Finance Basic – The basics of finance are very important for those working in the position of a supervisor or manager because budgeting and managing expenses are another responsibility that cannot be avoided.
But in reality, Finance Basics is important for everyone, no matter what our profession is. Financial knowledge is a very important and necessary element for success in that profession. Of course, the more knowledge we have about finances, the more secure it is in doing any business. Because if we hire someone else to manage our finances for us, how can we be sure or confident that they are honest enough with us?
“Can we analyze the break-even point? Do we understand all the numbers that are relevant to our company? Or do we understand what is causing our company’s profitability to decline?”
The HBR Guide to Finance Basic for Managers is written by Karen Berman and Miles Cook, top business management experts from Harvard University, who are consultants to many managers, executives, business owners, and start-up owners. This book will be like a tool and a confidence builder to become a financial expert. It is a complete guide that will provide the knowledge necessary to understand the basics of finance that every working person must have.
“Every business has financial information as a component. If we don’t know financial instruments, we can’t use that information.”
Every employee up to the managerial level will hear questions or requests for feedback that test their understanding of basic finance. If we speak the same language, they will understand that we can use financial tools as a basis for decision making. But the reality is that most employees, or managers, don’t even understand the difference between profit and cash flow. They can’t tell what is a balance sheet and what is an income statement. So when someone starts using these terms, we start to feel awkward because we don’t know how to proceed. When asked about this, our minds are blank.
“The balance sheet, the income statement, and the cash flow statement are three perspectives on a company’s financial performance.”
What does our company own? Who are our debtors? Who are we debtors to? What is the main source of income for our company? How is the money spent? How much profit have we made? Or what is the overall financial status of the company? We can find the answers to these questions with the following 3 financial statements.
1. Balance Sheet :
The balance sheet shows us what the company’s financial position is today. The balance sheet shows what the company owns, what it owes, and the company’s book value, or net worth, also known as shareholders’ equity.
- Assets – Liabilities = Shareholders’ Equity or Net Worth
- Liabilities + Shareholders’ Equity = Assets
The balance sheet shows assets on one side of the ledger and liabilities and owner’s equity on the other. It is called a balance sheet because the two sides must always be in balance. Examples of assets include cash on hand and marketable securities, receivables, and inventories. Liabilities are money owed to customers, payables, and other debts. They fall into two categories: current liabilities, which must be paid within one year, and long-term liabilities, which are debts due in more than one year.
2. Profit and loss statement or Income Statement :
The income statement shows the cumulative results over a given time frame. It indicates how much revenue we are generating from our company’s products or services. Are we growing revenue faster than our competitors? Are our sales and marketing staff doing a good job? And the income statement also tells us whether we are balancing costs with revenues well enough.
- Revenue – Expenses = Net Income
3. Cash Flow Statement :
The cash flow statement is a statement that shows in broad terms how a company earned and spent money over a given period of time. Expenses are shown on the statement as negative numbers, and sources of income are positive numbers. The bottom line in each category is the net total of inflows and outflows, and can be either positive or negative.
When we use ratios, we can compare our company’s financial performance with the industry average in the market and with our company’s past performance, which gives a clear indication of the progress or decline of our business operations.
Profitability Ratios
Profitability ratios measure a company’s ability to generate profits as a percentage of other figures, such as:
- Return on Assets (ROA): Indicates how well a company is using its assets to generate profits. It is a good measure for comparing companies of different sizes.
- Return on Equity (ROE): Shows profit as a %. It is a ratio that shows the ability to make profits compared to owner’s equity. It is an assessment of the rate of return that shareholders as owners of the business will receive.
- Return on Sales (ROS): Also known as net profit, this is the net profit that is calculated as a percentage of sales revenue. It measures how well a company is able to control costs and turn revenue into net profit.
- Net Profit Margin: Net profit margin shows how efficiently a company produces its products or services, taking into account only direct costs.
Operating ratio
This shows how well the company is using its assets to do its job and managing its cash. What is the asset turnover ratio? This ratio shows how efficiently the company is using all its assets, including cash, machinery, etc., to generate income. Operating ratios help you assess the efficiency level of a company. For example:
- Days Sales Outstanding (DSO) is the number of days it takes to collect cash from customers, which tells us how quickly a company can collect money from customers who are overdue.
- Days Payables Outstanding (DPO) is the average number of days that your business partners extend credit to you. It tells you how quickly your business pays other creditors. The higher the better, because instead of using the money to pay off debts, you can use it for other things.
Liquidity Ratios
The liquidity ratio tells you about a company’s ability to meet its short-term financial obligations, such as debt payments, salaries, and trade payables. For example,
- Current ratio: This ratio measures a company’s current assets relative to its current liabilities. To calculate it, divide total current assets by total current liabilities, which indicates the company’s liquidity to pay off its short-term debt. A value less than 1 means that the company has more current liabilities than current assets, and may have difficulty paying off its short-term debt. A value greater than 1 indicates that the company has enough current assets to pay off its short-term debt.
- Quick ratio: This ratio is modified from the current ratio. In the calculation, inventories are not included with other current assets such as cash, trade receivables, and marketable assets. This is because inventories can be converted to cash more slowly and may be worth less than book value. Therefore, the quick ratio indicates the liquidity of the business better than the current ratio.
- Cash ratio: A ratio used to analyze a company’s liquidity based on the most conservative principle. It takes current assets, which are cash and marketable securities, and divides them by current liabilities. If this ratio is high, it means that the company has high liquidity. However, if it is very high, it may mean that the company holds too much cash, which reduces the efficiency of asset utilization. Therefore, the asset efficiency ratio should be considered together.
- Account Receivable Turnover: The number of times a company can collect money from credit sales. It can be calculated by dividing net credit sales by average trade receivables, where average trade receivables are trade receivables at the beginning of the period plus trade receivables at the end of the period divided by 2. If the account receivable turnover ratio is high, it means that our company can collect money from credit sales quickly. However, if the ratio is too high, it may mean that the company is too strict in extending credit to customers, which may put them at a competitive disadvantage. Therefore, when comparing this ratio with other businesses, the company’s credit policy should also be considered.
- Average Collection Period: This is a calculation to show the debt collection period whether it is short or long to know the quality of the company’s debtors, including the efficiency of debt collection and the business credit policy. If the debt collection period is low, it means the quality of the debtors is good and they can pay quickly.
- Inventory Turnover: The number of times a company can sell its inventory. It can be calculated by dividing the cost of goods sold by the average inventory. The average inventory is the beginning inventory plus the ending inventory divided by 2. If the inventory turnover is high, it means that our company can sell products quickly. But if the rate is high, it means that there is too little inventory, which results in not enough products to sell and eventually we lose customers. Therefore, we must manage our inventory so that it is not too much or too little.
- Holding period: This ratio shows that the shorter the period, the better, and the faster the sale is for the business.
The principle is that expenses must match income.
The purpose of the income statement is to include all costs and expenses related to generating revenue in a given period of time. These expenses may not necessarily be the actual expenses paid during that period. Some expenses may be paid earlier, while others may be paid later when vendor bills become due. Therefore, the expenses on the income statement do not reflect the cash paid out. Therefore, a cash flow statement is needed to show how cash is coming in and out.
Cost expenses are not included in profits.
When costs are incurred, they do not appear on the income statement. So a company can buy trucks, machinery, computers, and so on, and the costs will only appear on the income statement as gradual depreciation over the life of the asset. All of these items are often paid off long before they are fully depreciated.
“The difference between profit and cash can wreak havoc on any business, especially for growing companies.”
A company may have to deal with the fact that a major customer is paying a bill very late, or a key vendor has to pay in advance. These things can wreak havoc on a company’s cash flow, even if they don’t have a significant impact on profits.
There are 3 important reasons why we should understand the Cash Flow Statement.
1. How can it help us see what is happening right now with our company, where the business is headed, and what the priorities of senior management are likely to be?
2. Most companies focus on profits, but when they should be focusing on profits and cash, of course, the impact is usually limited to operating cash flow.
3. People who understand cash flow tend to be given more responsibility and are therefore more likely to advance faster than those who focus solely on the income statement.
Cost-Benefit Analysis
It is important to understand the cost of the status quo. We must weigh the relative benefits of each investment against the potential negative consequences of not investing at all. The cost-benefit analysis must follow the following steps:
- Identify the costs associated with new business opportunities
- Look at the value of new investments
- Set deadlines for expected expenses and income.
- Look at the benefits of additional income that investment will bring.
- Assessing unmeasurable benefits and costs
Once you have completed this step, you are ready to start evaluating investment opportunities.
Break-even analysis
Break-even analysis tells us how much we need to sell to pay for our fixed investment, or in other words, where we will break even in our cash flow. With this information in hand, we can look at market demand and competitors’ market share to see if we can really sell that much. Break-even analysis also helps us to think about the impact of price and volume changes.
“Most companies conduct break-even analysis based on revenue and gross profit margin.”
Before we can calculate this, we need to understand these components.
- Fixed costs are costs that remain the same regardless of how many products or services are sold, such as insurance, executive salaries, or rent.
- Variable costs are costs that change with the number of units produced and sold.
Break-even quantity = Fixed cost / (Selling price per unit – Variable cost per unit)
Once we have decided on an investment opportunity, we should track its progress, tracking our projections against actual income and expenses. It is a good idea to do this on a monthly basis so that we can identify potential problems early on.
What information can’t be told by financial statements?
Financial statements are primarily historical, or historical information. The income statement and the cash flow statement tell us how our company performed in previous periods. The balance sheet provides a snapshot of our financial position at a given date. But businesses also need to know what’s happening now, and what’s likely to happen tomorrow. Here are three key types of information that we don’t get from financial statements.
- Non-financial organizational performance
If a company has a safety issue, it is likely to have one problem at a time. Safety is one aspect of organizational health. Another is employee engagement levels. Do people enjoy working at our company? Would they recommend it to a friend? To answer these questions, we need input from employees, and you won’t find this information in the financial statements. - What customers think,
their attitudes, their satisfaction with the company and its products, their grievances, complaints and so on, these things are also not reflected in the financial statements. Yet, these attitudes are important indicators of the future success of the company. After all, if a company cannot retain its customers and attract new customers, its prospects tend to be bleak. - What are competitors planning?
This issue rarely comes up, and most companies spend a great deal of time and resources trying to predict their competitors’ next moves. Smart companies keep an eye on those plans by analyzing competitors’ reports and press releases, talking to knowledgeable analysts and observers, and attending industry conferences. A business that ignores the competition is a business that is in jeopardy.
Conclusion
Business owners and employees should pay attention to the level of working capital of the company. Too little working capital can put the company in a bad position, which will certainly affect the ability to pay bills or take advantage of profit opportunities. But too much working capital can reduce the ability to make a profit, because this capital must be supported by finance in some way.
As people use financial statements to gain insights into companies, many have noticed that traditional balance sheets fail to reflect a company’s value and profit potential. The absence of intangibles on a balance sheet, such as skills, intellectual property, brands, or relationships, prevents us from recognizing the most productive assets. Instead, we should look beyond the bricks, mortar, equipment, and cash that make up the assets on a balance sheet to determine the true value of a company by looking at what it doesn’t show.
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