languages 2 The business cycle Setting up a company The Moving Balance Sheet® Creating value Cash and profit Setting up and running the business – the opening month Profit and loss (P&L) account The balance sheet Month 2 business cycle Going to the bank Doing the books 3 Where do all the business functions fit in? Sales Marketing Manufacturing Supply chain management Human resources IT, maintenance and engineering Research and development Finance 4 Financial planning – the budgets Budgeting Cash flow forecast Avoiding bankruptcy: how to generate cash 5 Measuring business performance – financial ratios Size P&L account (income statement) analysis Balance sheet analysis 6 Getting finance from the bank Introduction Your relationship with the bank Purpose of bank finance Is your request viable? Categories of finance Securing your bank finance Costs of borrowing Sources of help and support When should you apply for bank finance? Maintaining the dialogue Refinancing Summary 7 How our investors see us – stock market ratios What accounts do our investors want to see? Shares 8 Valuing a company Asset value Multipliers Market capitalisation Balanced Scorecard Cash flows 9 Shareholder value and economic profit Earnings before interest, tax, depreciation and amortisation (EBITDA) Economic profit Total shareholder return (TSR) 10 The hidden costs – depreciation, amortisation and tax Depreciation Goodwill Intangible assets Capitalising costs Taxation 11 What must we sell to make a profit? Variable costs Fixed costs Break-even point 12 Tools for evaluating projects Payback Discounted cash flow (DCF) Net present value (NPV) Internal rate of return (IRR) Terminal values Economic profit Pitfalls Other factors 13 Where is all our cash? Managing working capital Stock (inventories) Debtors Creditors Write-offs Cash flow implications of working capital Glossary of financial terms Acknowledgements Writing a book is a daunting task. I must firstly thank Professor Malcolm McDonald who told us that as a training consultant I should write books. Next, my colleague Peter Cheverton has provided an exemplary role model and inspired me to write a book on something I know a little about – finance for non- financial managers. As an engineer by background I attended countless finance programmes, but it was not until I came across a hands-on business simulation that I really got to grips with the subject. The simulation was so effective that not only was I converted, but its models are now the basis of all my explanations on financial matters. A big thank you must therefore go to Nigel Downing and Brian Helweg- Larsen of ProfitAbility® Business Simulations for providing such an excellent mechanism for conveying in simple terms the sometimes difficult concepts of finance. Lastly I thank my publisher Kogan Page for having the faith in me to produce a worthwhile book. Robert Cinnamon [email protected] I would like to thank Gordon Cousins for encouraging me to study, and then teach finance, and for working with me on the original ProfitAbility® design; Nigel Downing, for many years of friendship, working with me on Enterprise ProfitAbility® and building the business we run today; and my wife Sarah for her endless patience and total support. Brian Helweg-Larsen [email protected] Introduction Many parts of this book build on the business game Enterprise ProfitAbility®, developed by ProfitAbility® Business Simulations. You will see a pictorial representation of the finances of a business in Chapter 2 and it will be referred to throughout the book. In other sections, examples will be given of six companies (Ace, Best, Cool, Demon, Excel and First) competing with one another in this business simulation and so again you can refer to the picture of the business in Chapter 2 if you find this helpful. Readers who have a basic understanding of finance can dip in and out of the book at will. Others may find it helpful to read Chapter 2 first before moving on to more complex topics. Inevitably, different elements of finance overlap. So, if you do not understand a concept mentioned in one part of the book, check to see if it is explained more fully elsewhere. 1 So why do you want to know more about finance? Ask a group of business people why they need to know about finance and accounting, or more to the point, why they want to know about it, and the answers can be rather revealing. Most people say, ‘I just want to know what they (the accountants) are talking about.’ This covers a variety of confusions from the abundant use of jargon (do you know your EBIT from your PBIT?), to the incomprehension over apparently arbitrary conventions (and yes, some are just arbitrary conventions… ). The more vigorous the complaint, the more such comments betray a deeper problem. Typically, it is a face-saving way of saying that they don’t really understand the principles of financial and management accounting. That includes reading a balance sheet – can you? And knowing how it differs from a profit and loss account – do you? A variation and sophistication on this first response is, ‘I’d like to be able to understand why what happens to me, happens to me.’ I have heard a marketing director say, ‘The finance folk are a team along the corridor who reject my proposals.’ I have heard a production manager ask, ‘Why is it that the CFO always wins when we are discussing budgets?’ The general cry of, ‘It isn’t fair…’, when business people are confronted by their accountants, rises to a deafening climax when times are tough and cutbacks are required. After these initial, and often rather bitter, responses, the more thoughtful will start to say that what they really want is the confidence to challenge their accountant’s assertions. The marketing director wants to know why she is always told that she spends her budget too quickly, and, more importantly, does she really? The sales director wants to know why he is told to press customers to stick to their payment terms, or even to offer discounts for early payment, when what the customer really wants is extended credit, and in any case that big sales opportunity is just getting warm. The operations director is told that he is sitting on too much stock, yet the salespeople always explode when they run out of something. What he wants to know is, what’s the problem, and what’s too much? The buyer is pressed to ask suppliers for improved terms but what she would much prefer is for those suppliers to do her some real favours on developing new products. Who’s right, the buyer or the accountants, and how could they discuss the pros and the cons of each approach? Once you are able to discuss such questions, not only do the scales fall from the eyes but you are ready to move on to the next level of sophistication – actively managing your own financials. If you run your own business, you will (at least in the early days) often be asking this next question of yourself. Why is it that when cash flow is good, I don’t worry about it, I don’t even look at it, but when it’s bad it becomes an emergency demanding instant attention? At the point of crisis it is pretty difficult to pull anything out of the hat, and so most minds must turn to cost cutting. You know it’s short term, you know it will come back to haunt you, so why don’t you act to avoid such situations in the first place? One reason might be because you were making handsome profits at the time. I have stopped counting the number of businesses that make handsome paper profits, but still go bust. But for more on that, you must read on… Learning There is little doubt that we learn best through experience and, very often, from hard experience. If you want to learn about finance there is no better way than jumping in, feet first, committing yourself to some stuff, digging your hole, and then fighting to get out of it. I would guess that the ex-directors of Woolworths now understand the hard realities of costs and cash flow better than most. Now, you won’t thank me for that advice if you were to practise it in your own business, so we’ll aim to do it here, in someone else’s. People who read books are simply trying to speed things up, and maybe avoid some of the bear traps. This book aims to give you that guidance, but also to help you with the experience of jumping in feet first. We will explain the concepts, demystify the conventions, and translate the jargon by walking you through the set-up and first year’s trading of a real