BusinessStartupBundleForDummies®

TableofContents

BusinessStartupBundleForDummies

StartingaBusinessForDummies

TableofContentsIntroductionChapter1:PreparingforBusinessChapter2:DoingtheGroundworkChapter3:CanYouDotheBusiness?Chapter4:TestingFeasibilityChapter5:StructuringYourBusinessChapter6:PreparingtheBusinessPlanChapter7:GettingHelpChapter8:FindingtheMoneyChapter9:ConsideringYourMissionChapter10:MarketingYourWaresChapter11:EmployingPeopleChapter12:OperatingEffectivelyChapter13:KeepingTrackofFinancesChapter14:ManagingYourTaxPositionChapter15:DoingBusinessOnlineChapter16:ImprovingPerformanceChapter17:ExploringStrategiesforGrowthChapter18:BecomingaGreatManagerChapter19:TenPitfallstoAvoid

Chapter20:TenPeopletoTalktoBeforeYouStartChapter21:TenWaystoCutCostsChapter22:TenStepstoPreparetoMoveOn

BusinessPlansForDummies

TableofContentsIntroductionChapter1:StartingYourBusinessPlanChapter2:ChartingtheProperCourseChapter3:SettingOffintheRightDirectionChapter4:CheckingOuttheBusinessEnvironmentChapter5:TakingaCloserLookatCustomersChapter6:DividingCustomersintoGroupsChapter7:ScopingOutYourCompetitionChapter8:EstablishingYourStartingPositionChapter9:FocusingOnWhatYouDoBestChapter10:FiguringOutFinancialsChapter11:ForecastingandBudgetingChapter12:PreparingforChangeChapter13:ThinkingStrategicallyChapter14:ManagingMorethanOneProductChapter15:PlanninginTurbulentEconomicTimesChapter16:MakingYourBusinessPlanWorkChapter17:LearningfromOthers:ASampleBusinessPlanChapter18:TenQuestionstoAskAboutYourPlanChapter19:TopTenBusiness-PlanningNever-Evers

UnderstandingBusinessAccountingForDummies

TableofContentsIntroductionChapter1:IntroducingAccountingtoNon-AccountantsChapter2:Bookkeeping101:FromShoeBoxesto

ComputersChapter3:Taxes,TaxesandMoreTaxesChapter4:AccountingandYourPersonalFinancesChapter5:ProfitMechanicsChapter6:TheBalanceSheetfromtheProfitandLossAccountViewpointChapter7:CashFlowsandtheCashFlowStatementChapter8:GettingaFinancialReportReadyforPrimeTimeChapter9:ManagingProfitPerformanceChapter10:BusinessBudgetingChapter11:ChoosingtheRightOwnershipStructureChapter12:CostConundrumsChapter13:ChoosingAccountingMethodsChapter14:HowInvestorsReadaFinancialReportChapter15:ProfessionalAuditorsandAdvisersChapter16:TenWaysSavvyBusinessManagersUseAccountingChapter17:TenPlacesaBusinessGetsMoneyFromChapter18:Ten(PlusOne)QuestionsInvestorsShouldAskWhenReadingaFinancialReportChapter19:TenWaystoGetaBetterHandleontheFinancialFutureAppendixA:Glossary:SlashingthroughtheAccountingJargonJungleAppendixB:AccountingSoftwareandOtherWaystoGettheBooksinGoodOrder

StartingaBusinessForDummies®,3rdEdition

byColinBarrow

StartingaBusinessForDummies®,3rdEdition

PublishedbyJohnWiley&Sons,LtdTheAtriumSouthernGateChichesterWestSussexPO198SQEnglandE-mail(forordersandcustomerserviceenquires):cs-books@wiley.co.ukVisitourHomePageonwww.wiley.com

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AbouttheAuthorColinBarrowwas,untilrecently,HeadoftheEnterpriseGroupatCranfieldSchoolofManagement,wherehetaughtentrepreneurshipontheMBAandotherprogrammes.HeisalsoavisitingprofessoratbusinessschoolsintheUS,Asia,France,andAustria.HisbooksonentrepreneurshipandsmallbusinesshavebeentranslatedintotwentylanguagesincludingRussianandChinese.HeworkedwithMicrosofttoincorporatethebusinessplanningmodelusedinhisteachingprogrammesintothesoftwareprogram,MicrosoftBusinessPlanner.Heisaregularcontributortonewspapers,periodicalsandacademicjournalssuchastheFinancialTimes,TheGuardian,ManagementToday,andtheInternationalSmallBusinessJournal.

ThousandsofstudentshavepassedthroughColin’sstart-upandbusinessgrowthprogrammes,goingontorunsuccessfulandthrivingenterprises,andraisingmillionsinnewcapital.Heisontheboardofseveralsmallbusinesses,isaUniversityAcademicGovernor,andhasservedontheboardsofpubliccompanies,venturecapitalfunds,andonGovernmentTaskForces.

Author’sAcknowledgmentsIwouldliketothankeveryoneatWileyfortheopportunitytowriteandupdatethisbook–aswellasfortheirhelp,encouragement,feedback,andtirelessworktomakethisallhappen.

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TableofContents

Introduction

WhyYouNeedThisBookHowtoUseThisBookHowThisBookIsOrganised

PartI:GettingStartedPartII:MakingandFundingYourPlanPartIII:StayinginBusinessPartIV:MakingtheBusinessGrowPartV:ThePartofTens

IconsUsedinThisBookWheretoGoFromHere

PartI:GettingStarted

Chapter1:PreparingforBusiness

UnderstandingtheEnduringRulesofBusinessStrategy

Focus,focus,focusAppreciatingtheforcesatworkinyoursector

Recognisingthefirst-to-marketfallacy

GettinginShapetoStartUp

AssessingyourabilitiesDiscoveringarealneedCheckingthefitofthebusiness

ConfirmingViability

ResearchingthemarketDoingthenumbersRaisingthemoneyWritingupthebusinessplan

GoingforGrowth

GainingeconomiesofscaleSecuringacompetitiveadvantageRetainingkeystaffGainingcriticalbusinessmass

Chapter2:DoingtheGroundwork

UnderstandingtheSmallBusinessEnvironmentDefiningSmallBusinessLookingattheTypesofPeopleWhoStartBusinesses

MakingyourageanassetConsideringlocationWinningwithwomenBeingeducatedabouteducation

ComingUpwithaWinningIdea

Rankingpopularstart-upideasGoingwithfastgrowthSpottingagapinthemarketRevampinganoldideaUsingtheInternetSolvingcustomerproblemsCreatinginventionsandinnovationsMarketingotherpeople’sideasBeingbetterordifferent

BanningBadReasonstoStartaBusiness

SteeringclearofbadassumptionsAvoidingobviousmistakes

RecognisingthattheEconomyMatters

SpottingcyclesPreparingfortheupsanddowns

PreparingtoRecogniseSuccess

MeasuringbusinesssuccessExploringthemythandrealityofbusinesssurvivalrates

Chapter3:CanYouDotheBusiness?

DecidingWhatYouWantFromaBusiness

Gainingpersonalsatisfaction(or,entrepreneursjustwannahavefun)MakingmoneySavingtheplanet

ExploringDifferentTypesofBusiness

SellingtootherbusinessesOpeningallhoursMakingproductsServicingcustomers

WorkingfromHome

FindingthespaceCheckingouttherulesVanquishingvisitors

AssessingYourself

DiscoveringyourentrepreneurialattributesWorkingoutabusinessideathat’srightforyouFiguringoutwhatyou’rewillingtoinvestWeightingyourpreferences

Chapter4:TestingFeasibility

FindingEnoughProductorPeople

Howmuchisenough?BuyinginequipmentandsuppliesHiringinhelp

SizingUptheMarket

FiguringoutwhatyouneedtoknowFindingyoursegmentofthemarketBudgetingforyourresearchDoingthepreliminaryresearchConductingtheresearch

WorkingOutWhetherYouCanMakeMoney

Estimatingstart-upcostsForecastingsalesExceedingbreakeven

PartII:MakingandFundingYourPlan

Chapter5:StructuringYourBusiness

ChoosingtheRightStructureGoingintoBusinessbyYourself

AdvantagesDisadvantagesSettlingonsole-traderstatus

BuildinguptoNetworkMarketing

EvaluatingtheprosandconsDistinguishingpyramidsfromnetworkmarketing

WorkingwithaLimitedNumberofOtherPeople

TakingonanexistingbusinessFormingapartnershipLookingatlimitedpartnershipsCheckingoutco-operatives

FindingYourWaytoFranchising

LookingatfranchisetypesDefiningafranchise

FoundingaLargerCompany

OptingforalimitedcompanyBuyingoutabusiness

LookingatLegalIssuesinMarketing

NamingyourbusinessLookingatlogosProtectingpatentsRegisteringatrademarkDetailingyourdesignControllingacopyrightAbidingbyfairbusinessrulesSettingtermsoftradeDescribingyourgoodsDealingwithpaymentproblems

Chapter6:PreparingtheBusinessPlan

FindingaReasontoWriteaBusinessPlan

BuildingconfidenceTestingyourideasShowinghowmuchmoneyyouneedProvidingplanningexperienceSatisfyingfinanciers’concerns

WritingUpYourBusinessPlan

DefiningyourreadershipChoosingtherightpackagingDecidingonlayoutandcontentWritingandediting

MaintainingconfidentialityDoingduediligence

UsingBusinessPlanningSoftware

RecognisingthelimitsofsoftwareReviewingsystems

PresentingYourPlan

StarringinshowtimeMakinganelevatorpitch

Chapter7:GettingHelp

ConnectingwithGovernmentservicesLinkingtoLocalEnterpriseAgencies(LEAs)ChoosingSmallBusinessAssociations

TheFederationofSmallBusinessesForumofPrivateBusinessTheBritishChambersofCommerceAfewmorestringstoyourbow

UniversitiesandCollegesEnteringanIncubator

FindingtherighttypeofincubatorGettingintoanincubator

AssistingInventorsHelpingYoungEntrepreneurs

AttractingLivewireTrustingthePrince’sTrust

Learningbydoing–theYoungEnterprisemotto

Chapter8:FindingtheMoney

AssessingHowMuchMoneyYouNeed

ProjectingreceiptsEstimatingexpensesWorkingouttheclosingcashbalancesTestingyourassumptions

ReviewingYourFinancingOptions

DecidingbetweendebtcapitalandequitycapitalExaminingyourownfinances

DeterminingtheBestSourceofFinanceforYou

ConsideringthecostsSharingownershipandcontrolBeatingtheclockStayingflexibleGainingsecurityandcertaintyLimitingpersonalliability

GoingforDebt

BorrowingfrombanksFinancingcashflowGettingphysicalUnitingwithacreditunionBorrowingfromfamilyandfriends

SharingOuttheSpoils

BenefitingbybusinessangelsGoingforventurecapitalLookingtocorporateventuring

FindingFreeMoney

GettingagrantWinningmoney

Chapter9:ConsideringYourMission

DevelopingYourConceptComposingYourMissionStatement

Thinkingthroughyourmission

SeeingtheVisionThingSettingObjectivesandGoals

Chapter10:MarketingYourWares

MakingUptheMarketingMixDefiningYourProductorServiceParametersUsingAdvertisingtoTellYourStory

Consideringthecustomer’spointofviewMakinganexhibitionofyourselfSettingadvertisingobjectivesDecidingthebudgetDefiningthemessageChoosingthemediaChoosingthefrequencyWritingaleafletUsingtheInternetforviralmarketing

ProvidingopportunitiestoseeFiguringyourbang-for-the-buckratio

GettingintheNews

DecidingwhotocontactFollowingthroughUsingblogsandsocialnetworksSellingandSalesmanshipTellingthedifferencebetweensellingandmarketingSellingyourselfOutsourcingsellingMeasuringresults

PricingforProfit

CaringaboutbusinessconditionsWorkingtoyourcapacityUnderstandingconsumerperceptionsSkimmingversuspenetratingAvoidingsettingpricestoolow

PonderingPlaceandDistribution

ChoosingalocationWorkingfromhomeSelectingadistributionchannel

PartIII:StayinginBusiness

Chapter11:EmployingPeople

FindingGreatEmployees

Decidingonfull-orpart-timers

RecruitingandselectingTestingtofindthebest

ExploringOtherWaysofRecruiting

UsingagenciesUsingJobCentrePlusRecruitingovertheInternetOutsourcingjobs

MotivatingandRewardingEmployees

GettingthebestoutofemployeesDealingwithdifficultordemotivatedemployeesKeepingmotivationinthefamilyRewardingachievements

StayingontheRightSideofEmploymentLaw

KeepingemploymentrecordsPreparingcontractsofemploymentWorkinglegalhoursGrantingleaveAvoidingdiscriminationKeepingtheworkenvironmenthealthyandsafe

Chapter12:OperatingEffectively

ProposingPremises

CalculatingrequirementsFindingtherightpremisesRentingorowning?Sortingoutequipment

TakingtheMake-or-BuyDecision

Makingityourself–prosandconsOutsourcing–alowinvestmentoptionSettingqualitystandards

ChoosingaSupplier

EvaluatingtradingtermsBuildingarelationshipBuyingonline

MinimisingRiskandAssessingLiability

ProtectingyouremployeesCoveringyourselfagainstanemployeesuingProtectingassetsCoveringlossofprofitsGoodsintransitProtectingyourselfGuaranteeinggoodsandservices

DissectingDirectorsFindingandChoosingBusinessAdvisers

TallyingupanaccountantInvestinginabankSolicitingforalawyerManagingaconsultant

Chapter13:KeepingTrackofFinances

KeepingtheBooks

Recordingfinancialinformation

StartingsimplewithsingleentryDealingwithdoubleentryChoosingtherightaccountingprogramOutsourcingbookkeeping

UnderstandingYourAccountsForecastingCashFlowReportingYourProfits

CalculatinggrossprofitReckoningexpensesAppreciatingthedifferenttypesofprofit

AccountingforPricing

BreakingevenPricingforprofitBuildinginmoreproductsHandlingpricechanges

BalancingtheBooks

AbalancesheetCategorisingassetsAccountingforliabilitiesUnderstandingreserves

AnalysingPerformance

UsingratiosGearingdown

KeepingontheRightSideoftheLaw

Carryingoutanaudit

Filingyouraccounts

ManagingYourAccountant

Chapter14:ManagingYourTaxPosition

TacklingTaxesforDifferentTypesofBusinesses

FiguringoutsoletradersandpartnershipsLookingatleviesoncompaniesAssessingthebestlegalstructure

PayingTaxes

Valuingvalue-addedtaxMinimisingtaxes

HandlingEmploymentTaxes

PayingPAYEAllocatingnationalinsuranceAccountingforemploymenttaxes

PartIV:MakingtheBusinessGrow

Chapter15:DoingBusinessOnline

AppreciatingthePoweroftheInternet

RichnessversusreachClicksandbricksRecognisingthelimits–therearenone!

WhatYouCanDoOnline

GeneratingadvertisingrevenueRecruitingstaffAnsweringfrequentquestionsCarryingoutresearch

EstablishinganInternetPresence

DecidingoncontentDesigningthewebsiteUsingaconsultantRegisteringdomains

SellingGoodsandServices

UsingthirdpartywebsitesBuildingastorefrontGettingpaidonlineFulfillingorders

GainingVisibility

UnderstandingsearchenginesUsingasubmissionsservicePayingforplacementCheckingoutcompetitorsTrackingtraffic

Chapter16:ImprovingPerformance

CheckingYourInternalSystems

KeepingtrackofyourroutineAnalysingmarketposition

RetainingCustomers

RealisingwhyretainingcustomersmattersWorkingtoretaincustomers

ImprovingProductivity

TrimmingexpensesIncreasingmarginsWorkingsmarterRewardingresults

BudgetingforBeginners

SettingtheguidelinesAnalysingthevariancesFlexingthefiguresBudgetingfromzero

Chapter17:ExploringStrategiesforGrowth

UnderstandingtheImportanceofGrowth

MeasuringmarketshareBuildingabrand

IncreasingSales

GettingcustomerstobuymoreEncouragingreferralsEnteringnewmarketsathomeSellingoverseasAddingnewproductsorservicesDiversifyingasalastresort

FormingAlliances

GoingonthealliancetrailInvestigatingandapproaching

FranchisingYourWaytoGrowth

BoltingonafranchiseWeighingtheadvantagesanddisadvantagesDoingthepilotFindingfranchiseesRollingoutthefranchise

Chapter18:BecomingaGreatManager

BuildingaTeamFoundingprinciplesCoachingandTrainingAppraisingPerformanceDevelopingaLeadershipStyle

UnderstandingleadershipDelegatingEvolvingleadershipstylesforgrowthManagingchange

MeasuringMorale

PartV:ThePartofTens

Chapter19:TenPitfallstoAvoid

KnowingTooLittleBeingOverlyOptimisticabouttheMarketUnderestimatingStart-upTimeSpendingTooMuchattheStart

MistakingCashforProfitChoosingtheWrongPartnerIgnoringAccountingForgettingWorkingCapitalHavingNoClearCompetitiveAdvantageChoosingtheWrongLocation

Chapter20:TenPeopletoTalktoBeforeYouStart

SpeakingwithYourSpouseMakingUseofYourProfessionalNetworkBenefitingfromEntrepreneursWhoStartedaSimilarBusinessSpendingTimewithaFriendlyBankerTappingintoYourLocalEnterpriseAgencyDirectorCommunicatingwithYourCurrentBossCallingYourColleaguesBringinginYourBestFriendReportingtoanAccountantPluggingintoaBusinessAngelNetwork

Chapter21:TenWaystoCutCosts

UsingaSuggestionSchemeFormingSmartCirclesGoingGreenUsingLessUtilitiesStrippingOutWasteReducingShrinkageNegotiatingwithSuppliersGoingInforBenchmarkingGettingKittedOutforLessSettingCost-cuttingPriorities

Chapter22:TenStepstoPreparetoMoveOn

MonitoringMarketPricesValuingYourBusinessFiguringOutWhotoSellToDressingtoKillFindingAdvisersDoingDueDiligenceEarningOutYourProfitsStartingUpAgainBecomingaBusinessAngelWindingUp

CheatSheet

IntroductionIfyou’vepulledthisbookdownfromtheshelforhaditpassedtoyoubyafriendorlovedoneasagift,youdon’thavetobepsychictoknowsomethingaboutyourcurrentbusinesssituation.Youmaybeinneedofthisbookforanynumberofreasons:

YousawLehmanBrothers’staffqueuingoutsidetheirofficeswithcardboardboxesanddon’twantthattohappentoyourbusiness.

Arelative,hopefullyadistantandelderlyone,hasdiedandleftyouapileofdoshandyoudon’tfancyleavingittoyourstockbrokertoloseonyourbehalf.

Youremployerisinthemiddleofamajordownsizingoperationaswellasproposingtocloseitsfinalsalarypensionschemeandrelocatetosomewherewithlousyschoolsandnohealthcarefacilities.

Youhaveagreatideaforaworld-beatingproductthatnoonehaseverthoughtofbuteveryoneoftheworld’sbillionInternetusersdesperatelyneeds–whentheyhearthegoodnewsthey’regoingtoclickapathtoyourwebsite.

Yourbrother,sister,father,motherorbestfriend–orworsestill,allofthem–hasstartedhisorherownbusinessandretiredtoachateauinFrancetobreedhorses,tendthevinesandsailonaluxuryyacht.

Ifyourpresentsituationisfoundedlargelyonluckandserendipity,thatisn’tenoughtogetyouthroughthebusinessstart-upprocessunaided.Goodideas,hardwork,relevantskillsandknowledgeaboutyourproductanditsmarket,thoughessential,ontheirownaren’tenough.The400,000smallfirmsthatclosetheirdoorseveryyearintheUnitedKingdom,afigurethatrosesharplyintherecent

recession,areevidenceenoughthattheprocessisatoughone.

Thisbookisaimedatyouifyoueitherwanttostartupabusinessortoreviewyourprospectsinthesmallbusinessworld.Itbringstogether,fromawidevarietyofsources,theessentialelementsofknowledgethatareaprerequisitetounderstandingtheworldofsmallbusinessandtoachievingfinancialandpersonalsuccesswhatevertheeconomicweather.

WhyYouNeedThisBookMostbusinessfailuresoccurwithinthefirst18monthsofoperation.Thatfactalonehasmadeitincreasinglyclearthatsmallbusinessesneedspecialhelp,particularlyintheirformativeperiod.Themostcrucialneedsforownersandmanagersinclude:

Helpinacquiringbusinessskillsinsuchareasasbasicbookkeepingandaccounting.Mostfailingbusinessessimplydon’tknowtheirfinancialposition.Eveniftheorderbookisfull,thecashcanstillrunout.

Knowledgeofwhatsortsoffinanceareavailableandhowtoputthemselvesinthebestpossiblepositiontoraisemoney.Surprisingly,fundsaren’tinshortsupply.Problemslie,rather,inthebusinesspropositionitselfor,moreoften,inthewayinwhichtheownermakesthepropositiontothefinancier.

Informationwithwhichtomakerealisticmarketassessmentsofthesizeandpossibilitiesoftheirchosenmarket.Over-optimismaboutthesizeandeasewithwhichamarketcanbereachedisanalltoocommonmistake.

Skillsandtoolstogrowtheirbusinessesintovaluableassetstopassontofamilymembersortosellupandsailoffintothesunset.

Thisbookgivesyouhelpinalltheseareas.

Inaddition,everybusinessneedsabusinessplan,astatementofbusinesspurpose,withtheconsequencesofeachelementofthatpurposespeltoutinfinancialterms.Youmustdescribewhatyouwantyourbusinesstodo–whoitspotentialcustomersare,howmuchthey’relikelytospend,whocansupplyyouandhowmuchtheirsuppliescost.Thenyoumusttranslatethoseplansandprojectionsintocash–howmuchyourbusinessneeds,howmuchyoualreadyhaveandhowmuchyouexpect‘outsiders’toputin.Thisplanalsohelpsyoutoavoidcatchingthe‘commoncold’ofsmallbusinesses–underestimatingtheamountofstart-upcapitalyouneed.Goingbacktoabankandaskingfor30percentmorefundingsixmonthsafteropeningyourdoors,andretaininganycredibilityatall,isdifficultifnotimpossible.Andyetnewbusinessesconsistentlyunderestimatehowmuchmoneytheyneedtofinancetheirgrowth.

Manypeoplehaveneverpreparedabusinessplan,theydon’tknowhowtostartandtheyneednewknowledge.That’swherethisbookcomesin.Inthesechapters,Igiveyoutheinformationyouneedtoformulateandfollowabusinessplan.

Thebookisalsoinvaluabletoinnovators,whohavespecialproblemsofcommunicationandsecuritywhentheytrytotranslatetheirideasintobusinesses.Alltoooftentheirinventionsareleftforothercountriestoexploit,ortheyfeelunhappyaboutdiscussingideas,believingthatapatentistheironlyprotection.Butmoreoftenthannot,thesebusinessownerssimplydon’tknowwhototalkto,littlerealisingthatsophisticatedhelpisoftencloseathand.Thusthisbookilluminatesapathfromthelaboratorytothemarketplacesothatsmallfirmsandinventorscanseeaclearroute.

HowtoUseThisBookStartingaBusinessForDummiescanhelpyousucceednomatter

whatkindofbusinessexpertiseyou’relookingfor.Ifyouhaveagreatandprovenbusinessidea,youmaywanttoplugstraightintofindingouthowtoraisefinance.Ifyouneedmorethanjustyourselftogetyourgreatbusinessideaofftheground,thenyoumaywanttodiscoverhowtofindgreatemployeesorperhapsabusinesspartnertotakesomeofthefinancialandemotionalstrain.Thisbookissetupsothatyoucandipinandoutofitinanumberofwaysdependingonyoursituation.

Ifyouhaven’tstartedabusinessbefore,orbeenprofitaccountableforpartofanenterprise,thenyoumaywanttostartatthebeginningandworkyourwaythrough.

Ifyou’remoreexperienced,thenyoumaystartbyselectingtheareasyouarelessknowledgeableabouttofillinthegapsandworkoutwardsfromthere.

Ifyou’requiteconfidentinthebusinessworld,youcanusethebookasaguideandmentortoreviewaparticulartopic.Youcanevenuseittoplantosellyourbusinessafterit’sestablishedandmoveontoadifferentchallenge.

Ifyoulearnbyexample,youmaywanttoflipthroughthebook,usingtheTrueStoryiconasyourguide.Thetextnexttothisiconhighlights‘straightfromthehorse’smouth’examplesofhowsuccessfulentrepreneurshavetackledspecificsituations,beitfindingapartner,raisingfinanceorgettingafreegrantfromthegovernment.

Thenextsectiontellsyouwhatthevariouspartsofthebookcoversothatyoucanturntoacertainpartforaspecificneed.

HowThisBookIsOrganisedStartingaBusinessForDummiesisdividedintofivemainpartsbasedonthemajorelementsinvolvedinplanning,launchingandrunninga

business.Youdon’thavetoreadalltheparts,however,andyoucertainlydon’thavetoreadtheminorder.Eachchapterisdevotedtoaparticularbusinessstart-uptopicandyoumayneedsomechaptersmorethanothers.Feelfreetojumpfromsectiontosectionandchaptertochapter;pickandchoosewhatreallymatterstoyouandyourbusinessproposition.

PartI:GettingStartedBeforeyougetabusinessoffthegroundyouhavetodoallthepreliminarylegworkandmakesurethatyouhaveaviablebusinessonyourhandsbeforeyoucommittoomuchtimeandmoney.Thispartgetsyouontrackrightawaybyhelpingyoutogathercrucialinformationonyourmarketplace,potentialcustomersandcompetitors,andsotestwhetheryourideaisviable.Italsoprovidesachanceforyoutocheckoutyourskillsandattributestohelpyouestablishtherightbusinessforyoutostart.

PartII:MakingandFundingYourPlanToensurethatyourbusinessprospersyouhavetoknowsomethingaboutthelegalstructuresunderwhichyoucantradeandwhichsuitsyoubestattheoutset.Youneedabusinessplantohelpyoubothtesttheviabilityofyourpropositionandtoshareyourideasandaspirationswithothers,includingpotentialinvestors,bankersorpartners.Youalsowanttoreviewthefinancingoptionstomakesurethatyougetboththerightamountandtypeoffinanceforyourbusinessneeds.Youdon’thavetodoallthisonyourown,becausethechaptersinthispartlistkeyorganisationsthatofferadviceandhelptobusinessstarters.

PartIII:StayinginBusinessAfteryougetgoingyou’llalmostcertainlyneedtoemploystaffeitherfulltime,parttimeoronatemporarybasis.Thisinvolveslegalresponsibilitiesthatyoushouldbepreparedfor.Abusinessneedscontrollinginmuchthesamewayasacarorplanedoes.Youneedtounderstandwhatthekeycontroldocumentsare,andwhattheytellyouabouthowyourbusinessisperforming.Youalsoneedtohaveasoundappreciationofyourincome,expensesandtaxliabilities,andhowtominimisethoseliabilitieslegitimately.

PartIV:MakingtheBusinessGrowAfteryouhaveyourbusinessupandrunningyouwanttoseehowfastyoucanmakeitgowithoutblowingagasketorrunningofftheroad.Partofthisprocessisabitlikefine-tuningacarengine.Butpartinvolvessubstantiallychangingeverything,includingtheproductsandservices,themarketsyouserveandperhapseventheverynatureofyourbusinessoperations.Theprocessmayeveninvolveadoptingastrategytofranchiseyourbusinessidea,boltafranchiseontoyourventureorformsomeotherformofstrategicalliance.Thispartcoverstheinsandoutsofexpandingyourbusinesssafelyandsmartly.

PartV:ThePartofTensThePartofTenspresentsfourchapters.Oneisacollectionofwarningsabouttheproblemsthatmostnewbusinessesarelikelytoencounterandhowtocounteractthem.Anothercontainsdetailsofthepeopleyouabsolutelyhavetotalktobefore,duringandafteryou’vestartedup.Thethirdchaptergivesvitaldetailsonhowtocutcostsandsokeepyourbusinesscompetitive.Thefinalchapterprovidespointersonmaximisingthevalueofyourbusiness,findingabuyerandthenmovingontopasturesnew.

IconsUsedinThisBookTohelpyoupinpointvitalinformation,I’veplacediconsthroughoutthetexttosteeryoutonuggetsofknowledge.

Thisiconcallsyourattentiontoparticularlyimportantpointsandoffersusefuladviceonpracticaltopics.

Thisiconservesasafriendlyreminderthatthetopicathandisimportantenoughforyoutomakeanoteof.

Business,likeanyspecialistsubject,isawashwithspecialisedtermsandexpressions,someofwhichmaynotbefamiliartoyou.Thisicondrawsyourattentiontothese.

ThisiconalertsyouthatI’musingapracticalexampleshowinghowanotherbusinessstarterhastackledaparticulartopic.Oftenyoucanapplytheexampletoyourownbusiness.

Thisiconalertsyoutoapotentialdanger.Proceedwithcaution;lookleftandrightbeforecrossing.Infact,thinkcarefullyaboutcrossingatallwhenyouseethisicon.

Thisiconreferstospecialisedbusinessfactsanddatathatareinterestingasbackgrounddatabutnotessentialforyoutoknow.Youcanskipparagraphsmarkedbythisiconwithoutmissingthepoint–butreadingthemmayhelpyoubuildcredibilitywithoutsideinvestorsandpartners.

WheretoGoFromHereTakeaminutetothumbthroughthetableofcontentsandgetcomfortablewiththetopicsthebookcovers.Pickachapterthatstrikesaparticularchordwiththeaspectofstartingabusinessthat’suppermostinyourmind.Readthatandseewhereitleadsyou.

YoucanalsouseChapter6,‘PreparingtheBusinessPlan’,asaframeworkforgatheringknowledgeanddivingbackintotheotherchaptersasyougo.

Ifallelsefails,startatthebeginning.Thattechniquehasaprettygoodtrackrecord.

Chapter3

CanYouDotheBusiness?

InThisChapterUnderstandingwhetherbeingyourownbossisrightforyou

Checkingoutvariousventures

Settingupyourbusinessathome

Figuringoutyourprofitmotive

Takingaskillsinventorytoidentifyanygaps

Governmentsarekeentofosterentrepreneurship:newbusinessescreatejobsforindividualsandincreasedprosperityfornations,whicharebothprimarygoalsforanygovernment.Ifthosenewfirmsdon’tthrowpeopleoutofworkwhenrecessionsstarttobite,supportingthembecomesdoublyattractive.

Butpeople,youincluded,don’tstartbusinessesorgrowexistingonessimplytopleasepoliticiansortogivetheirneighboursemployment.Theyhavemanyreasonsforconsideringself-employment.Theideaofescapingthedailygrindofworkingforsomeoneelseandbeinginchargeoftheirowndestinyattractsmostpeople.Butdespitethemanypotentialbenefits,theyfacerealchallengesandproblems,andself-employmentisn’tarealisticoptionforeveryone.

Thequestionsyouneedtoaskyourselfare:CanIdoit?AmIreallytheentrepreneurialtype?Whataremymotivationsandaims?HowdoIfindtherightbusinessforme?Thischaptercanhelpyoudiscovertheanswers.

DecidingWhatYouWantFromaBusiness

Seewhetheryourelatetoanyofthemostcommonreasonspeoplegiveforstartingupinbusiness:

Beingabletomakeyourowndecisions

Havingabusinesstoleavetoyourchildren

Creatingemploymentforthefamily

Beingabletocapitaliseonspecialistskills

Earningyourownmoneywhenyouwant

Havingflexibleworkinghours

Wantingtotakeacalculatedrisk

Reducingstressandworry

Havingthesatisfactionofcreatingsomethingtrulyyourown

Beingyourownboss

Workingwithouthavingtorelyonotherpeople

Thetwocentralthemesconnectingallthesereasonsseemtorevolvearoundgainingpersonalsatisfaction–makingworkasmuchfunasanyotheraspectoflife–andcreatingwealth–essentialifanenterpriseisgoingtolastanylengthoftime.

Evenwhenyourpersonalityfitsandyourgoalsarerealistic,youhavetomakesurethatthebusinessyou’restartingisagoodfitforyourabilities.

Thefollowingsectionsexplorethesereasonsinmoredetail.

Gainingpersonalsatisfaction(or,entrepreneursjustwannahavefun)Nooneparticularlyenjoysbeingtoldwhattodoandwhereandwhentodoit.Workingforsomeoneelse’sorganisationbringsallthosedisadvantages.Whenyouworkforyourself,theonlypersontoblameifyourjobisboring,repetitiveortakesuptimethatyoushouldperhapsspendwithfamilyandfriendsisyourself.

Anothersourceofpersonalsatisfactioncomesfromtheabilityto‘dothingsmyway’.Employeesareconstantlypuzzledandoftenirritatedbythedecisionstheirbossesimposeonthem.Alltoooftenmanagersinbigfirmssaythatthey’dneverspendtheirownmoneyinthewaythepowersthatbeencourageorinstructthemtodo.Managersandsubordinatesalikefeelconstrainedbycompanypolicy,whichseemstosetoutarbitrarystandardsfordealingwithcustomersandemployeesinthesameway.

Thehighfailureratefornewbusinessessuggeststhattheglamourofstartingupontheirownseducessomepeoplewhomaybemoresuccessfulandmorecontentedinsomeotherlineofendeavour.

Runningyourownfirmallowsyoutodothingsinawaythatyouthinkthemarket,andyouremployees,believetoberightatthetime.

MakingmoneyApartfromwinningthelottery,startingyourownbusinessistheonlypossiblewaytoachievefullfinancialindependence.Butitisn’triskfree.Intruth,mostpeoplewhoworkforthemselvesdon’tbecomemegarich.However,manydoandmanymorebecomefarwealthierthantheywouldprobablyhavebecomeworkingfor

someoneelse.

Youcanalsoearnmoneyworkingatyourownpacewhenyouwanttoandevenhelpyourfamilytomakesomemoneytoo.

Runningyourownbusinessmeanstakingmorerisksthanyoudoifyou’reworkingforsomeoneelse.Ifthebusinessfails,youstandtolosefarmorethanyourjob.If,likemostownermanagers,youoptforsoletraderstatus–someoneworkingusuallyonhisownwithoutformingalimitedcompany(findmoreonbusinesscategoriesinChapter5)–youcanenduppersonallyliableforanybusinessdebtsyouincur.Thiscanmeanhavingtosellyourhomeandotherassetstomeetyourobligations.Inthesecircumstances,notonlywillallyourhardworkhavebeentonoavail,butyoucanendupworseoffthanwhenyoustarted.Also,windingupabusinessisfarfromfunorpersonallysatisfying.

Idon’twanttodiscourageyou,justtoapplyarealitycheck.Thetruthisthatrunningyourownbusinessishardworkthatoftendoesn’tpaywellatfirst.Youhavetobeokaywiththosefactsinordertohaveachanceofsuccess.

FightingpovertythroughtradeTraidcraft’smissionistofightpovertythroughtrade,practisingandpromotingapproaches to trade thathelppoorpeople indevelopingcountries transformtheir lives. The company hasmore than 450 different products sourced frommore than 100 producer groups in almost 30 developing countries, sellingthrough its nationwide network of fair traders and online shop. Traidcraftraisesfundsandgivesaid,helpandadvicetothetuneof£1.5millionayeartohelp enterprises in developing countries. Projects include improving marketaccessforwomenproducers inVietnam;helpingIndian teaworkersachievesustainablelivelihoods;andanalysingthedairysectorinKenya,identifyingkeyconstraints affecting smallholder dairy farmers and their access tomarkets.Traidcraft received the Queen’s Award for Industry for SustainableDevelopment,alongwithahostofotherawards.Oh,anditdoesaprettygood

jobofmakingmoney too–with£15million turnovereachyear,businesshasbeengrowingatanaverageof18percentayear,makingareturnoncapitalof10 per cent. More details are on the company’s website,www.traidcraft.co.uk/socialaccounts.

SavingtheplanetNoteveryonehasmakingmoneyastheirsoleaimwhensettingupinbusiness.Accordingtothegovernment’sfigures,around20,000‘socialentrepreneurs’runbusinessesaimingtoachievesustainablesocialchangeandtradewithasocialorenvironmentalpurpose.Theycontributealmost£25billiontothenationaleconomyandassistlocalcommunitiesbycreatingjobs,providingethicalproductsandservicesusingsustainableresourcesandreinvestingashareoftheprofitsbackintosociety.

Ethicalbusinesseshavesomeuniqueadvantages.Forexample,accordingtothoserunningsuchfirmstheycanrelativelyeasilyattractandretainintelligentpeople.Over70percentofstudentssaythatapotentialemployer’strackrecordisanimportantfactorinjobchoice.Customersalsolikeethicalfirms.AccordingtoarecentEuropeanUnionsurveyonsustainableconsumption,86percentofthosepolledintheUnitedKingdom,Spain,Germany,GreeceandItalysaidthattheyfeltverystronglyaboutwantingthingstobeproducedandmarketedresponsibly.Theyalsoblamedbrandsfornotprovidingmoreenvironmentallyandsociallyfriendlyproducts.

Ifyouwanttoexploretheprospectsforstartingasocialenterprise,contacttheSchoolforSocialEntrepreneurs(website:www.sse.org.uk;tel:02089810300),whichcanhelpwithspecificandtailoredsupport.Ifyouneedfundstostartasocialenterprise,contactBridgesCommunityVentures(website:www.bridgesventures.com;tel:02072625566),aventurecapitalfirmwithasocialmission.Itsfoundingprincipleisthatallthefundsitinvestsgotobusinesseswithaclearsocialpurposeaswellas

aimingtoachievefinancialreturnsforinvestors.

ExploringDifferentTypesofBusinessAtonelevelallbusinessesarethesame–theysellsomethingtopeoplewhowanttobuyfromthem,whiletryingtomakeanhonestbuckalongtheway.Atanotherlevelmanyverydifferenttypesofbusinessandwaysofdoingbusinessexist,evenwithinwhatsuperficiallycanappeartobeverysimilarfields.

SellingtootherbusinessesBusiness-to-business(B2B)enterprises,suchasthosesellingmarketresearch,databasemanagement,corporateclothing,managementconsultancy,telemarketingorgraphicdesign,involveonebusinesspersonsellingtoanother.Theattractionsarethatyou’redealingwithotherpeoplewhohaveadefiniteneedandusuallybuyinrelativelargequantitiesandatregularintervals.Forexample,anindividualmaybuyenvelopesinpacksofadozenafewtimesayear,butabusinessbuysscores,perhapseventhousands,andputsinanordereverymonth.Corporatecustomersarehardertowin,butareoftenworthmorewhenyouhavethem.Andunlikeprivateindividuals,businessesliketoforgerelationshipsthatendureovertime.

Somedownsidesexisttoo.Businesscustomersexpectcredit,perhapstakingbetween60and90daystopayup.Iftheygobusttheymayowealotofmoneyandtakesomeoftheirsuppliersdownwiththem.Youmayhavetoattendexhibitionstomakeyourpresenceknown,acostlyandtime-consumingprocess,oradvertiseintradedirectories.Checkoutthesewebsitestofindoutmoreaboutthesetopics:www.idealbusinessshow.co.ukandwww.b2bindex.co.uk.

OpeningallhoursConventionalshops,restaurantsandthelikehavelongopeninghoursandhavetomeettheexpectationsofincreasinglysavvyconsumers,whoseaccesstotheInternethasmadethemawareofcompetitivepricesaswellashighspecificationsandstandardsofservice.Theupsideofanyformofretailingisthatyou’realmostinvariablypaidupfront.Butjustbecauseyougetthecashinyourhanddoesn’tmeanthatyoudon’thavetomeetexactingstandards.Customersareprotectedintheirdealingsinamyriadofwaysandifyoufallshortoftheirlegalentitlementyoucanendupwithabiggerbillthanasimplecashrefund.(IcoverlegalissuesinChapter10,‘MarketingYourWares’.)Inconventionalretailingyoualsohavetorentpremisesandstockthemwithproducts,bothfactorsthatcanaddsignificantlytothebusinessrisk.

Increasingly,newretailbusinessstart-upsareInternetbased.Thewebsiteisineffecttheshopwindowandthestockofproductsbeingsoldmayevenbeinawarehouseownedbyathirdparty.Thiskeepsup-frontcostsdownbutmeanskeepingabreastoffast-changingtechnologies–theInternet,serversandcomputerhardwareandsoftware.(IlookattheseinmoredepthinChapter15.)

MakingproductsOneoftheattractionsofmanufacturingisthatyouhaveagreaterdegreeofcontroloverthequality,costandspecificationoftheendproductthanaretailerorwholesalermight.Butwiththoseadvantagescomesomeheftypenalties.Factories,equipment,stocksofrawmaterialsandemployeesarecostlyoverheads.Youhavetoincurtheseexpenseswellbeforeyou’recertainofanyorders–anunlikelywayintobusinessforsomeonewithoutpreviousmanufacturingexperienceandadeepwallet.Suchownersalsobearsomesignificantriskstowardstheiremployees.TheUKmanufacturingsectorreportsover32,000work-relatedaccidentstotheHealthandSafetyExecutiveeachyear.Thisfigureincludesover

6,200majorinjuriessuchasfracturesandamputationsaswellasaround40fatalities.

Amorelikelyroutetomanufacturingforanewbusinessissubcontracting,whereyou’reworkingforamanufactureronpartofaproduct.Themostcommonexamplesofsubcontractorsareplumbers,electriciansandcarpentersinbuildingwork,metalandplasticcasingproductionandthelikeincivilengineeringandawiderangeofactivitiesintheinformationtechnologysector.

ServicingcustomersServiceindustriesnowdominatetheBritisheconomyandaccountforaround70percentofgrossdomesticproduct(thevalueofthegoodsandservicesthatthecountryproduces).Servicesincludefinancialintermediaries,hairdressing,realestate,computerservices,researchanddevelopment,education,healthandsocialwork,refusedisposal,recreational,culturalandsportingactivitiesandanextensiverangeofotheractivitieswherenophysicalgoodsplayamajorpartinanytransaction.Intruth,however,mostmanufacturedgoodsincludeaserviceelement,thoughthebusinessfunctionsareoftenseparated.Forexample,manufacturingbusinessesproducecarsbutarequiteseparatefromthegaragechainsthatrepairthosevehicles.Butsomemanufacturersgofurther–Dellmanufacturescomputersandalsocarriesoutdeliveryandmanyotherservicefunctions.

Servicebusinessesrequireahighdegreeofpersonalinvolvementandassuchcallforfounderswhoseetheirpeopleskillsaspivotal.Inanutshell,ifyoudon’tenjoyunderstandingtheintimatedetailsofwhatmakescustomerstickandthengoingoutofyourwaytomeettheirneeds,runningaservicebusinessmaybeoflittleappeal.

WorkingfromHome

Fewdedicatedstatisticsexistonthenumberofpeopleoperatinghome-basedenterprisesasdistinctfromthosesettingupindedicatedpremises.IDC,aUS-basedresearchfirm,claimsthataround18millionofthe29millionowner-managedbusinessesinUSarehomebased.UScensusdatashowsthat17.6millionbusinessesemploynoonebuttheboss.Putthesetwofactstogetherandworkingonthereasonableassumptionthatthemajorityofhome-basedbusinessesareone-man(andone-woman)bands,thenaroundtwothirdsofallsmallbusinesswouldappeartobehomebased.Eventhosenotworkingfromhomenowoftenstartoutfromthere,likethefoundersofBloomingMarvellous(seethenearbysidebar).

BloomingMarvellousJudy Lever and Vivienne Pringle started Blooming Marvellous literally on akitchen table back in 1983. Having attended a business start-up course inKensington,Londonrunbytheauthor,theyputfurtherfleshontotheirbigidea.Bothwere pregnant, and after searching for the kind of fashionable clothestheyusedtowearanddrawingablanktheyguessedthey’dfoundagapinthemarket.Theykepton theirday jobsandwouldmeetafterworkeverydayatJudy’shousetoanswerenquiries,sendoutleafletsanddespatchproductsoutin the post every day. They outsourced work to a pattern cutter, a smallfactory, some fabric suppliers and eventually to a small distribution centre.Aftera yearor soofmodest sales they felt confidentenough to setup theirfirst businesspremises– a 1,200 square footwarehouseona businessparkstaffedbyfourofthewomenwho’dbeenworkingintheirdistributioncentre.

Eventually, the company employed 150 people in 14 shops and extended itsrange to includenurseryproducts, toys, themedbedroomaccessoriesandaseparate brand calledMiniMarvellous that catered for children aged 2 to 8years.Over a third of sales camedirectly via theirwebsite. In July 2010 thecompany was bought by Mothercare, which three years earlier had alsoacquiredtheEarlyLearningCentre.

Startingabusinessfromhomegivesyouanumberofdistinct

advantagesoverthoseplumpingforpremisesstraightaway.AstudybytheUSSmallBusinessAdministrationtrackingthesurvivalratesonnewbusinesses(www.sba.gov/ADVO/research/business.html>RedefiningBusinessSuccess)concludedthatstartingfromhomesignificantlyimprovedafounder’schancesofsucceeding.Otherstudiescomingfromorganisationslessimpartialsuggestthathome-basedbusinessaretwothirdsmorelikelytosurvivethecrucialfirstfouryearsoftradingandsoestablishafirmfooting.

Threebigadvantagesthatahome-basedbusinesshasoveritspeersthatgiveitanedgeare:

Lowercosts:Startingfromhomesavesmostofthe£35,000start-upcoststhattheaveragebusinessincursevenbeforeittakesitsfirstorder.Thechancesarethatyouhavenearlyeverythingyouneedtostartupyourbusinessalreadysomewherearoundyourhome.ThekitchentableworkedfineforBloomingMarvellous(seethenearbysidebar)tomaketheirplans,packuptheirfirstordersanddotheiraccountsfrom.Youcanpressintoserviceagarage,loft,sparebedroomorgardenshedforawholehostofbusiness-relatedtasksfromholdingstocktobeingadedicatedofficespaceawayfromthenormalhustleofhomelife.Yourcomputer,howeverold,willalmostdefinitelyworkjustfine,unlessyou’restartingabusinessatthecuttingedgeofdesignorontheInternet.

Moretime:Moneycanbuylotsofthings,buttimeisn’toneofthem.Howeverclosetoyourbusinesspremisesyouare,you’llspendanhourormoreadaytravellingtoandfromit.I’msureifyourshop,restaurantorofficeisonlyacoupleofmilesawayyouwon’tbelievethatproposition.Howonearthcoulditbepossibletotakeanhourtotraveljustamile?Well,animmutablelawsaysthatthecloseryourhomeistoyourbusinesspremises,themoreoftenyoutravelbetweenthetwo.Ergo,ifyou’re20milesawayyougoonceaday,covering40miles,andifyou’reonly5milesawayyoucome

homeforlunchandreturnonceortwicemoreeachweektocollectthingsyou’veforgotten.Whateverthedistance,theaverageweeklytraveltimeisaboutthesame.Workingfromhomegivesyoubackallthatwastedtimespenttravellingandyoucaninvestthetimeinyourbusiness.

Lessstress:Commutingtoworkonadailybasisisstressful.Inanyvibrantandsuccessfuleconomicarearoadworks,accidents,delaysandtrafficjamsareprettymuchthenorm.Fewpeoplearefortunateenoughtoworkinacar-freeareaorwhereparkingisneveraproblem.Evenifyoucouldfindsuchaparadisethechancesareitwouldbeuselessasabusinessproposition.Depopulatedareasareequallydevoidofcustomers,suppliersandpeopletoemploy.

FindingthespaceAsafirststeplistalltheactivitiesinvolvedingettingyourbusinesstothepointwhereithassomethingtosell.Ifyou’regoingtorunabookkeepingservicethiscouldbequiteashortlist.Youneedacomputer,somesoftwareandperhapsaleafletsettingoutyourpricesandtherangeofservicesonoffer.Butifyou’regoingtorepairmusicalinstruments,say,thenyoumayneedmuchmorespaceincludingperhapsaworkshop.

Clearly,ifyouliveinacul-de-sacattheendofanarrowlanesurroundedbyotherhousesyou’reunlikelytobeallowedtomanufactureusinghazardouschemicalsandhavearticulatedvehiclesdeliveringandcollectinginthemiddleofthenight.Youalsohavetoconsiderhowyourneighbourswillbeaffected,evenifyou’relegallyallowedtooperateyourbusiness.

Youdon’t,ofcourse,havetocarryouteveryactivityrelatedtoyourbusinessyourself,nordoyouhavetodoitallonyourpremises.Ifyouthinkaboutityou’llseethatnobusinessdoes

everythingitself.

Whenyouknowhowmuchspaceyouneedforbusinessandwhatyou’llbedoinginthatspaceyoucanstarttoscouryourhomeandgardenforspacetoconverttobusinessuse.Thefollowingsectionsoutlinesomeareastoconsider–notanexhaustivelist,butenoughideastokick-startyourthinking.

Usingthegarage

Themostobviousdiscreetspacethat’sseparatefromthehouseandlikelytobefreeoffamilytrafficisyourgarage(ifyouhaveone).Youcanmovecarsontothedriveoraneighbouringstreet,subjecttoyourinsurancecompanybeinghappywiththatarrangement.AccordingtotheRACFoundation,although71percentofmotoristshaveagarage,only41percentuseittoparktheircar.Mostpeopleuseitasstorageforjunkoraretoolazytoopenthegaragedoors.

TheGarageConversionCompanyhassampleplansandinformationonanypossiblerestrictionsthatmayapply(www.garageconversion.com;gotoConversionIdeasandthenHomeOffice).

Parkingintheparkingspace

Thisareaandanyprivatedrivecouldbeusedforacaravan-basedoffice,althoughyouneedtokeepinmindthatvisitors,suppliersandofcourseyouandyourfamilystillneedtogetaccesstoyourhome.

Ifyoudothinkthatacaravanisworthconsideringcheckoutthatyourhousedeedsallowyoubecausecovenantswereintroducedintothetitledeedsofnewpropertiesfromthe1960sonwardstopreventpeoplekeepingcaravansathome.Evenifyou’relegallyallowedtokeepacaravanathomeyoushouldconsideranypossibleimpactonyourneighboursanddiscuss

yourplanswiththem.Caravansthatcouldbeusedasahomeoffice,thoughprobablynotastouringcaravans,sellforupwardsof£1,000.

Plantingyourselfinthegarden

Youcaninstallashedupto4squaremetreswithoutplanningconsentundercertaincircumstances.Theexactrulesarealittlecomplicated;forexampletheshedcan’tbebiggerthan50percentofyourgarden,youcan’terectoneinaconservationareaandyourtitledeedscan’texpresslyprohibityou.GreatLittleGarden(www.greatlittlegarden.co.uk)andLeisureBuildings(www.leisurebuildings.com)bothofferadviceonplanningissuesandhavesectionsonusinggardenshedsashomeoffices.Shedsthatyoucoulduseforhomeofficepurposessellatgardencentresfor£800upwards.

Afurtheralternative,ifspaceallows,istorentorbuyaportable‘room’.Portakabin(www.portacabin.co.uk)andForemansRelocatableBuildingSystems(www.foremansbuildings.co.uk)haveselectionsofnewandsecond-handcabinsforrentandsale.

Climbingintoanattic

Convertinganattictousablespaceislikelytobeanexpensiveoptionandsomethingtoconsiderlaterafteryourbusinessisupandrunning:£10,000istheentrylevelpriceincludingaladderandawindow;doublethatifyouwanttoincludeaWC,plasteredwallsandapowersupply.

Youmaynotneedplanningpermissionbutaswithgardenshedstherulesarecomplicated.Econoloft(www.econoloft.co.uk;gotoFAQandWillINeedPlanning)andUKLoftConversion(www.uk-loft-conversion.com;gotoFAQandDoINeedtoGetBuildingRegulationsandPlanningApproval?)haveinformationontherulesandmuchelse

besides.

Doublingupinthespareroom

Ifyoudohaveaspareorunder-utilisedroomthenyoursearchforofficespaceisprobablyover.Itwillhaveheat,lightandpowerandmayalsobeoutofthewayofgeneralfamilytraffic.Ifit’scurrentlyabedroomyoucouldgetthebestofbothworldsbyputtinginasofabedanddeskwithlockeddrawers.Inthatwayoccasionalguestscanstillusetheroomandyoucanhaveitformostofthetime.Thoughfarfromidealthiscanbealowcostoptionthatyoucanimplementquickly.

Options(www.optionsfit.com)providesguidesandproductsforturningyourspareroomintoanoffice.

CheckingouttherulesWhateverbusinessyouplantorunfromhomeandwhetherthespaceyouuseisinsideoroutsideofyourpropertyyouneedtocheckoutanumberofimportantrulesandregulationsbeforeyoustartup.

Planningconsentandbuildingregulations

Theextenttowhichtheuseofyourhomeandthelanditstandsonchangesdetermineswhetherornotyouneedplanningconsentortoconsiderbuildingregulations.Youmayneedpermissionforanystructuralalterations,increaseintraffic,noise,smellsoranythingsuchasoperatingunreasonablehoursoranydisturbancethatcouldaffectyourneighbours.

YoucanfindoutinformallyfromyourlocalcouncilbeforeapplyingandtheCommunitiesandLocalGovernmentwebsite(www.communities.gov.uk;gotoPlanning,Buildingandthe

Environment)hasdetailedinformationonallthesematters.YoucanalsogetfreeanswerstospecificquestionsusingUKPlanning’sPlanningDoctor(www.ukplanning.com),aservicesupportedbysome20UKcouncils.

GuidelinesforusingspaceathomeKeep these factors inmindwhendecidingonanareaof yourhome toworkfrom:

Theroomorareaneedstobewelllit,warminwinterandcoolinsummer.

The space shouldn’t be claustrophobic because you could be in it 12hoursaday.

Somewhereyoucanclose thedoor, shut yourbusinessoff andgetonwithnormalfamilylifewillbeagreatasset.

Allow room for some modest expansion. Try to anticipate what yourbusinessmightlooklikeayearoutandmakesurethespaceyouallocatecanaccommodatethat.Movingisdisruptive,timeconsumingandexpensive.

You’llneedpower,atelephonelineandaccesstotheInternet.

Lookingathealth,safetyandhazards

Ifyou’llbeworkingwithmaterialsthatareflammable,toxic,giveofffumesorarecorrosiveyoushouldcheckonthewebsiteoftheHealthandSafetyExecutive(www.hse.gov.uk/risk)whereyou’llfinddetailedguidanceandadviceonallaspectsofsafetyatwork.

Consideringinsurance

Yourhomeinsurancepolicywon’tcoveranybusinessactivitysoyoumustinformyourinsurerwhatyouplantodofromhome.Youcanfindoutmoreaboutwhetherornotwhatyouplantodofrom

homeneedsspecialinsurancecoverandwheretofindaninsurancecompanyontheBusinessLinkwebsite(www.businesslink.gov.uk;gotoHealth,Safety,Premises;Insurance;InsureYourBusinessandAssets–GeneralInsurances;andthenBusinessInsuranceIfYouWorkfromHome).

Managingthemortgage

Unlessyouownfullythefreeholdyourpropertysomeotherpartysuchasamortgagelender,landlordorfreeholdermayneedtogivetheirpermissionforyoutorunabusinessfromhome.Evenasafreeholderyoucouldfindthatacovenanthasbeenincludedintoyourtitledeedstopreventyouoperatingcertainactivitiesfromyourhome.

Realisingbusinessrates

Youcurrentlypaycounciltaxonyourhome,butafteryoustartusingpartofitoryourgroundsforbusinesspurposesyoucouldbeliabletopaybusinessratesonthepartofthepropertyyouuseforwork.Youcanseesomeexamplesofhowbusinessratingisappliedtohome-basedbusinessesontheValuationOfficeAgencywebsite(www.voa.gov.uk/council_tax/examples_working_from_home.htm).Sometypesofsmallbusiness,particularlythoseinruralareasprovidingproductsorservicesofparticularbenefittothecommunity,areexemptfrompayingbusinessrates,orpayatareducedrate.Yourlocalcouncilwillhavedetailsofsuchschemes.

Anticipatingcapitalgainstaximplications

Anyincreaseinvalueofyourmainhomeisusuallyfreeofcapitalgainstax(CGT)whenyousell.However,ifyousetasidearoomorparticularareasolelyforworkinginthenyoumaybeliableforCGTonthatproportionofanygain.Ifyouexpecttousealarge(over10percent)partofyourhomeforbusiness,takeprofessionaladvicefromyouraccountantandchecktheHMRevenueandCustomswebsite(www.hmrc.gov.uk/cgt)formoreinformationonCGTand

howtocalculateanypossibleliability.

Taxratesandtheirmethodsofpaymentarealwaysinastateofflux,moresosincethegovernmentintroducedemergencymeasuresin2010toreducethecountry’sindebtedness.

Readyingforrefuse

Ifyourbusinesswillcreateadditionalordifferentrefusefromthatofanormaldomesticnaturethenyoushouldcheckyourlocalcouncil’spolicyoncollectingforbusinesses.AlsocheckonNetRegs(www.netregs.gov.uk),thegovernmentwebsitethatprovidesfreeenvironmentalguidanceforsmallbusinessesintheUK,whatyourresponsibilitiesarefordisposingofwasteandhazardoussubstances.

Keepinginwiththeneighbours

Afteryou’vesatisfiedyourselfthatyou’recomplyingwithalltherelevantrulesandregulationsyou’dstillbeprudenttoadviseyourimmediateneighboursofyourplans.Theymaybeconcernedwhentheyseeanyunusualcomingsandgoingsfromyourhomeandatimelywordsetstheirmindsatrest.Talkingwithneighbourswillbeespeciallyimportantifyou’redoingbuildingwork.

TheCentralOfficeofInformationserviceDirectgovhassomeusefulpointersonwhatmightcauseproblemswithneighboursandhowtoresolvesuchissues(www.direct.gov.uk;gotoHomeandCommunity,YourNeighbourhoodRoadsandStreets,andthenNeighbourDisputes).

Dealingwiththefamily

Youmightbeinclinedtosloparoundjustbecauseyou’reworkingat

home.Thedangersherearetwofold:

You’llgiveoutthewrongsignalstoeveryonearoundyou.Asfarastheycanseeyou’rejust‘athome’andassuchavailableformoreorlessanythingthatthey’dusuallyexpectinadomesticenvironment.

Youmaynotfeelasthoughyou’reatworkyourself.Theoperativewordhereisappropriate.Thatdoesn’thavetomeanasuitandtie,but‘smartcasual’isagoodyardstickandcertainlyanotchupfromwhatyouweararoundthehousenormally,sayatweekends.

Dressisapowerfulwayofsendingsignalstothosearoundyouthatyou’re‘atwork’.Herearesomeothertoolstohelpharmonisebusinessandpersonallifewhileyouwork.

Negotiatingwithyourpartner

Yourspouse,partnerorhousemate,whetherornothehasaparttoplayinyourbusiness,willbeaffectedandexpecttobeconsultedonhowyouplantomakeuseofwhatheprobablyseesashispremises.Theeffectisdoubleifhe’spickingupthefinancialslackuntilyourbusinessgetsgoing.Thesemeasureshelpkeepthemyourlovedoneonside:

Tellhimaboutyourbusinessideasearlyonandwhyyouthinkyou’llsucceedwithoutdisruptinghomelifeunreasonably.

Discussthespaceyouneed,whyyouneeditandifnecessary‘trade’space.Ifyouhavetohaveoneofthebedrooms,seewhatcanyouofferascompensation.Inoneratherdramaticcaseaboatbuilderneededallofthedownstairsroomsfor12monthstobuildaprototype.Theboatbuilderagreedtobuildapatioandconservatorytheyearhisfirstboatsold.

Seewhetheryoucanprovidea‘quickwin’foreveryonein

yourhome.Forexample,ifyouneedbroadbandInternetofferaccesstoeveryoneeitherbysettingtimeasideonyourcomputerorbyprovidinganotherwirelessenabledcomputer.Orifyou’repaintingandredecoratingyouroffice,getotherroomsdonetoo.

Explaintheupsidepotentialofwhatsuccesswillmeanforeveryoneinyourfamilywhenyourbusinessgetsestablished:moremoney;part-timeemploymentforthosewhowantit;andeventuallyperhaps,amovetobusinesspremises.

Handlingchildren

Oneoftheadvantagesofstartingyourbusinessfromhomeisthatyoucanadoptagreatwork–lifebalancefromtheoutset.Youcantakethekidstoschool,behomewhentheygetback,sharemealswiththemandhandleemergencytripstodoctorsanddentistyourself,ratherthanhavingtocallinfavoursfromrelativesandfriends.Fewworkingmoreconventionallyoutofanofficeanhourormore’scommuteawaycanlookafterfamilymatterswithsuchrelativeease.

Pre-schoolchildrenwhoaregoingtobeathomewhenyouneedtoworkareadifferentmatteraltogether.Sometimesthey’reasleeporrestingandyou’refreetoworkatwill.Otherwiseyouhavetwooptions.Thesimplestistohaveanannytocoveryourpeakworkinghours.Makesurethenannyknowsyou’reworkingandfindsomewhereinthehousewhereanynoisewon’tdisturbyou.Alternatively,findachildminderornurserynearby.

VanquishingvisitorsYoumayliveinanareabesiegedbydoor-to-doorsalespeople,over-friendlyneighbourswhonowknowyou’reworkingfromhomeorpoliticiansafteryourvote.Youcanbecertainthannoonewillbecallinguninvitedtodiscusbusiness.Dealingwithanunwanted

visitormayonlytakeacoupleofminutes,buttheinterruptiontoyourworkflowmayaddasmuchas20minutestothatwastedtime.Threevisitorsaweekandyou’velostanhour’soutput,mountinguptonearlysevenmandaysovertheyear.That’sprobablyequivalenttohalftheamountofholidayyou’llbeabletotakeinyourfirstyearorsoinbusiness,soyouneedtofindawaytoisolateyourselffromsuchdistractions.

AssessingYourselfBusinessisn’tjustaboutideasandmarketopportunities.Businessisaboutpeopletoo,andattheoutsetit’smostlyaboutyou.Youneedtomakesurethatyouhavethetemperamenttorunyourownbusinessandtheexpertiseandunderstandingrequiredforthetypeofbusinessyouhaveinmind.

Thetestattheendofthissectionrequiresnorevisionorpreparation.Youmayfindoutthetruthaboutyourselfandwhetherornotrunningabusinessisagreatcareeroptionorapotentialdisasterforyou.

DiscoveringyourentrepreneurialattributesBusinessfoundersarefrequentlycharacterisedaspeoplewhoareburstingwithnewideas,highlyenthusiastic,hyperactiveandinsatiablycurious.Butthemoreyoutrytocreateaclearpictureofthetypicalsmallbusinessfounder,thefuzzierthatpicturebecomes.Inreality,themostreliableindicatorthatapersonislikelytostartabusinessisthathehasaparentorsiblingwhorunsabusiness–suchpeoplearehighlylikelytostartbusinessesthemselves.

Thatbeingsaid,commentatorsgenerallyacceptsomefairlybroadcharacteristicsasdesirable,ifnotmandatory.Checkwhetheryourecogniseyourselfinthefollowinglistofentrepreneurialtraits.

Acceptingofuncertainty:Anessentialcharacteristicofsomeonestartingabusinessisawillingnesstomakedecisionsandtotakerisks.Thisdoesn’tmeangamblingonhunches.Itmeanscarefullycalculatingtheoddsanddecidingwhichriskstotakeandwhentotakethem.

Managersinbigbusinesstendtoseektominimiseriskbydelayingdecisionsuntiltheyknoweverypossiblefact.Theyfeelthatworkingwithoutallthefactsisn’tprudentordesirable.Entrepreneurs,ontheotherhand,knowthatbythetimethefogofuncertaintyhascompletelylifted,toomanypeopleareabletospottheopportunityclearly.Infact,anentrepreneurisusuallyonlyinterestedindecisionsthatinvolveacceptingadegreeofuncertainty.

Driventosucceed:Businessfoundersneedtoberesultsoriented.Successfulpeoplesetthemselvesgoalsandgetpleasureoutoftryingtoachievethemasquicklyaspossibleandthenmoveontothenextgoal.Thisrestlessnessisverycharacteristic.

Hardworking:Don’tconfusehardworkwithlonghours.Attimesanowner-managerhastoputin18-hourdays,butthatshouldn’tbethenorm.Evenifyoudoworklonghours,aslongasyouenjoythem,that’sfine.Enthusiastscanbeveryproductive.Workaholics,ontheotherhand,haveanegative,addictive,drivenqualitywhereoutputs(results)arelessimportantthaninputs.Thistypeofhardworkiscounterproductive.Realhardworkmeansstickingatatask,howeverdifficult,untilyoucompleteit.Itmeanshittingdeadlinesevenwhenyou’redead-beat.Itmeansdoingsomethingsyoudon’tmuchenjoysoyoucanworkyourwaythroughtotheactivitiesthatyouenjoymost.

Healthy:Apartfrombeingabletoputinlongdays,successfulsmallbusinessownersneedtobeonthespottomanagethefirmeveryday.Ownersaretheessentiallubricantthatkeepsthewheelsofsmallbusinessturning.

Theyhavetopluganygapswhenotherpeopleareillorbecausetheycan’taffordtoemployanyoneelseforthatparticularjob.Theycan’taffordtheluxuryofsickleave.Evenaweekorso’sholidayissomethingofaluxuryintheearlyyearsofabusiness’slife.

Innovative:Mostpeoplerecogniseinnovationasthemostdistinctivetraitofbusinessfounders.Theytendtotackletheunknown;theydothingsinnewanddifficultways;theyweaveoldideasintonewpatterns.Buttheygobeyondinnovationitselfandcarrytheirconcepttomarketratherthanremaininanivorytower.

Self-disciplined:Owner-managersneedstrongpersonaldisciplinetokeepthemselvesandthebusinessonthescheduletheplancallsfor.Thisisthedrumbeatthatsetsthetimingforeverythinginthecompany.Getthatwrongandyousendincorrectsignalstoeverypartofthebusiness,bothinsideandout.

Oneofthemostcommonpitfallsfornovicebusinesspeopleisfailingtorecognisethedifferencebetweencashandprofit.Cashcanmakepeoplefeelwealthyandifitresultsinarelaxedattitudetocorporatestatussymbolssuchascarsandluxuryofficefittings,thenfailureisjustaroundthecorner.

Totallycommitted:Youmusthavecompletefaithinyourbusinessidea.That’stheonlywayinwhichyoucanconvinceallthedoubtersyou’reboundtomeetalongtheroute.Butblindfaithisn’tenough.Youhavetobackyourcommitmentupwithasoundbusinessstrategy.

Wellrounded:Smallbusinessfoundersarerarelygeniuses.Somepeopleintheirbusinessnearlyalwayshavemorecompetenceinonefieldthantheycouldeveraspireto.Butthefoundershaveawiderangeofabilityandawillingnesstoturntheirhandtoanythingthathastobedonetomaketheventuresucceed.Theycanusuallymaketheproduct,market

itandcountthemoney,butabovealltheyhavetheself-confidencethatletsthemmovecomfortablythroughunchartedwaters.

Workingoutabusinessideathat’srightforyouTakesometimetodoasimpleexercisethatcanhelpyoudecidewhattypeofbusinessisagoodmatchwithyourabilities.Takeasheetofpaperanddrawuptwocolumns.Intheleft-handcolumn,listallyourhobbies,interestsandskills.Intheright-handcolumn,translatethoseinterestsintopossiblebusinessideas.Table3-1showsanexampleofsuchalist.

Havingdonethisexercise,balancethepossibilitiesagainstthecriteriathatareimportanttoyouinstartingabusiness.

Figuringoutwhatyou’rewillingtoinvestI’mnotjusttalkingaboutmoneyhere.Howmuchareyouwillingtoinvestofyourtime,yourinterestandyoureducation,aswellas

your(andyourinvestors’)money?

Spendingtime

Howmuchtimeareyouwillingtodevotetoyourbusiness?Thatmaysoundabasicenoughquestion,butdifferentbusinessesdoneindifferentwayscanhavequitedifferenttimeprofiles.OnebusinessstarterIknowstartedaFrenchbakeryinLondon.Hewasdeterminedtomakehisowncroissantsanddidsoforthefirstthreemonths.Butmakinghisownbreadmeantstartingworkat4a.m.Becausehedidn’tcloseuntilcityworkerspassedhisdoorontheirwayhome,bythetimehecleanedupandtookstock,hewasworkinga15-hourday.Buthestillhadthebookstodo,orderstoplaceandplanstoprepare.Heeventuallysettledfora10-hourday,whichmeantthathehadtobuyinready-bakedcroissants.

Furtheringyoureducation

Youmayhaveidentifiedamarketopportunitythatrequiresskillsoverandabovethosethatyoucurrentlyhave.Theremay,forexample,beagapinthemarketforTeachingEnglishasaForeignLanguage(TEFL),buttodosorequiresamonthofintensivestudyplusa£1,000coursefee.DoingtheTEFLcertificatemayinvolveyouinmoreskillupgradingthanyouwanttocommitto,attheoutsetatleast.Soeitheryouneedtofindcustomerswhodon’trequireyoutohavethatqualification,oryouneedtothinkaboutalesseducationallychallengingbusiness.

Keepingthingsinteresting

Ifyouwanttostartarestaurantandhaveneverworkedincatering,getajobinone.That’sthebestwaytofindoutwhetheryoulikeaparticulartypeofwork.Youmayfindthatarestaurantlooksverydifferentfrombehindthechairasopposedtoonit.Somebusinessesareinherentlyrepetitive,withactivitiesthatfollowapredictablepattern.Ifthatsuitsyou,fine,butifnotthenperhapsyouneedtoconsiderabusinessventurewithashiftingrangeof

tasks.

WeightingyourpreferencesAfteryouhaveanideaofsomeofthebusinessesyoumaywanttostart,youcanrankthosebusinessesaccordingtohowcloselytheymatchwhatyouwantfromstartingabusiness.Gothroughthestandardsyouwantyourbusinesstomeetandassignaweightbetween1and5toeach,onarangefromnotimportantatalltoabsolutelymusthave.Next,listyourpossiblebusinessopportunitiesandmeasurethemagainstthegradedcriteria.

Table3-2showsasamplerankingforJaneClark,animaginaryex-secretarywithschool-agedchildrenwhoneedsworkbecauseherhusbandhasbeenmaderedundantandislookingforanotherjob.Janeisn’tinapositiontoraisemuchcapital,andshewantsherworkinghourstocoincideherchildren’sschoolday.Shewantstorunherownshowandshewantstoenjoywhatshedoes.

BecauseminimalcapitalwasanimportantcriterionforJaneshegaveitaweightof5,whereasmeetinginterestingpeople,beinglessimportanttoher,wasonlyweighted1.Janegaveeachofherthreebusinessideasarating,inpoints(outoffive)againstthesecriteria.Asecretarialagencyneededcapitaltostartsoshegaveitonly1point.Back-uptypingneededhardlyanymoneyandsheallocated5pointstoit.Herworked-outchartisshowninTable3-3.

Theweightingfactorandtheratingpointmultipliedtogethergiveascoreforeachbusinessidea.ThehighestscoreindicatesthebusinessthatbestmeetsJane’scriteria.Inthiscase,typingauthors’manuscriptsscoredoverback-uptyping,becauseJanecoulddoitexactlywhenitsuitedher.

Chapter20

TenPeopletoTalktoBeforeYouStart

InThisChapterIdentifyingallthekeypeoplewhocanhelpyougetstarted

Leveragingyournetworkofcontactstomaximumadvantage

Takingadvantageoffreeadvice

Gettingthelowdownonwhatpeoplereallythinkareyourstrengthsandweaknesses

Startingupabusinesscanbealonelyendeavour,butyoudon’thavetodoitallonyourown.Hundredsofpeople,somejustafewfeetaway,cangiveyouusefulinsightsintoyourskillsandattributes,andtheymayevenhaveausefulperspectiveontheviabilityofyourbusinessidea.

SpeakingwithYourSpouseYourspousemaynotknowagreatdealaboutyourgreatbusinessidea,butyoucanbesuresheknowsalotaboutyou.Yourspousecanremindyouofyourweaknessesandhelpyouplaytoyourstrengths.Shealsoneedstobepreparedforthelonghoursandlackofholidaysthataresuretofeatureintheearlymonthsandyearsasyougetyourbusinessestablished.Thismaymeanthatyouneedtore-dividetheexistingsharingofhouseholdandfamilytasks,suchastakingchildrentoschool,familyvisitsandpaintinganddecorating,toreflectthenewbalanceofwork.Thatmayprovecontentious,sotalkingtheissuesthroughattheoutsetmaysaveconflictand

argumentswhentimeconstraintsreallystarttobite.

Themoneyputintothebusinessisgoingtohaveanimpactonthemoneyavailableforotherareasoffamilyexpenditure,soyourspousealsohastobecomfortablewiththefinancialcommitmentsyou’retakingon.Unlikemostotherinvestmentsyoumayhavemade–onhousesandcars,forexample–youcanloseallthemoneyyouputintoabusinessirrevocably.

Onewould-beentrepreneurwhosetouttoopenabookshopwasremindedbyherpartnerhowshedislikeddealingwiththegeneralpublic.Shelovedbooksanddelightedinvisitingbookfairsandauctions.Butwhenremindedthatessentiallythejobentailedopeningandclosingashopsixdaysaweek,herenthusiasmleveltookadive.Bettertakeadivebeforeyoustartupthanhaveyourcashtakeadiveafewweeksafterwards.

Ifyou’rethinkingoftakingupsomefranchises–ChemicalExpress(www.chemicalexpress.co.uk),forexample–thenyoumaybeaskedtobringyourpartneralongtotheinitialinterviewevenifshe’snotgoingtobeinvolvedintherunningofthebusiness.ChemicalExpresswantstomakesurethatyourpartnerisbackingyou100percent,bothpracticallyandemotionally.

MakingUseofYourProfessionalNetwork

Thepeopleinyournetworkofassociateshavelargechunksoftheknowledgeyouneedtogetyourbusinesssuccessfullylaunched.Theabilitytocreateandmaintainstrongprofessionalrelationshipsisanimportantkeytobusinesssuccess.Networkingisavitalbusinessskillthatletsyoucultivatelastingbusinessrelationshipsandcreatealargesphereofinfluencefromwhichyoucanfindnew

clients,contacts,referralsandopportunities.

Youcanuseanetworkforjustaboutanything,fromfindinganewsuppliertogettingintroductionstooverseassalesagents.Youcanfindareliablebankmanager,anewaccountingsoftwarepackageoragreatvenueforyournextbusinessmeeting.Yournetworkcontacts,unlikealmosteveryoneelseinthebusinessworld,areusuallyunbiasedandauthoritative.Youshouldmakefewmajordecisionswithoutrecoursetonetworkcontacts.

BenefitingfromEntrepreneursWhoStartedaSimilarBusiness

Peoplelikenothingmorethantalkingaboutthemselvesandtheirsuccesses.Obviously,ifsomeonethinksyou’regoingtostealhercustomers,sheshutsuplikeaclam.Butifthebusinessyouplantostartisunlikelytoinfringeontheirsphereofactivities,mostestablishedentrepreneursareonlytoohappytopassonsomeoftheirhard-earnedtips.

Firstestablishthatyou’renotgoingtotreadontheentrepreneur’stoes.Forexample,ifyouplantostartupinthesamelineofbusiness30milesaway,youhavelittlechanceofcausingeachothermuchtrouble.Youmayevenbeabletoopenashopatthefarendofthesametownasacompetitorwithoutdoingtheentrepreneuranyseriousdamage.

Useyourcommonsenseastowhomtoapproachand,tobeonthesafeside,doublethedistancethatyoufeelisasafegapbetweenyou.

Youmayalsofindsomeonewho’shadabusinessfailureinthefieldyouplantostartupinandispreparedtotalk.Youcanfindsuchpeoplebyscouringthepressortalkingtotradeassociationsandotheroperatorsinyoursector.

Don’ttakeeverythingentrepreneurssay,eventhemostsuccessfulones,asinevitablyright.ThefivebusinesspeoplewhocomprisethedragonsintheBBCprogrammeDragon’sDen,withacombinedpersonalwealthnearing£1billion,canreasonablybeexpectedtoknowathingortwoaboutnewbusinessideas.AndrewGordonpresentedtothemhisinventionforproppingupwobblytablelegsandtheyunreservedlygaveitthethumbsdown.Despitebeingrippedtoshredsasaconcept,hisstabletable(www.stabletable.co.uk),eightplasticleavespinnedtogether,hassoldinindustrialvolumesontheInternet.Thedeviceearnedthe34-year-oldinexcessof£500,000inhisfirstyearandisnowbeingsoldinpacksof25foruseinrestaurants,hotels,pubsandcafesthroughouttheworld.Andrewisaninspirationtoallwould-bebusinessstarterswhoseideasreceivealessthanrapturousreceptionfromfellowentrepreneurs.

Eventscanbeavaluableroutetoextendingyourbusinessnetwork.Usefulorganisationsincludethefollowing:

TheGlasshouse(http://theglasshouse.net),foundedin1998,holdsnetworkingeventsbringingentrepreneurs,financiersandbusinessadvisersacrossallsectorstogethertoprovidesupport,encouragementandinspirationtowould-bebusinessstarters.

TheJuniorChamberInternationalUnitedKingdom(www.jciuk.org.uk)isapersonaldevelopmentandnetworkingorganisationfortheunder-40s.It’spartoftheglobalJuniorChamberInternational(JCI),whichhasover250,000membersin100differentcountries.

Networking4business(www.networking4business.com)organisesbusiness-to-businessnetworkingeventsthatenableyoutomeetmanyotherbusinesspeoplewithoutany

commitmentandinarelaxed,informalatmosphere.

SpendingTimewithaFriendlyBanker

Despitehavinghadabadpressduringthecreditcrunch,theseguysandgirlshavealottoofferotherthanoodlesofcash(ornot!).Bankersseealotofdifferentpeopleaboutalotofdifferentbusinesses.Youcandrawontheirwiderangeofknowledgeandexperience.Yourbankermaybefamiliarwithyourtypeofbusinessorthelocationyou’reinterestedin,orhaveadviceondifferentfinancingoptions.

Startbytalkingwithabankmanageryoudon’twanttoborrowmoneyfrom.Begintheconversationbyaskingforadvice,ratherthanmoney.Onlywhenyou’veconvincedyourselfthatyourpropositionisanappropriateoneforabankshouldyoumakeapitch.(SeeChapter8formoreaboutbanksandbankmanagers.)

TappingintoYourLocalEnterpriseAgencyDirector

Over1,000businessexpertsaresittinginalocalofficesomewherenearyoujustwaitingtoofferadvice,help,encouragementandsupporttoanyonethinkingaboutstartingabusiness.Theevenbetternewsisthattheservicestheyprovideareeitherfreeorlowcost.EnterpriseAgencies(seeChapter7)havebeenaroundfor25yearsandareaninitiativestartedbybigbusinesstohelpsmallbusiness.

Bankmanagers,businessexecutivesonloanaspartoftheircareerdevelopmentandtheoccasionalcivilservant,accountantand

lawyerstafftheseagencies.Makesurethatyougrabyourfairshareofthisexpertise.

CommunicatingwithYourCurrentBoss

Talkingtoyourbossaboutanythingotherthanthejobinhandisalwaysatrickydecision.Talkaboutyourentrepreneurialvisiontoosoonandyoumayfindyourselfsidetrackedforpromotionandpayrisesandperhapsevenfirstinlineforthenextdownsizingevent.Leaveittoolateandyourbossmayseeyouractionasdisloyaltyatbestandbetrayalatworst.

Ifyouplantostartupinthesamelineofworkandpossiblyeventrytotakesomekeyaccountswithyou,thenyou’dbettertalktoalawyerratherthanyourboss.Butiftheclimateisrightandyoucantalktoyourboss,anumberofvaluablethingsmayhappen.Youbosscanbeasourceofinvestmentcapital,abusinesspartnerorausefulresourceforbusinessadviceandcontacts.

Yourbossmayevenbecomeyourfirstcustomer,ifthebusinessesarecompatible.

CallingYourColleaguesThoseyou’veworkedalongsideovertheyearshaveformedaviewaboutyourtalents.Yourspousehasseenyouafterwork,butthey’veseenyouatwork.Iftheydon’tknowyourstrengths,weaknesses,foiblesanddesires,thennoonedoes.Atworsttheymaytellyouthatyou’rebarmyandexplainwhy;atbesttheymayjoinyouintheventureorinvesttheirhard-earnedsavingsinyourbusiness.

Ifyouwerethinkingabouttakingonapartner,thencastingyoureyearoundyourcolleaguesisagoodplacetostartlooking.Remember,itcutsbothways.Althoughtheymayknowalotabouthowyouperformatwork,youknowasmuchaboutthem.

BringinginYourBestFriendOntheassumptionthatyourbestfriendisn’tyourspouse,thensherepresentssomeoneelsewhoshouldbeabletotellyouwhetheryou’retherightsortofpersontostartuptheparticularbusinessyouhaveinmind.Youcanstartoutbyaskingyourfriendtoreviewyourskillsandknowledgeinventory(seeChapter3)andsoprovideavaluablecrosscheckonyourself-assessment.Infact,youshouldalwaysfindsomeonewhoknowsyoureallywelltogothroughthisandthebusinessidea-evaluationprocess(alsoinChapter3).Unfortunately,everyone’scapacityforself-deceptionisunlimited,andyoushouldn’tmissanyopportunityforarealitycheck.

ReportingtoanAccountantYouneedanaccountantinanyevent(IexplaintheprocessoffindingoneinChapter14).However,don’tmissoutonmakingthemaximumuseofasmanyaccountantsaspossiblewhenresearchingtoestablishyourbusiness.Takeallthefreeadviceyoucanget,becausemostaccountantsgiveyouafreefirstmeetinginthehopeofsigningyouupasaclient.

Pumptheaccountantsasmuchasyoucanforanytips,pointersoradviceonthebusinessyouhaveinmind.

Accountantsarethefirstportofcallforanyentrepreneurseekinghelpandadvice,aheadofbankmanagers,smallfirmadvisersandbusinessassociates.Asa

consequence,they’retherepositoriesofanenormousamountofinformationoneveryaspectofbusiness,notjustfinance.

Accountantsdrawanincreasingamountoftheirrevenuefromnon-accountingtasks,andsomeevenmakemoremoneyfromprovidinggeneralbusinessadvicethantheydofromauditing.

Mostaccountantsaresoletradersorinsmallpartnershipsoperatinginmuchthesamewayasyouplantodowhenyousetupyourbusiness.Sounlikebankmanagers,whoallworkinlargeorganisations,accountantscanidentifywithyourproblemsandconcerns.

TalktotheAddedValueNetwork(website:www.avn.co.uk;tel:08452262371),anetworkofover5,000accountantsworkinginover400officesacrosstheUnitedKingdomwhoarefocusedonhelpingentrepreneursstartupandgrowtheirbusinesses.Itoffersafree‘BusinessBuilderReview’tailoredtosuityourneedsbutbasedonitsexperiencesinhelping115,000owner-managedbusinesses.

PluggingintoaBusinessAngelNetwork

Businessangels(seeChapter8)havesomeattractiveattributes.Theyaren’tasriskaverseasventurecapitalfirms;theyactmorequickly,puttingupmoneyinweeksratherthanmonths;andtheyaren’tsofussyaboutyourpedigree.Butwhenitcomestogivingahelpinghand,they’reabsolutestars.UsingthebusinessangelnetworksoutlinedinChapter8youcanfindanangelwithexpertiseinthesectorinwhichyouhaveaninterest.

Chapter22

TenStepstoPreparetoMoveOn

InThisChapterDecidingwhentosellup

Puttingapriceonyourbusiness

Gettingthebestadvice

Figuringoutwhattodonext

Howevermuchyouloveyourbusiness,thetimecomeswhenyouwanttorealisesomeorallofthevaluetiedupinthebusiness.Itmaybejustthatyouwanttobuyayachtandhavethetimeforthatround-the-worldadventureyou’vebeenpromisingyourself;itmaybethatyou’vetakenthebusinessasfarasyoucanandtorealiseitsfullpotentialitneedsanotherskipperatthehelm;oritmaybethatyourbackers,ifyouhaveany,wanttobailoutthemselves–venturecapitalfirmsoftenhaveitchyfeetandwanttotaketheirprofitsfromonesectortopilethemintothenextbigthing.Whateverthereasonforlookingforanexit,togetthebestvalueoutofyourbusinessfollowthesetenguidelines.

MonitoringMarketPricesTimingiscrucialwhenitcomestosellingabusiness.Since1900,27‘bull’marketshaveexisted,whencompanysharesrisesharply,withcorresponding‘bear’markets,thelatestexamplebeingin2008–2010,whenover-optimisticinvestorsgetmauledasthebottomdropsoutofstockmarkets.Theseupsanddownscanresultinvery

steepcurves,withbusinessvaluesoscillatingbyasmuchasa50percentandthechangesinthemarket’sperceptionofvalueoftenhavinglittletodowiththeactualperformanceofbusinessesthemselves.

Businesseslistedonthestockmarkethavenodifficultyinworkingoutwhattheirbusinessesareworthatanymomentintime–sharepricesarepublisheddailyinthefinancialpressandeveryfewminutesonfinancialwebsites.Butbecausemostbusinesses,yoursinallprobabilityincluded,aren’tlistedonastockmarket,youcan’teasilykeeptabsonmarketsentimentforthevalueofyourbusiness.

StepforwardBDOStoyHaywardandtakeabow.BDOStoyHayward’sPrivateCompanyPriceIndex(PCPI)trackstherelationshipbetweenthecurrentFTSEprice/earningsratio(P/E;checkhowtocalculatethisinChapter5)andtheP/Escurrentlybeingpaidonthesaleofprivatecompanies.Putsimply,thePCPIletsacompanywithoutastockmarketlistinggetareasonableideaofwhatitmayactuallysellfornow.Gotowww.bdo.uk.com/library/a-z>PCPIPrivateCompanyPriceIndex.

ValuingYourBusinessSettingaprecisevalueonabusinessisn’tquiteassimpleas,say,determiningthepriceofyourhome.Onepossiblewayistoadduptheassets,takeawaytheliabilitiesandintheorythedifferenceisthevalueofyourbusiness.However,yourassetscompriseitemssuchasstockthatmaybehardtovalue,anddebtorswhomayormaynotactuallypayup.(IcoverthesetermsinChapter13.)Businessesaremoreusuallyvaluedusingaformulaknownastheprice/earningsratio(IshowhowthisiscalculatedinChapter5).P/Eratiosvarybothwiththebusinesssectorandcurrentmarketfeelingaboutthatsector.ThemarketasawholegenerallytradeswithP/Esofbetween14and20,withtheaveragesince1870being15.

YoucancheckouttheP/EforyourbusinesssectoreitherbylookingintheFinancialTimes,oratProShare’swebsite(www.proshareclubs.co.uk,thenclickResearchCentre,thenPerformanceTables).YouneedtoregistertoaccessthedataontheProSharewebsite,butregistrationisfree.ThereyoucanseethecurrentP/Eratioforeverycompanyinyoursector,aslongasthey’relistedontheLondonStockExchange.Ifyouwanttoseehowmuchinterestexistsinyourbusinesssectorrightnow,visitInteractiveInvestor(www.iii.co.uk,selectMarketsandthenSectors).Thereyoucanseethesectorwhosesharesinvestorshaveboughtandsoldthemostoverthepastday,monthandyear.

Privatecompaniesdon’ttradeonashighaP/Emultipleastheirbigbrothersonthestockmarket.SoifapubliccompanyinyoursectorisonaP/Eof12,asaprivatecompanyyourprospectiveP/Eisaround8,orathirdless.Why?Goodquestion.Thesimplestansweristhatalthoughsharesinyourbusinessarehardtodisposeof,youcanunloadapubliccompanyeverybusinessdaybymakingaphonecalltoyourbroker.Inotherwords,thepremiumisforliquidity.

FiguringOutWhotoSellToDeterminingasellingpriceisonething,butfindingawillingbuyerisamuchmorechallengingtask.Priceandbuyerareinter-relatedfactors,becausewhateverequationyouusetoarriveatbusinessvalue,attheendofthedayabusinessisonlyworthwhatsomeonewiththedoshcanpay.Theseareyouroptions:

Sweetheartdeal:Sellingouttosomeoneyouknowordobusinesswithisaneasyoption.Unfortunately,it’snotalwaysthewaytogetthebestpriceforyourbusiness,

becauseonlyonebuyerisintheframe.Notonlydoesittaketwototango,butyoursaleworksbetterifyouhaveatleasttwopeopleinterestedinbuyingyourbusiness.

Tradesale:Thisiswhenyousellouttoanothercompany,usuallyamuchlargeronewithaccesstofinanceandotherresourcesthatmayenableyourbusinesstohaveacontinuingfuture.Thisinvolvespublicisingthatyou’resellingupandcreatingtheenvironmentforseveralbidderstoenterthering.Youcansellthebusinessyourself,perhapsbyadvertisingorbywordofmouth.Butusuallyyouappointabusinessbrokertohandlethedeal,muchasyou’duseanestateagenttosellyourhouse.

Managementbuy-out(MBO):Youmaybeabletosellyourbusinessofftoyourmanagementteam.Thatinvolvesthemraisingthemoney,perhapsfromaventurecapitalfirm(IcoverthissubjectinChapter8).YoucanfindoutmoreaboutMBOsfromtheCentreforManagementBuy-outResearch(CMBOR),foundedbyBarclaysPrivateEquityandDeloitteattheNottinghamUniversityBusinessSchool(www.nottingham.ac.uk/business/cmbor).

Managementbuy-in:Thisinvolvessellingthebusinesstoanewmanagementteam,invariablywiththefinancialbackingofaventurecapitalfirm.Theteamisledbysomeone,usuallyfromasimilarindustrytoyours,who’sprovedsuccessfulinbuildingupandsellingoutabusinessbefore.

BIMBOisacombinationofamanagementbuy-inandbuy-out,usuallyinvolvinganexternalmanagingdirectorbeingbroughtintorunyourbusinesswithyourmanagementteamandfinancialbackingfromaventurecapitalfirm.

Employeebenefittrust:Thisinvolvesformingatrusttoholdsharesonbehalfofemployees,sothattheemployeescanineffectendupowningasubstantialsliceofthebusiness.

Sometaxincentivesareavailabletoretiringownerswhosell(orgift)sharestosuchatrust.YoucanfindoutmoreaboutthisoptionfromEmployeeOwnershipOptions(www.employeeownership.co.uk/finance.htm).Itsgoalistoraiseawarenessofthebusinessoptionsavailabletosmallfirmswhenthey’rethreatenedwithclosureeitherasaresultofsuccessionproblemsorasaresultofdivestment.

Goingpublic:Thisinvolvessellingsharesinthebusinesstothepublicthroughastockmarketflotation.Inthatwayyoucanrealisesomeofthevalueinyourbusinessgraduallyoveraperiod.Thisisacomplicatedandexpensiveprocessandyouneedprofessionaladvice.AIM,thejuniorUKstockmarket,hasseenover3,000companieslistedsinceitstartedin1985,someofwhichhaveatbestamodesttradingrecord.CheckouttheLondonStockExchange(www.londonstockexchange.com/companies-and-advisors/aim/for-companies/joining/aim.htm)forafulldescriptionoftheoptions,what’sinvolved,howmuchitcosts(lots!)andwhocanadvise.

Passingontothefamily:Lessthan33percentoffamilybusinessesarepassedontothesecondgenerationandbarely13percentsurvivethroughtothethirdgeneration.Somuchforthebadnews–theonesthatdocanbeverysuccessful.ALDI(shortfor‘AlbrechtDiscounts’);Michelin,controlledandrunbyFrançoisMichelin,hissonEdouardandtheirpartnerRenéZingraff;andMars,foundedbyMinnesotansFrankandEthelMars,whoinventedtheMilkyWaybar,areamongtheworld’sbiggestfamilybusinesses(checkoutFamilyBusinessMagazineatwww.familybusinessmagazine.com,thenOldestFamilyCompaniesforafulllist).TheFamilyFirmInstitute(www.ffi.org),theInternationalCentreforFamiliesinBusiness(www.icfib.com),PeterLeachLLP(www.peter-leach.com),whostartedtheFamilyBusinessCentreataccountantsBDOStoyHaywardandnowrunsitasastand-aloneventure,andtheFamilyBusinessInstitute

(http://familybusinessinstitute.com)areorganisationsdedicatedtoprovidingeducationandnetworkingopportunitiesforfamilybusinesses,aswellashelpwithsuccessionplanning.

Sellingtheassets:Ifthebusinesscan’tbesold,perhapsbecauseit’sunprofitable,orbecauseit’saone-manbandandhasnoprospectsofoperatingwithouttheowner,thentheremainingoptionistosellofftheassets,payoutwhat’sowedandpocketwhat’sleft.

Youalmostcertainlyalreadyknowthenameofthebuyerofyourbusiness.Makealistofallthecompetitors,customers,suppliersandemployeeswhoyoubelievemaybenefitfromtakingoveryourbusiness.Thentrawlthefinancialpresstoseewhoelsehasboughtorbeeninvolvedinanywayinthesaleofacompanysimilartoyours.CheckoutAcquisitionsMonthly(www.aqm-e.com)toseewhatdealshavebeendoneandwhatactivebuyersareinthemarket;andDaltonsBusiness(www.daltonsbusiness.com/SearchStat.asp),whereyoucanseethemarketdemandstatisticsbydifferenttypesofbusiness.

DressingtoKillWhoeveryouplantosellyourbusinessto,youshouldplanaheadtomakethebusinesslookitsbest.Blemishessuchaspoorprofitperformance,baddebts,creditdowngradesandbeingdraggedthroughthecourtsbyex-employeesclaimingtohavebeenunfairlydismissedaren’tdesirable.Youshouldtrytomakethethreeyearspriortoyourexitlookasgoodaspossible.Thatmeansprofitmarginsshouldbeconsistentlyhigh,thesalesandprofitcurveshouldbeheadingupwardsandstrongfinancialcontrolsystemsshouldbeinevidence.

Checkouttheseorganisationstoseehowyourbusinessislikelytoappeartoawould-bebuyer.

InterCompanyComparison(www.icc.co.uk)andJordans(www.jordans.co.uk)provideregularlyupdatedonlinecompanyinformationservicesthatenableuserstoaccessandretrievedataonindividualcompanies,directorsandshareholders.Theyalsoenableuserstoproduceindustry,group,peerandindividualreports,allowingyoutocompareyourbusiness’sperformancewiththatofothersimilarcompanies,aswellasobtainingin-depthfinancialprofiles.

Creditgate.com(www.creditgate.com)andCreditReporting(www.creditreporting.co.uk/b2b)areamongagrowingnumberofcompaniesthatofferacomprehensiverangeofcreditreportsinstantlyonline,includingcreditcheck,creditrating,companyprofile,creditscore,creditreference,creditlimit,companydirectorsandcountycourtjudgments(CCJs).Youcangetyourownbusinessratingfromoneoftheseagenciestoseehowyouappeartoawould-bebuyer.

TheCentreforInter-firmComparison(www.cifc.co.uk)helpsbusinessesofeverykindimprovetheirprofitabilityandproductivitybyprovidingexpertiseinbenchmarking,performancemeasurementandfinancialcontrol.Itgathersfinancialinformationonindustriesbasedondetailedinformationthatparticipatingfirmsprovide–inabsoluteconfidence–onacomparablebasis.TheCentrethenprovidestheinformationshowingindustryaverageandbestandworstperformancestandards,without,ofcourse,revealingtheindividualparticipants’data.

Whenyouwanttobringapurchasertothenegotiationtable,youneedtoprepareaninitialmarketingdocumentcalledasalesmemorandum.Themanagementwritetheinitialdraftand

yourcorporateadviserthenpolishesitup.Itshould:

Makethebusinesssoundattractiveandfeatureproductliterature,photographs,chartsandtables.

Beasourceofsolidinformation,butnotover-fullofnumbersandanalysis.Thebuyerandtheiradviserwillgetyouraccountsthemselves.

Showthatthebusinesshasscopeforimprovementanddevelopmentifsomeonewithmoremoneyandwiderskillsandexperiencetakesitforward.Otherwiseit’shardforpotentialbuyerstoseewhatvaluetheycanadd.

Containnodetailedconfidentialinformationorcommerciallysensitiveinformation,suchasthenameofcustomersorsuppliers.Nobuyermakesafinaldecisiononthebasisofasalesmemorandum,soyoucanprovidethisinformationlatertoseriousbuyersonly.

Betailoredtomeettheneedsofdifferentpotentialbuyers.Forexample,competitorsknowalotabouttheindustryandyourproducts,soyoudon’tneedtoexplainthattothem.

FindingAdvisersTheinformationinthischaptershouldgiveyouanideaofwhatyouneedtoknowinordertoexitfromyourbusinesssuccessfully.Butalthoughyoushouldknowthequestions,youneedadvicewithfindingtheanswers.Theseorganisationscanhelpyoufindprofessionaladvisersandadvicefromthoseexperiencedinsellingbusinesses:

HWisanationalbusinessadvisoryandaccountancyfirmwithanetworkofover60officesstrategicallyplacedthroughoutEngland,WalesandScotland,offeringadviceona

rangeoffinancialmattersincludingspecifichelpwithsellingyourbusiness(www.hwca.com/business-services/buying-and-selling-businesses/).

BusinessLink(www.businesslink.gov.uk,thenselectBuyorSellaBusinessandthenGettingReadytoSell)hasacomprehensiverangeofadvicecoveringeverythingfrompreparingyourbusinessforthesaletohandlingpotentialredundancies,includinglinkstosourcesofprofessionalhelp.

BDOStoyHayward,anaccountancyfirm,hasapublication,GuidetoSellingYourBusiness(availablefromwww.bdo.co.uk),whichsetsoutitsserviceoffertoentrepreneursplanningtosellup.

Gettingthebestcorporatefinanceadvice,asthewholesubjectofsellingandbuyingabusinessisknown,isn’tcheap.Expecttopayoutbetween3and7percentofthevalueofyourbusiness,andtohavetolayoutalargishfive-figuresumonthetabletokickthingsoff.Butgoodadvicecandoubletheamountofmoneyyouactuallyendupwithwhenyoutaketax,pensionsandwarrantiesintoconsideration.

DoingDueDiligenceWhenyoubuyahouse,youandyoursurveyorcrawlovereverywherewithatapemeasuretocheckoutsizes,andemployvariousinstrumentstoseewhetheranydamp,dryrotorotherunpleasantinfestationexiststhatcouldaffectitsvalue.Yourlawyermakessurethatthesellersactuallyowntheproperty,nomortgageisoutstandingandnoimminentplansexisttobuildamotorwaythroughthegarden.Averysimilarprocesshappenswhenbusinessesareboughtandsold,inaprocessknownasduediligence.Theaccountshavetobecorrect,taxpaiduptodateandmortgagesdeclared,andanylawsuitsrumblinginthebackground

forunfairdismissalofemployees,disputeswithsuppliersordefectiveproductssuppliedneedtobeflushedoutintotheopen.

Attheendoftheduediligenceprocess,lotsofpeopleendupwithliabilities.Thecorporatefinancefirmandthelawyersareresponsibleforthequalityoftheiradviceandiftheygetitwrongtheycanbesued.Theaccountantsareresponsibleonyoursidefordeliveringproperaccountsandonthebuyer’ssideforinterpretingthemcorrectly.Thesellertoohastogiveguaranteesthatshe’stoldthetruth,thewholetruthandnothingbutthetruth.Ifthatprovesnottobethecase,shemaymissoutonaslugofthesaleprice.

Sellersareusuallyrequiredtogivewarrantiesandindemnitiestothebuyertotheeffectthateveryimportantthingshesaysaboutthebusinessanditsaccountsistrue,andthatshe’shaveleftnothingmaterialunsaid.Bywayofguarantee,aportionofthesellingpriceisn’tpaidupforaperiodofayearorso,givingtimeforthebuyertouncoverskeletons.

AllBusiness.com,awebsitewithresourcesforentrepreneursincludinghow-toarticles,businessforms,contractsandagreements,expertadviceandblogs,hasafree40-pointduediligencechecklist(gotowww.allbusiness.com,thenselectShopLegalForms,thenMergersandAcquisitions,thenDueDiligenceChecklist).YoucanbuythefullMontyfor$25.

EarningOutYourProfitsOnetrickthatbuyersandtheircannyadvisersusetomakesurethatyourbusinessisreallyworthallthebundlesofdoughthey’repayingoutistomakeyoudosomeofthehardworkforthem.Thethinkingbehindthisisthatbecauseyou’vebeenrunningthefirmforyears,noone’sbetterqualifiedthanyoutomakesurethatyoukeepsweet

customersandsupplierswithwhomyoupresumablyhaveagoodworkingrelationship.

Typically,ifanearn-outisproposedit’sforbetween10and30percentofthesalepriceandcoversaperiodbetweenoneandthreeyears.Therulehereisthatsellersshouldresistsuchproposalsandbuyersshouldinsist!

Mostofthecostsinvolvedinsellingyourbusinessarebasedonapercentageofthesellingprice.Thatfigureincludestheearn-outamount,whetherornotthefigureisactuallyachieved.SomeuniquetaximplicationsexistthatyouoryouradvisershouldcheckoutwithHMRevenueandCustoms(www.hmrc.gov.uk/manuals/ersmmanual/ERSM110000.htm).

StartingUpAgainHavingworkedouthowtostartabusiness,builditupandselliton,youmaybejustifiedinthinkingthatyouhaveawinningformulaformakingmoney:justkeepturningthehandle.OnebusinessfounderwhocameonaprogrammeatCranfieldSchoolofManagementboughtoutachainofthreepubs,builtituptoadozenandthensoldouttoanationalbrewerychainforahealthyprofit.HerepeatedtheprocessthreetimesmoreandforallIknowisstillfollowinghissimplebuteffectivebusinessmodel.Thevaluehediscoveredwasthatbigbrewersdidn’twanttobuyapubortwoatatime.That’stoomuchlikehardwork.Inanyevent,ittakesasmuchmanagementtimetobuyonepubasitdoestoacquireachain.

Abuyerdoesn’twanttopayyouforabusinessonlytofindoutthatyoustartupanewbusinessandbecomeacompetitor.Abuyerexpectsyoutosignanon-competeclauseaspartofthe

salecontract.Thisrequiresyounottocompeteforacertainnumberofyearswithinadesignatedgeographicalarea.Thegoodnews–forsellers,thatis–isthatsuchagreementsaredifficulttoenforceandaren’talwayslookedonfavourablybythecourts,becausetheyrestrictanindividual’semploymentoptions.

BecomingaBusinessAngelIfyoudon’twanttorunabusinessbutdowanttostayinvolved,thenyoucanconsiderbecomingabusinessangel,backingotherpeople’sbusinesseswithyourmoneyandexpertise.IcoverthissubjectinthesectiononbusinessangelsinChapter8.

RobertWrightstarteduphisbusiness,aone-planeregionalairline,straightfrombusinessschool;he’dalreadyqualifiedasapilot.Robertbuiltthecompany,tradingasCityFlyerExpress,uptoasubstantialventureandsoldittoBritishAirwaysforasizeableeight-figuresum.Overtheyearsfollowingthesalehetookstakesinahandfulofsmallbusinessesandsomenotsosmallones,suchasWizzair.com,usingonlyamodestfractionofthegainmadefromthesaleofhisowncompany.

WindingUpIfforanyreasonabusinessappearstohavenovalue,perhapsbecauseit’smakinglossesandhasnoassetsworthyofthename,itmaystillbepossibletosalvagesomethingfromthewreckage.Intheworstcaseyourcreditorscanapplytowindyourbusinessupifthey’reowedmorethan£750.Theycanserveastatutorydemand(Form4.1)forthemoneydueandifit’snotpaidorsecured,orasettlementisn’tagreed,within21days,theycanappointa

liquidator.Theliquidator’sjobistopayoffthecreditors,startingwithherself.Norealisticlikelihoodexistsofanythingbeingleftfortheowner(s)goingthisroute.

Beforeyoureachthisstageyoushouldtakeprofessionaladviceurgently,notleastbecauseyoumaybeliableformoreexpensesthanyouthink.Intheory,ifyou’retradingasalimitedcompanythenyourliabilitiesarecappedatyourstatedsharecapital.However,tradingonafterthebusinesshasbecomeinsolventleavesthedirectorsopentoachargeofwrongfultrading.Insuchcasesthedirectorscanbepersonallyliableforthecompany’sdebts.

Talkwithyouraccountant,checkoutyourpositionbyreadinguponthegovernment’sInsolvencyServicewebsite(www.insolvency.gov.uk)orcontactamemberoftheInsolvencyPractitioners’Association(www.insolvency-practitioners.org.uk).Adirectoryofmembersisonthewebsite.

Toaccessthecheatsheetspecificallyforthisbook,gotowww.dummies.com/cheatsheet/startingabusinessuk.

Findout"HOW"atDummies.com

BusinessPlansForDummies®,3rdEditionVisitwww.dummies.com/cheatsheet/businessplansuktoviewthisbook'scheatsheet.

TableofContents

Introduction

WhyYouNeedThisBookHowtoUseThisBookHowThisBookIsOrganised

PartI:DeterminingWhereYouWanttoGoPartII:SizingUpYourMarketplacePartIII:WeighingUpYourCompany’sProspectsPartIV:LookingtotheFuturePartV:APlanner’sToolkitPartVI:ThePartofTens

IconsUsedinThisBookWheretoGofromHere

PartI:DeterminingWhereYouWanttoGo

Chapter1:StartingYourBusinessPlan

GettingtheMostOutofYourPlan

Lookingtothefuture

AccountingforyourhistoryAnticipatingyourdifferentaudiences

PuttingYourPlanonPaper

ExecutivesummaryCompanyoverviewBusinessenvironmentCompanydescriptionBusinessstrategyFinancialreviewActionplan

Chapter2:ChartingtheProperCourse

DevelopingYourCompany’sVisionStatement

ThinkingbigUsingthepowerofpassionBuildingabrand

CreatingYourCompany’sMissionStatement

GettingstartedDefiningyourbusiness(in50wordsorless)

IntroducingGoalsandObjectives

UsinggoalstomanagetheplanLookingatgoalsversusobjectives

SettingYourOwnGoalsandObjectives

GuidelinesforsettinggoalsGuidelinesforsettingobjectives

GettingitrightAvoidingthepitfallsStretchingfortargetsTimingiseverything

Chapter3:SettingOffintheRightDirection

WonderingWhyValuesMatter

LookingattoughchoicesAvoidingbeinglostandunpreparedValuinghavingvalues

IdentifyingYourOrganisation’sValues

ThinkingaboutinvestorsConsideringtherestofthecrewExistingbeliefsandprinciples

PuttingTogethertheValuesStatement

DevelopingavaluesstatementPreparingavaluesstatement–thefullMonty

PartII:SizingUpYourMarketplace

Chapter4:CheckingOuttheBusinessEnvironment

DefiningtheBusinessThatYou’reInAnalysingYourIndustry

StructureMarketsRelationshipsFinance

ResearchingYourMarket

EstablishingyourknowledgegapsCarryingoutdeskresearchGettingintothefieldUsingtheInternet–wisely

RecognisingCriticalSuccessFactors

TechnologyManufacturingOperationsHumanresourcesOrganisationServicesLocationMarketingDistributionGovernmentregulationOutsourcing

PreparingforOpportunitiesandThreats

It’sabeautifulmorningDarkcloudsonthehorizon

Chapter5:TakingaCloserLookatCustomers

CheckingOutWhoYourCustomersAre

ThegoodcustomerThebadcustomerTheotherguy’scustomer

DiscoveringWhyYourCustomersBuy

UnderstandingneedsDeterminingmotivesMonitoringcomplaints

FindingOutHowYourCustomersMakeChoices

RealisingthatperceptionsarerealityFindingthefivestepstoadoption

RememberingtheBigPictureDealingwithBusinessCustomers

SizingupsecondhanddemandThinkingofdecisionmakingasaformalaffairJudgingtheforcestobereckonedwith

Chapter6:DividingCustomersintoGroups

DefiningMarketSegmentsWaystoMakeMarketSegments

LookingatwhoisbuyingLookingatwhattheybuyWonderingwhytheybuy

FindingUsefulMarketSegments

Isthesegmenttherightsize?Cancustomersbeidentified?Canthemarketbereached?

Chapter7:ScopingOutYourCompetition

UnderstandingtheValueofCompetitorsIdentifyingYourRealCompetitors

CompetitionbasedoncustomerchoiceCompetitionbasedonproductuseCompetitionbasedonstrategyCompetitioninthefuture

PredictingYourCompetitors’Moves

FiguringouttheirgoalsUncoveringtheirassumptions

CompetingtoWin

OrganisingfactsandfiguresChoosingyourbattles

PartIII:WeighingUpYourCompany’sProspects

Chapter8:EstablishingYourStartingPosition

SizingUpSituationAnalysisIdentifyingStrengthsandWeaknesses

FindingyourframesofreferenceCountingupyourcapabilitiesandresourcesComingupwithcriticalsuccessfactors

AnalysingYourSituationin3-D

TakingaglanceatcompetitorsCompletingyourSWOTanalysis

MeasuringMarketShare

Chapter9:FocusingOnWhatYouDoBest

DescribingWhatYouDo

ConstructingatypicalvaluechainComparingdifferentvaluechainsForgingyourownvaluechain

StayinginBusiness

SearchingforcompetitiveadvantageFocusingoncorecompetenceSustaininganadvantageovertime

EarmarkingResources

Chapter10:FiguringOutFinancials

UnderstandingaProfitandLossAccount

RevenueCostsProfitMarginsmatter

BuildingtheBalanceSheet

SettlingonlayoutAssetsLiabilitiesandowners’equity

ExaminingtheCash-FlowStatement

CashinandcashoutWhat’sleftover

EvaluatingFinancialRatios

Short-termobligationsLong-termresponsibilitiesRelativeprofitability

UnderstandingBreak-Even

Chapter11:ForecastingandBudgeting

ConstructingaFinancialForecast

Ponderingthepro-formaprofitandlossaccountLookingattheestimatedbalancesheetProjectingcashflow

ExploringAlternatives

UsingtheDuPontformulaExploringthewhat-ifanalysis

MakingaBudget

Wonderingwhat’sinthebudgetDiscoveringhowbudgetsaremadeUsingratiostoimproveyourbudgetAnalysingvariancesFlexingyourbudgetBudgetingforcapitalexpenditureDeducingpaybackDiscountingcashflowCalculatingtheinternalrateofreturn

PartIV:LookingtotheFuture

Chapter12:PreparingforChange

DefiningtheDimensionsofChange

LookingateconomictrendsTakingheedoftechnologicaltrendsPoringoverpoliticaltrendsConsideringculturaltrends

AnticipatingChange

TryingouttrendforecastingSeekingoutscenarioplanningLookingatdemographictimebombsDoingaPESTanalysis

AssessingtheEffectsofChange

RollingthediceWinningorlosing

Chapter13:ThinkingStrategically

MakingStrategyMakeaDifference

ThinkingwhatstrategymeansWonderingwhenstrategyworks

ApplyingOff-the-ShelfStrategies

Learninglow-costleadershipStandingoutinacrowdFocusingonfocus

CheckingOutStrategicAlternatives

Goingup,down,orsidewaysLeadingandfollowing

LookingattheMarketingMixComingUpwithYourOwnStrategy

Chapter14:ManagingMorethanOneProduct

FacingtheProduct/ServiceLifeCycle

StartingoutGrowingupCopingwithmiddleageFacingtheseniorstretchJudgingwhereyouarenowMilkingcashcows

FindingWaystoGrow

Sameproduct/service,samemarketNewmarketornewproductNewproductandnewmarketUnderstandingtheadoptioncycleProtectingintellectualproperty

ManagingYourProductPortfolio

LookingatstrategicbusinessunitsAimingforthestarsLookingstrongandattractiveHasteningslowly

ExtendingYourE-PenetrationBuyingOutCompetitors

KnowingwhyyouwanttobuyInvestigatingandapproachingValuingthebusinessLimitingtherisks

PartV:APlanner’sToolkit

Chapter15:PlanninginTurbulentEconomicTimes

CyclesandtheMultiplierEffect

DownturnsgaloreCyclesaredifferentAnticipatingtrouble

PreparingfortheWorst

DeleveragingbalancesheetsContainingworkingcapitalPricingunderpressureMaintainingmarketshareConservingcashKeepingkeyemployeesSellingoffassets

PreparingfortheUpturn

AcquiringcompetitorsPlanningshorttermforthelongterm

Chapter16:MakingYourBusinessPlanWork

ShapingYourCompany

Livingtheplan

PuttingtogetheranorganisationDevelopingprocedures

PreparingYourPeople

EncouragingleadershipDevelopingskillsCreatingacultureBuildingateamRewardingresultsAssemblingyourfinancesPlanningfortheexit

Chapter17:LearningfromOthers:ASampleBusinessPlan

SafariEurope:BusinessPlan

PartVI:ThePartofTens

Chapter18:TenQuestionstoAskAboutYourPlan

AreYourGoalsTiedtoYourMission?CanYouPointtoMajorOpportunities?HaveYouPreparedforThreats?HaveYouDefinedYourCustomers?CanYouTrackYourCompetitors?WhereAreYouStrong(andWeak)?DoesYourStrategyMakeSense?CanYouStandBehindtheNumbers?AreYouReallyReadyforChange?IsYourPlanClear,ConciseandCurrent?

Chapter19:TopTenBusiness-PlanningNever-Evers

FailingtoPlanintheFirstPlaceMissingOutonAssumptions

ExternalassumptionsInternalassumptions

Second-GuessingtheCustomerUnderestimatingYourCompetitionIgnoringYourOwnStrengthsMistakingaBudgetforaPlanShyingAwayfromReasonableRiskAllowingOnePersontoDominatethePlanBeingAfraidtoChangeForgettingtoMotivateandReward

CheatSheet

IntroductionSoyoupulledthisbookofftheshelfanddecidedtogiveusatry.Goodmove.You’vecometotherightplace.Believeitornot,wedon’tneedtoreadtealeavestoknowabitaboutyourbackground.Infact,we’dgosofarastosuggestthatyouprobablyfindyourselfinoneofthefollowingsituations:

You’veagreatideaforabrand-newgadgetandcan’twaittogetyourowncompanyupandrunning.

Yourbossjustturnedoveranewleafandwantsabusinessplanfromyouinthreeweeks.

You’vealwaysrunthebusinesswithoutabusinessplan,andyou’retheonewhoturnedoverthenewleaf.

Youthoughtyouhadabusinessplanforthecompany,butitdoesn’tseemtobedoingthejobthatitshould.

Thebusinessandeconomicclimatelooksawholelotmorehostilethanthelasttimeyouthoughtaboutwritingabusinessplanandyouwanttobedoublysureofgettingitright.

Areweclose?Whateveryoursituation,you’renotgoingtoneedthosetealeavestomakeabusinessplan,justreadthisbookinstead.Wecan’ttellyouthefutureofyourbusiness.Butthebusinessplanthatwehelpyouputtogetherpreparesyouforthefuture.Andwe’rewithyoueverystepoftheway.

WhyYouNeedThisBookYoumaynotknowhowtomakeabusinessplanjustyet,butyou’resmartenoughtoknowthataplanisimportant.Weknow,fromyearsofworkingwithcompanieslargeandsmall,thatabusinessplanis

ofworkingwithcompanieslargeandsmall,thatabusinessplaniscrucial–yourplanistheonlywaythatyoucangetwhereyouwanttogo.

Thisbookhelpsyoucreateyourbusinessplanstepbystep.Alongtheway,youmaydiscoverthingsaboutyourbusinessthatyouneverrealised–thingsthatjustmayhelpyoubeatthecompetition.Weeventhrowinafewlaughsaswell.

Sure,forsomeofyou,abusinessplanissomethingthatyou’rerequiredtoputtogethertoraisemoneyforastartupcompany.Atbest,it’saformality;atworst,arealpainintheneck.Butabusinessplanisn’tjusttheretoraisemoney;itcanalsobeapowerfultool–onethat’sboundtomakeyourcompanyabetterplacetoworkandyourbusinessamoresuccessfuloperation.

Isabusinessplanmagic?No–nosorceryhere.Abusinessplanworksbecauseitforcesyoutostopandthinkaboutwhatyou’redoing.Itpromptsyoutofigureoutwhatyouwantyourcompanytobeinthefutureandhowyouintendtomakethefuturehappen.Thenyourplanactsasatemplate,guidingyouthroughthestepsrequiredtomeetyourgoals.Forexample:

Abusinessplanrequiresyoutolookcarefullyatyourindustry,yourcustomersandthecompetitiontodeterminewhatyourrealopportunitiesareandwhatthreatsyouface.

Abusinessplantakesagoodhardlookatyourcompanyaswell,sothatyoucanhonestlyandobjectivelyrecogniseitscapabilitiesandresources,itsstrengthsandweaknessesanditstrueadvantages.

Abusinessplancoaxesafinancialreport,aforecastandabudgetoutofyou,sothatyouknowwhereyoustandtodayandwhatthefutureholds.

Abusinessplanpreparesyouforanuncertainfuturebyencouragingyoutocomeupwithbusinessstrategiesandalternativestoincreaseyourchancesofsuccessdownthe

road.

HowtoUseThisBookBusinessPlansForDummies,3rdEditionwillhelpyourbusinesssucceednomatterwhoyouareorwhatyourjobdescriptionis,whetheryou’repartofalargecorporationoraone-personshow.Dependingonyoursituation,youmayfindyourselfdippingintoandoutofthebookindifferentways:

Ifbusinessplansarenewtoyou,youmaywanttostartatthebeginningandletusbeyourguides.Wetakeyoufromyourcompanymissionallthewaythroughtomakingyourbusinessplanwork,andwekeepyourheadabovewaterthewholeway.

Ifyou’realittlemoreexperienced,youmaywanttoheadstraightforoneofthemoreinterestingwateringholes:howtorecognisethecriticalsuccessfactorsinyourbusiness,forexample,orwheretolookforyourcompany’sstrengthsandweaknesses.Afterdippinginanywherealongtheway,you’llmostlikelydiscoveryetanothersectionwhereyouwanttospendsometime.

Justremember–nomatterwhereyoufindyourself,you’renevertoolatetostartabusinessplan,andnevertoolatetomaketheonethatyouhaveevenbetter.Ineachcase,youcanfindwhatyou’relookingforbetweenthesebright-yellowcovers.

HowThisBookIsOrganisedBusinessPlansForDummiesisdividedintosixparts,basedonthemajorelementsofyourbusinessplan.Youdon’thavetoreadalltheparts,however,andyoucertainlydon’thavetoreadtheminorder.

Eachchapterisdevotedtoaparticularbusiness-planningtopic,andyoumayneedsomechaptersmorethanyoudoothers.Feelfreetoskiparound;pickandchoosewhatyou’rereallyinterestedin.

PartI:DeterminingWhereYouWanttoGoWhenputtingtogetherabusinessplan,youhavetodecidewhereyouwanttoendupinthefuture.Thisparthelpsyougetontrackrightawaybyestablishingamissionforyourcompany,alongwithbusinessgoalsandobjectives.Thenwehelpyouexamineyourcompany’svaluesandyourvisionforthefuture.

PartII:SizingUpYourMarketplaceTomakeausefulplanforyourbusiness,youhavetoknowsomethingaboutthemarketyou’regoingafter.Inthispart,wehelpyouexamineyourindustryandfigureoutwhatittakestobesuccessfulbyidentifyingwhereyouropportunitiesandthreatscomefrom.Wealsohelpyouanalyseyourcustomers,sothatyoucanunderstandwhotheyare,whattheyneedandhowyoucangroupthemtobetterservethem.Finally,wehelpyouscopeoutyourcompetition,tryingtodetermineexactlywhatyouneedtowin.

PartIII:WeighingUpYourCompany’sProspectsInthispart,weturnourfullattentiontoyourcompany.Wehelpyoulookasobjectivelyasyoucanatyourcapabilitiesandresources,identifyingthestrengthsthatyoucancountonandtheweaknessesthatyouneedtodealwith.Wealsohelpyouzeroinonwhatyoudobest,enablingyoutofigureouttherealvaluethatyouprovideforyourcustomersandthetrueadvantagethatyouhaveoveryourcompetitors.Finally,weguideyouthroughyourfinancesandhelpyouputtogetherafinancialforecastandabudget.

PartIV:LookingtotheFutureThemainreasonwhyyoumakeabusinessplaninthefirstplaceistogetreadyforwhatliesaheadforyourbusiness.PartIVhelpsyoulookintoyourfutureandpreparesyouforchange.Weintroduceseveralstandardalternativesandshowyouhowyoucanusethemtocomeupwithstrategiesofyourown.Andweconsiderthedifferentdirectionsthatyoucantakeasyourcompanygrowsbigger.

PartV:APlanner’sToolkitYourbusinessplanisnogoodifyoucan’tputittowork.Inthispart,wehelpyoushapeyourcompanytobeasefficientandeffectiveasitcanbe.Wealsohelpyoupreparethepeopleinyourcompanysothatthey’vetheskillstheyneedtoaccomplishthegoalssetoutinyourplan.Finally,weshowyouasampleofarealbusinessplan,sothatyouknow–starttofinish–whatyou’reaimingfor.

PartVI:ThePartofTensThePartofTensisacollectionofreminders,hints,observationsandwarningsaboutwhattodo–andnottodo–asyouworkthroughyourbusinessplan.Thesechaptersfocusonthebigpicture,solookatthemwheneveryouneedalittleperspectiveonwhereyoustandandwhereyou’reheaded,especiallyiftheroadaheadstartstolookalittlebumpy.

IconsUsedinThisBookToguideyouthroughyourbusinessplanpreparation,weincludeiconsintheleftmarginsofthebook.Here’swhattheymean:

Thisiconindicatestipstoputyouwayaheadofthecompetition.

Whereveryouseethisicon,youfinddefinitionsofbusiness-guruterms.

Thisiconcallsyourattentiontoilluminatingexamplesfromthebusinessworld.

Thisiconflagssituationsthatapplymostlytolargecompanies,butthatmayhelpsmallcompaniesaswell.

Ouch!,youmaygetburnedunlessyouheedthesewarnings.

Thisiconservesasafriendlyreminderthatthetopicathandisimportantenoughforyoutonotedownforthefuture.

Thisiconletsyouknowaboutwebsitesfromwhichyoucandownloadfreefinancialspreadsheets,tablesandotherusefulgoodies.Thesecanhelptakethegruntandgroanoutofnumber-crunchingcashflowforecasts,‘whatif’projectionsandothertediousbutvitalrepetitivecalculations,aswellaskeepyouup-to-dateonimportantrulesandregulations.

WheretoGofromHereTakeaminutetothumbthroughthisbookandgetcomfortablewithwhat’sinside.Thenpickoutoneortwochaptersthattickleyourfancy.Betteryet,turntoachapterthatyoualreadyknowsomethingabout.Or,ifyou’rereallydaring,turnthepageandstartatthebeginning.

Don’tforgettousethetableofcontentsforachapter-by-chapterbreakdown.Theindexisalsoanexcellentplacetoturntofindaspecifictopicrightaway.

Wanttomakeyourbusinessplanlookgreat,orneedsomehandsonsupport?Gotowww.dummies.com/go/businessplansfordummiestofindtipsandadviceonshapingupyourbusinessplan.Youcanalsodownloadaglossaryfromheretogetyourheadaroundthebusinessjargon.

PartI

DeterminingWhereYouWanttoGo

Inthispart...

Nomatterwhatyou’dliketofinish,from

wallpaperingthebedroomtohookingupthenewrouter,it’sawfullyeasytopassoverallthepreliminarystuffandjumprightintothethickoftheproject.Let’sfaceit,thepreliminariesareabitboring.Butforthereallyimportantthingsinlife–andinbusiness–preparationiseverything.Sopreparingtodoyourbusinessplanranksrightupthereinimportancewitheachoftheothermajorstepsasyoucreateaplan.

Inthispart,wehelpyoupreparetoplanbylookingatwhatabusinessplanisallabout.First,welookathowtoestablishamissionforyourcompanyanddevelopbusinessgoalsandobjectiveswithallyourstakeholdersinmind.Wealsopointoutwhyvaluesaresoimportanttoyourcompany,andshowyouhowyoucanuseyourcompany’svalues.Finally,welookathowavisionforyourcompanygivesyousomethingtoaimforandadirectiontotake.

Chapter3

SettingOffintheRightDirection

InThisChapterUnderstandingwhyasetofvaluesissoimportant

Figuringoutwhoyourstakeholdersare

Identifyingyourcompany’scurrentbeliefsandprinciples

Puttingtogetheryourcompanyvaluesstatement

Youmayaskyourselfwhyonearthyou’rereadingachapteronvaluesinabookonbusinessplanning.Wecanhearwhatyou’rethinking:Hey,it’sthetwenty-firstcentury.Today’sbusinessethicsrevolvearoundsurvivalinthemarketplace:catertoyourcustomers,beatthecompetition(hey,demolishthem!),make‘loadsamoney’andrun.

Yeteveninabusinessworlddominatedbymarketeconomies,globalcompetitionandthelawsofthejungle,valuesstillmatter.Infact,we’reconvincedthatsuccessfulbusinessplansmuststartwithastatementofcompanyvalues.

Now,don’tgetuswronghere–wehavenoquarrelwithprofits.Weabsolutelylovethem,andweexpecttoearnlotsforourselvesovertime.Butshort-termprofitsdon’tgofaroverthelonghaul.Valuesandavisionkeepeverybodyinyourcompany–evenifyou’reonlytwopeople–oncourseandheadinginthesamedirection.Whatifyou’reacompanyofone?Takingtimetoestablishyourvaluesandvisionwillstillkeepyouontrackasyourbusinessgrows.

Inthischapter,wepointoutwhyvaluesaresoimportantinthefirstplace.Wehelpyouidentifyyourcompany’svaluesbynotingwho

place.Wehelpyouidentifyyourcompany’svaluesbynotingwhohasastakeinyourbusinessanddiscoveringthebeliefsandbusinessprinciplesthatyoualreadyhold.Thenweshowyouhowtoputtogetheravaluesstatementforyourcompany.

WonderingWhyValuesMatterYourcompanyfacesallsortsofoptions,alternativesanddecisionseverydaythatyou’reinbusiness.Ifyoutakethetimetodefineyourcompany’svalues,theseprinciplesandbeliefscanguideyourmanagers,employees,orjustyou(ifyou’reinbusinessforyourself)asyoufacecomplicatedissuesthatdon’thaveeasyanswers.Whentheunexpectedhappens,youcanreactquicklyanddecisively,basedonaclearsenseofwhat’simportant.

Lookingattoughchoices

Considerascenario.FrankLittleisanindependentconsultantworkingforalargeUK-basedpetrochemicalfirmthatwe’llcallBiggOil.He’sconductingmarketanalysisforoneofthecompany’slargestdivisionsandisinvolvedinanimportantprojectconcerningthedevelopmentofnewoverseasbusiness.

Frank’sgoodatwhathedoes,andhesketchesoutseveraloptionsfortheproduction,distributionandpricingofpetrochemicalsinthreecountries.Inoneofhismostpromisingscenarios,thenumbersforacountrythatwe’llcallFriedoniayieldsubstantiallyhighershort-termprofitsthantheothertwo–primarilybecausethatnationdoesn’tyethaveexpensivepollution-controlproceduresinplace.TheothertwonationshaveenvironmentallawssimilartothoseintheUK.

Here’sFrank’sdilemma:byintroducingitsproductlineintoFriedonia,Frank’sclientcanmakehugeprofits.Sure,theresultingpollutionmaycauseecologicaldamagethatmaypossiblybetraced

pollutionmaycauseecologicaldamagethatmaypossiblybetracedbacktoBiggOil.Butthissituationisnotillegal,accordingtoFriedonia’scurrentlaws,andFrankstandstogetalotmorebusinessfromBiggOiliftheprojectgoesahead.

Heagonisesoverthesituationandhisreport.WhatshouldFrankrecommendtoseniormanagement:

Gofortheshort-termbucks?

Voluntarilyenactprocedurestocontrolpollution,eventhoughthecompanyisnotlegallyrequiredtodoso?

ForgetFriedoniauntilthecountryhasstrongerenvironmentallaws?

MaybeyoucanrelatetoourfriendFrank’squandary,havingfacedsimilarkindsofethicalquestionsandtrade-offsinyourownbusiness.

IfFrankhadasetofvalueswrittendown,thosevaluescanhelphimoutofhisquandary.Valuesprovideaframeworktoguidepeoplewhoareconfrontedwithdifficultchoices.

Havingnofundamentalguidelinestofollow–or,worseyet,beingtoldtoplayitsafeor‘don’trocktheboat’–businesspeopleinFrank’spositionareforcedtochoosethesafestpath,andthatpathisoftendeterminedbyprofits,promotionprospectsorjobsecurity.Buttheeasiestpathisnotalwaysthebest.

AvoidingbeinglostandunpreparedWhathappenswhendisasterstrikes?Weallrememberheadline-grabbingstoriesinwhichunexpectedtroublestarnishedtheimagesofallsortsofcompanies,suchasthefollowing:

Exxon(oilmanufacturerandexporter):TheinfamousoiltankerValdezspilledmillionsofgallonsofcrudeoilintoapristineAlaskanbay,causingincalculableenvironmentaldamage.TheTotalFinaElftankerErikadidmuchthesameofftheBrittanycoastin1999.

Perrier(naturalcarbonatedwaterbottler):In1989,French-basedPerrierwasthemarketleaderinbottledmineralwater,itsnamesynonymouswithpurityandquality.Perrierwaterwasonthetablesofvirtuallyeveryhigh-classrestaurantaroundtheworld.Salespeakedat1.2billionbottlesayear.TheplantatVergèze,nearNimes,wastooledupfor1.5billion,withcapitalinvestmentandpersonneltomatch.ThePerrierwaterbenzenecontaminationincidentin1990wipedoutalifetimeinvestmentinpromotingtheimagesofpurityandquality.Coca-Colahadasimilarexperiencewhenitsbrandof‘pure’bottledwater,Dasani,hadtobewithdrawnin2004.Farfrombeingproducedusinga‘highlysophisticatedpurificationprocess’,basedonNASAspacecrafttechnology,itturnedouttobecontaminatedwithbromate,apotentiallycancer-causingchemical.

Intel(computerchipmanufacturer):AflawinitsPentiumchip(whichwasorwasn’treallysignificant,dependingonwhoyoutalkedto)ledtocorporateapologiesandproductreplacement.

Thesecompaniesallstumbledoverso-calledexternalities(touseeconomicsdoublespeak).Externalitiesrefertothosecircumstancesthatextendbeyondafirm’simmediatecontroltoissuesthataredeeperthansimplymakingamint.Overtime,thefailuretoseethepoweroftheseoutsideforces–andtoaccountforsocialandethicalvalueswhenyoumakedecisions–canresultinseriousorevendisastrousconsequencesfor

yourcompany.Astheexamplesillustrate,we’renottalkingaboutoneunhappycustomer,folks;we’retalkingaboutbig-timetrouble.

Ourlistofexamplescouldincludeepisodesinvolvingcompaniesofeverysizeinallindustries.Facedwithunexpectedevents,unpreparedcompaniesoftenreactasthoughthey’reintotaldisarray.Whenacompanylacksasetofstatedvaluesthateverybodysubscribesto,theinterpretationofimportantissuesisleftuptoanyoneandeveryoneinthecompany.Thenthecompanyislikelytofinditselfspeakingwithmanyvoicesandgoinginseveraldirections,resultinginconfusedemployees,unhappycustomers,anangrypublicandmaybe,disappointedinvestors.

Valuinghavingvalues

Avaluesstatementisasetofbeliefsandprinciplesthatguidestheactivitiesandoperationsofacompany,nomatterwhatitssize.Thepeopleatthetopofyourcompanymustexemplifyyourstatedvalues,andyourcompany’sincentiveandrewardsystemsshouldleadallemployeestoactinwaysthatsupportyourcompany’svalues.

Here’sanexampleofjusthowimportantavaluesstatementcanbe.Inthesummerof1985,theUnitedStatesexperiencedwhatwasdescribedbymanypeopleasaterroristattack.SomeoneintheChicagoareatamperedwithbottlesofTylenol,thebest-sellingpainrelieverfromMcNeilLaboratories,asubsidiaryofthehealthcaregiantJohnson&Johnson.AnunknownnumberofTylenolcapsuleswerelacedwithcyanide,andeightpeopledied.ThetragedycreatedabusinesscrisisforJohnson&Johnson.

Johnson&Johnsonreactedquicklyanddecisivelytothethreat

Johnson&Johnsonreactedquicklyanddecisivelytothethreatagainstitscustomers.ThecompanypulledeverybottleofTylenolfromretailshelvesthroughoutAmerica–amassiveundertakingthatultimatelycostthecompanymorethan$100million–anditdidsoimmediatelyuponlearningoftheproblem.

Whenthecrisiswasfinallyover,Johnson&Johnsonbecameacorporaterolemodel.Thecompany’slightning-fastresponsetotheTylenolincidentearneditareputationasoneofthemostresponsiblecompaniesintheworld,onethattakesitscivicdutiesseriouslyandiswillingtoputthepublicgoodaheadofitsownprofits.Johnson&Johnson’smanybusinessesbenefitedaccordingly.

WhydidJohnson&Johnsonbehavesowellwhensomanyothercompaniesfindthemselvesparalysedinsimilarsituations?Thereasonsaresummedupinthecompany’sstatementofvalues,anextraordinarydocumentcalledtheJohnson&JohnsonCredo(seethe‘TheJohnson&JohnsonCredo’sidebar).

TheJohnson&JohnsonCredo‘Webelieveourfirstresponsibilityistothedoctors,nursesandpatients,tomothersandallotherswhouseourproductsandservices.Inmeetingtheirneeds,everythingwedomustbeofhighquality.Wemustconstantlystrivetoreduceourcostsinordertomaintainreasonableprices.Customers’ordersmustbeservicedpromptlyandaccurately.Oursuppliersanddistributorsmusthaveanopportunitytomakeafairprofit.

Weareresponsibletoouremployees,themenandwomenwhoworkwithusthroughouttheworld.Everyonemustbeconsideredasanindividual.Wemustrespecttheirdignityandrecognizetheirmerit.Theymusthaveasenseofsecurityintheirjobs.Compensationmustbefairandadequate,andworkingconditionsclean,orderlyandsafe.Employeesmustfeelfreetomakesuggestionsandcomplaints.Theremustbeequalopportunityforemployment,developmentandadvancementforthosequalified.Wemustprovidecompetentmanagement,andtheiractionsmustbejustandethical.

competentmanagement,andtheiractionsmustbejustandethical.

Weareresponsibletothecommunitiesinwhichweliveandworkandtotheworldcommunityaswell.Wemustbegoodcitizens–supportgoodworksandcharitiesandbearourfairshareoftaxes.Wemustencouragecivicimprovementsandbetterhealthandeducation.Wemustmaintainingoodorderthepropertyweareprivilegedtouse,protectingtheenvironmentandnaturalresources.

Ourfinalresponsibilityistoourstockholders.Businessmustmakeasoundprofit.Wemustexperimentwithnewideas.Researchmustbecarriedon,innovativeprogramsdevelopedandmistakespaidfor.Newequipmentmustbepurchased,newfacilitiesprovidedandnewproductslaunched.Reservesmustbecreatedtoprovideforadversetimes.Whenweoperateaccordingtotheseprinciples,thestockholdersshouldrealizeafairreturn.’

Formorethanhalfacentury,thecredohassuccessfullyguidedbehaviourandactionsacrossthesprawlingJohnson&Johnsonempire,currentlya£17billionworldwidecorporationemployingmorethan109,500people.

TheJohnson&JohnsonCredoworkssowellbecauseeachemployeetakesitseriously.Withtheactiveencouragementandinvolvementoftopmanagement,fromthechairpersonondown,thecredoisinvoked,praisedandcommunicatedthroughoutthecompany.Old-timersandnewemployeesalikearecontinuallyremindedoftheimportanceofthemessage.Promotionsdepend,inpart,onhowwellmanagersliveuptoanddisseminatethevaluesofthecredowithintheirareasofresponsibility.ThecredoisasignificantfactorinJohnson&Johnson’scontinuedperformancenearthetopofitsindustry–andanindicationofwhythecompanyissowellregardedbysomanypeople.

Rememberthefollowingpointsaboutvalues:

Avaluesstatementisasetofbeliefsandprinciplestoguideyourcompany’sactivities.

Clearlystatedvaluescanhelpyourcompanyreactquicklyanddecisivelywhentheunexpectedstrikes.

Everybodyinyourcompanymustembracethecompany’svalues.

IdentifyingYourOrganisation’sValues

Valuesstatementsoftenaddressseveralaudiences.TheJohnson&JohnsonCredo(refertotheprecedingsection),forexample,speakstodoctors,patients,customers,suppliers,distributors,employees,stockholdersandthecommunityatlarge.Asyoubegintoworkonyourowncompany’svalues,youneedtothinkaboutdifferentgroups,eachofwhichhassomerelationshipwithyourcompany.

Stakeholdersaregroupsofpeoplewhohaveaclaimorinterestinhowyouoperateyourbusiness.Thestakesinvolvedcanbetangibleandlegallybinding,ortheymaybeinformalarrangementsorexpectationsthathavedevelopedovertime.Althoughalltheseinterestedpartieshaveastakeinwhatyoudo,stakeholdersmayhavedifferentideasandratherstrongfeelingsaboutwhatvaluesyourcompanyshouldembrace.

You’regoingtoputtogetheravaluesstatementprimarilyforthebenefitofemployees,ofcourse(orjustforyourself,ifyouoperateabusinessalone).Butyourcompany’svaluesaregoingtohaveanobviousimpactonallyourstakeholders,includingowners,

obviousimpactonallyourstakeholders,includingowners,shareholders,customers,suppliers,regulators–andevenyourmother,ifsheloanedyou£10,000tostartyourbusiness.Asyoustarttoidentifythevaluesthataremostimportanttoyourcompany,you’regoingtohavetoconsiderdifferentviewpoints,includingthefollowing:

Thedemandsofyourshareholders(ifyouhaveany)

Theinterestsandexpectationsofallyourstakeholders

Thebeliefsandprinciplesthatyouandyourcompanyalreadyhold

Inthefollowingsections,wetakeacloserlookateachofthesefactors.Whenyoucomeupwithapreliminarylistofcompanyvaluesthatyoufeelaremostimportant,youareinagoodpositiontogoonandcreateavaluesstatement.

AshortvaluesstatementthatworksMcKinseyprovideamarvellousexampleofasetofvaluesthathavebeenstronglyandclearlyarticulatedforover60yearsinsuchawaythatanymemberoftheprofessionalstaffwhoisoreverhasbeenemployedwithMcKinsey,anywhereintheworld,caninstantly,seriouslyandpassionatelytellyouwhatthecompanystandsfor.Thissituationisbroughtaboutthroughasetof‘guidingprinciples’:

Servingclients:

Adheretoprofessionalstandards.

Followthetopmanagementapproach.

Assisttheclientinimplementationandcapabilitybuilding.

Performconsultingincost-effectivemanner.

Buildingthefirm:

Operateasonefirm.

Maintainameritocracy.

Showagenuineconcernforourpeople.

Fosteranopenandnon-hierarchicalworkingatmosphere.

Managethefirm’sresourcesresponsibly.

Beingamemberoftheprofessionalstaff:

Demonstratecommitmenttoclientservice.

Strivecontinuouslyforsuperiorquality.

Advancethestateoftheartofmanagement.

Contributetoaspiritofpartnershipthroughteamworkandcollaboration.

Profitfromthefreedomandassumetheresponsibilityassociatedwithself-governance.

Upholdtheobligationtodissent.

ThinkingaboutinvestorsEconomistsarguethatwhenitcomestocompanyvalues,youreallyhavetoworryaboutonlyonesignificantgroup:theshareholders.Onpaper,atleast,theshareholdersarethetrueownersofthefirm,andtheydeserveyourundividedattention.Inthisviewoftheworld,managersaresimplypaidagentsofthosewhoownthecompany,nomatterhowfarremovedthoseownersmaybe,andyoudon’tneedtoknowmuchmoreaboutvaluesexcepttocarryoutyour

toknowmuchmoreaboutvaluesexcepttocarryoutyourshareholders’wishes.

Now,wecan’treallyarguewiththispicture,asfarasitgoes,butitdoesn’tsquarewiththeintentionsofmanyshareholdersouttheretoday.Forstarters,yourcompanymaynothaveanyinvestors,unlessyoucountyourselfandthebankaccountthatyouwipedouttostartyourcompany.Inaddition,pensionandmutualfundsnowcontrolthemajorityofpubliclyheldstocks,andtheinvestorswhobuythesefundsaremainlyinterestedinmakingtheirownpersonalnesteggsgrow.Theseshareholdersareabsenteeowners.Theyseldomdemandaserioussayinmanagementdecisionmaking.Whensomethinggoeswrongwiththecompanyorwiththeirfund,theysimplysellthesharesandgetonwiththeirnextinvestment.

Sowhat’sourpoint?Althoughshareholdersobviouslyareanimportantbunch,deservingtheattentionofcompaniesthathaveshareholders,theirdemandsshouldn’tnecessarilycrowdoutallothervoices.Remember–yourshareholdershavetheluxuryofsellingoffsharesandmovingontootherchoiceswhenthingsgowrong.Asamanagerorowner,youdon’thavethatoption.

Yourcompanywillbemuchbetteroffinthelongrunifyoutakeabroaderview,acknowledgingnotjusttheshareholders,butalsoallthestakeholders,givingeachgrouptheattentionthatitdeserves.

ConsideringtherestofthecrewIfyouthinkaboutit,youmaybesurprisedathowmanytypesofpeopleareinvolvedinwhatyourcompanydoes–everyonefromsupplierstodistributorsandfrombankerstocustomers.Eachgrouphasitsownsetofinterestsandlookstoyourcompanytofulfilaseriesofpromises.Theexplicitpromisesthatyoumakemaytaketheformoflegalagreements,licences,freelanceagreements,orpurchaseorders.Yourimplicitpromisesrepresenttheunwritten

purchaseorders.Yourimplicitpromisesrepresenttheunwrittenexpectationsofthevariousgroupsthathavedealingswithyourcompany.

Foreachgroupofstakeholdersthatyouidentify,asktwobasicquestions:

Whatarethesepeoplemostinterestedin?

Whatdothesepeopleexpectfrommycompany?

Inotherwords,whatistheirstakeintheactivitiesandbehaviourofyourcompany?Atfirstglance,itmayseemthatyourinterestsconflictwithyourstakeholders’interests.Youmaywanttomaximiseprofitsovertimeasoneofyourcompany’skeyvalues,forexample.Youmaydecidethatservingcustomersisimportantaswell.Butwhatdoyourcustomerswant?Theycertainlyhaveastakeinyourbusiness,andyou’reprobablysafetosaythatthey’relookingforqualityproductsandservicesatreasonableprices.

Dothesetwovaluesconflictwitheachother?Notnecessarily.Wouldn’tmostcustomersratherbuyfromcompaniesthattheytrust,companiesthattheyfeelcomfortablewith,companiesthathaveservedthemwellinthepast?Inaddition,customersdon’treallyliketheuncertaintyandtimewastedintryingnewproductsorservices,andtheywon’tmakeachangeunlessthey’rereallypushedtodoso.Inotherwords,mostofyourcustomersdon’twanttodenyyouprofits,becausetheyrealisethatyourbusiness–andtheirfavouritegoodsandservices–won’tbearoundforlongifyoucan’tmakeanymoney.(Forthelowdownonfiguringoutyourcustomers,checkoutChapters5and6.)

Atthesametime,customersaren’tstupidandcertainlydon’twanttobetakenadvantageof.We’veallheardstoriesaboutfoodandhardwarestoresthattrytomakeaquickbuckafterfloods,hurricanesorearthquakes.Althoughcompetitionusuallykeepspricesincheck,scarcitycreatesopportunityand

thetemptationtooverchargecustomers.Butagain,customersarestakeholdersinthebusiness,withinterestsandexpectations.Afteradisasterisoverandtheclean-upisbehindthem,thosesamecustomersoftentaketheircashelsewhere,rewardingstoresthatmayhavebehavedmoreresponsiblyinthecrisis.

Nowyouneedtobringtogetherallyourinformationonthepeoplewhohaveastakeinyourcompanyandtocreateastakeholderprofile.Followthesesteps:

1.Listallinterestgroupsthathavearelationshipwithyourcompany.Don’tforgettoincludetheless-obviouscandidates.Yourlistmayincludecustomers,owners,shareholders,banks,creditors,suppliers,distributors,businesspartners,industryassociates,regulatoryagencies,advocacygroupsandsoon.(SeeFigure3-1forfurtherdetail.)

2.Rankthestakeholdersbyimportancetothebusiness.Howdoeseachgroupaffectyourbusinessgoals?

3.Recordwhatyouthinkaretheinterestsofeachgroup.4.Recordwhatyouthinkaretheexpectationsofeachgroup.

Doyourcompany’sactionsfitwithwhatyou’veidentifiedasbeingyourkeystakeholders’expectations?Alwaysbeawareofhowyourbusinessdecisionsareperceivedbythegeneralpublic.Howdothosedecisionslookfromtheotherside?Doyouseesatisfiedcustomers,contentedemployees,helpfulcreditors,responsivesuppliersandeagerdistributors?Ifnot,howisyourcompanygoingtorespondtothosestakeholderswhofeelthatyou’relettingthemdown?

Ideally,ofcourse,youwanttoplanaheadwhenitcomestoyourdealingswithallstakeholders.Thesecrettorespondingbeforemolehillsbecomemountainsliesinhavingaclearunderstandingofeachgroup’sexpectationsandasetofvaluesthatacknowledges

Figure3-1:Stakeholdermapping.

eachgroup’sexpectationsandasetofvaluesthatacknowledgeseachgroup’sinterests.

ExistingbeliefsandprinciplesDrawingupalistofabstractbeliefsandprinciplesisonething,puttingthosebeliefstothetestisanother.Toughchoicescomealong,forcingyoutoexamineyourbeliefsclosely.Ifyourunaone-personcompany,youalreadyknowsomethingaboutwhatyoustandfor.Ifyou’repartofabiggercompany,chancesarethatcertainbeliefsandvaluesareinherentinthewayinwhichyourcompanydoesbusiness.Thebestwaytogettotheheartofthosebeliefsandprinciplesistoimaginehowyou’drespondtotoughdilemmas.

ThinkaboutthesituationsdescribedintheBeliefsandPrinciplesQuestionnaire(seeFigure3-2).Askotherpeopleinyourcompany,ortrustedcolleaguesfromoutsideyourbusiness,howthey’dreacttothesesituations.ChancesareyouwishthatthequestionnaireincludedaboxmarkedOtherorDon’tknow.Butthewholepointofsituationsthatputyourvaluestothetestisthatthey’renotalwayseasy.

Figure3-2:BeliefsandPrinciplesQuestionnaire.

Answerstothequestionnairepointtothebeliefsandprinciplesthatyourcompany’smanagersandemployeesalreadyhold.

Keepinmindthatthisquestionnairehasnorightorwronganswers;noone’sgoingtosendanotehomeorgiveanyoneabadmark.You’resimplytryingtoidentifythebasicvaluesthatyourcompanyalreadyfeelscomfortablewith.Completedquestionnairesgiveinsightsintothegeneralbeliefsandprinciplesthatyourcompanyconsiderstobeimportant.

Whenthinkingaboutyourcompany’sbeliefsandprinciplesbearinmindthat:

Manypeople,rangingfromemployeestocustomers,haveastakeinwhatyourcompanydoes.

Differentstakeholdersmayhavedifferentviewpointswhenitcomestoyourcompany’svalues.

Yourcompanyneedstoacknowledgeasmanystakeholderperspectivesaspossible.

Companyvaluesshouldbetiedtothebeliefsandprinciplesthatyoualreadyhold.

PuttingTogethertheValuesStatement

Whenyou’veagoodideaofjustwhoyourcompany’sstakeholdersare,andwhenyou’vegottogripswiththegeneralbeliefsandprinciplesthatyourcompanyalreadyholds,youhavetobringthesetwoworldstogether.Buthowdoyoucreateawrittenstatementofvaluesbasedonthosegeneralbeliefsandprinciplesthatalsoguideyourcompanytowarddoingtherightthingintheeyesofallyourstakeholders?

First,keepinmindthatyourcompany’svaluesstatementrepresents

First,keepinmindthatyourcompany’svaluesstatementrepresentsmorethanaquickto-dolist.Yourvaluesreachbeyondquarterlygoalsorevenyearlytargets.They’remeanttoguideyouthroughthosetoughdecisionsasyoubuildasustainablebusinessthatlastsandgrowsoveryearsanddecades.

Maybeyourcompanyalreadyhassomesortofvaluescredoinplace.Ifso,you’reastepaheadofthegame.(Youlosepoints,however,ifyouhavetoglanceatthedustyplaqueontheofficewalltoreadit.)Ifyoucan’tdigupaready-madevaluesstatementtostartwith,beginputtingtogetheryourown.You’vetwooptions.

DevelopingavaluesstatementYoumaynothavetheluxuryofspendingweeksormonthstodevelopavaluesstatement,soweshowyouaquickwaytocreateonetosetyourcompanyontherighttrack.Ifyourcompanyissmall,youcanfollowthestepsyourselforwithoneortwoofyourcolleagues–noneedforlongmeetingsandcarefulreview:

1.Meetwithyourcompany’schiefdecision-makerstotalkaboutthegeneralcompanyvaluesthatshouldguideemployeebehaviour.2.Prepareafirst-draftlistofallthevaluesdiscussedinthemeetingandcirculatecopiesforreview.3.Scheduleoneortwofollow-upmeetingswithseniormanagerstoclarifyandconfirmafinalsetofvalues.4.Createavaluesstatementthatcapturestheagreed-uponvaluesclearlyandconcisely,andgetitapproved.5.Meetwithmanagersatalllevelstomakesurethattheyunderstandtheimportanceof,andreasoningbehind,thecompanyvaluesstatement.6.Seethateveryemployeegetsacopyofthestatement.

Thevaluesstatementthatyoucomeupwithheremayserveyouwellforalongtime.Attheveryleast,itshouldmeetyourneedswhileyouworkonamorecompleteandpermanentversion.

whileyouworkonamorecompleteandpermanentversion.

Ifyou’repartofalargercompany,however,you’regoingtohavetogothroughabitmorerigmaroletogetaconsensus.Sorry.

Makesurethateveryemployeereceivesacopyofyourcompany’svaluesstatement,alongwithanexplanationofitspurpose.Ifyou’reinbusinessforyourself,placeaframedcopyofthevaluesstatementnearyourdeskor(ifyouworkfromhome)stickitonthefridge.Don’tletitgatherdust.Forabiggercompany,printthevaluesstatementonwallet-sizedcards,anddon’tforgettoincludeitintheannualreport.Yourcompany’svaluesmustbereferredto,reliedonandunderstoodtobeaguidingforceintheactionsandactivitiesofeverypersonwhorepresentsyourcompany.

Preparingavaluesstatement–thefullMonty

Whyisthequickwaytocreateavaluesstatementnotalwaysgoodenough?Ifyou’repartofalargefirm,thequickwayreliesheavilyontheideasandsuggestionsofpeopleatthetopoftheorganisation.Yetthebestinsightsoncompanyvaluesoftencomefromemployeesthemselves–peoplefromdifferentbackgroundsandvariouslevelsinthecompanywhocandrawonarangeofbusinessexperiences.

Thelongwaytocreateavaluesstatementtakesalittlemoreeffort,butgettingtheseemployeesinvolvedusuallyisworthit.Followthesesteps:

1.Selectthreeorfourrepresentativegroupsofemployees,includingamixofpeoplefromalllevelsandfunctionsinyourcompany.

2.Havethegroupsmeetonaratherformalbasisoveratwo-tothree-monthperiodtocomeupwithvaluesthatshouldguidethebehaviourofeveryemployeeinthefirm.Youhavetopointthegroupsintherightdirectionatthebeginning.StartbyaskingeveryonetofilloutthequestionnaireshowninFigure3–2earlierinthischapter.

3.Askgroupmemberstocreateashortlistofthevaluesthattheythinkaremostimportant.Encouragethemtobackupthislistwiththeirreasons,remindingthemthatvaluesareoftenthetiebreakerswhenitcomestotoughmanagementdecisionsanddifficultchoices.

4.Bringtheliststogetherandcreateapriorityrankingofallthevaluessuggested.5.Composeastatement,motto,orcredothatincludesthemostsignificantandwidelyheldvalues,alongwithcompellingreasonsforthosevalues.6.Havethegroupsreviewandratifyyourvaluesstatement.

Whenthetimecomestoconductthoseannualemployeeperformancereviews(youknow,theonesthateveryonelovestohate),usethemasanopportunitytopromoteyourcompany’svalues.Bringoutacopyofthevaluesstatementandaskeachemployeehowwellhisorherindividualactivitiesreflectthecompany’svalues.Atthesametime,askyourselfwhethertheincentiveandrewardsystemsinyourcompanyworktowardsupportingthosevalues.

Keepthefollowinginmindwhenputtingtogetheravaluesstatement:

Eventhoughyouthinkthatyouknowyourvalues,getting

themdownonpaperisworththeeffort.

Thebestinsightsoncompanyvaluescomefromemployeesthemselves.

Makethevaluesstatementavailabletoeverybodyinyourcompany.

Chapter5

TakingaCloserLookatCustomers

InThisChapterCheckingoutwhoyourcustomersare

Discoveringwhyyourcustomersbuy...

...Andwhytheymaynotbuyagain!

Findingouthowyourcustomersmakechoices

Rememberingthebigpicture

Dealingwithbusinesscustomers

Themostcrucialpartofbusinessplanninginvolvestakingalong,hardlookatcustomers–thoseyouenjoyhaving,thoseyouwouldlovetolandandthoseyouwouldjustassoongiveawaytosomeunsuspectingcompetitor.Thestakesarehigh.Howwellyouknowyourcustomersultimatelydetermineshowsuccessfulyouare.Butfiguringoutwhatmakescustomerstickcanbedownrightfrustrating.Ifyou’vetrieditbefore,youmaybetemptedtothrowupyourhandsandleavetheentiremesstotheso-calledexperts–marketinggurus,consultantsorperhapsastrologers.Don’t.Thischaptershowsyouhowtobetteracquaintyourselfwithyourcustomerssothatyoucanofferthemmorevalueandservethemmoreprofitablythananyoneelseoutthere.

Inthischapter,wetakeacloserlookatwhycustomersbuyyourproductsandservicesinthefirstplacebyexploringtheirneedsandmotives.Andweinvestigatehowtheymakechoicesinthemarketplacebyexaminingcustomerperceptionsandtheirdecision-makingprocess.Finally,wetakeaquicklookatyourcustomersthatareactuallyotherbusinesses.

areactuallyotherbusinesses.

CheckingOutWhoYourCustomersAre

Afreshlookatcustomersstartswiththeonesyouenjoyseeing–thosewhoregularlypurchasegoodsorservicesfromyou.Butsometimes,knowingwhatsomethingisnotcanbejustasimportantasknowingwhatitis.Youcanfindoutasmuchaboutyourownbusinessandbestcustomersbyobservingtheotherkindsofcustomersoutthere–thecustomerswhoaredifficult,thecustomerswhoaregoneandthecustomerswhomyouneverhad.

ThegoodcustomerGoodcustomersaretheoneswhobringasmiletoyourface,theonesyoulikeserving,theoneswhoappreciateyou,theoneswhokeepyouinbusiness.They’rethecustomersyouwanttokeepcomingbacktimeandagain.Tokeepallthosegoodcustomershappy,however,youmayneedtoknowmorethanthefactthatTomlikesChinesefood,MaryhasaweaknessforchocolatesandHarrylovesredties.

Why?Isn’tsimplyknowingindividualcustomersonsomepersonalbasisenough?Well,notquite.Whathappensifyou’vehundredsoreventhousandsofsmallcustomers,suchasifyourunashop,orifyourstaffturnoverishighasinmostpartsofthecateringindustry?

Insuchcases,you’venosubstituteforagooddatabasesytemfortrackingyourrelationshipwithclientsandthenmakingappropriateproductorseviceoffers.Forexample,supermarketsnowanalysecustomerpurchasesandmaketargetedspecialoffersbasedontheirunderstandingofthecustomerprofile.Thisallhelpstomakecustomersfeelspecialandloved.Yourbusinesscanmeasureanddescribeitscustomersinseveralways:

describeitscustomersinseveralways:

Trackwhereyourcustomersare,breakingthemdownbycountry,region,cityorpostcode.

Figureoutwhoyourcustomersare,includingtheirage,gender,occupation,income,educationandethnicorigin.

Discovermoreabouthowtheylive–theirhobbies,favouritesportsteams,restaurantchoicesandholidaydestinations,forexample.

You’reprobablyastepaheadofushereandhavealreadynoticedthatmanyofthesecriteriaresultingroupsofcustomersthatlookalike.Whenmarketinggurusdividecustomersintospecificgroups,theycallthemmarketsegments.Ifyou’dliketogetabetterhandleonhowtoseparateyourowncustomersintomarketsegments,checkoutChapter6.

Whenitcomestounderstandingcustomers,onegoodstrategyistofindoutwhatotherbusinessestrytofindoutabouttheircustomers.Keeptrackofthequestionsthatothercompaniesaskyou.RicherSoundsstores(achainofhi-fiandhomecinemaretailers),forexample,routinelyaskforyourpostcodewhenyoustepuptothetill.Andyouoftenfindalistofpersonalquestionsonproductregistrationforms,warrantycardsandcustomerservicemailings.Somecompaniesevenofferasmallrewardifyoutellthemsomething–anything–aboutyourself.Butgoeasyhere.RadioShack,anAmericanelectronicsretailer,begantolosealotofgoodwillwhencustomersgrewsuspiciousabout–orjustannoyedby–allthequestionsthattheirshopassistantswereasking.

Thebadcustomer

‘Abadcustomer?Isn’tthatacontradictioninterms?’youask.‘Howcantherebesuchathingasabadcustomer,especiallyforacustomer-orientatedcompany?’Keepinmindthatyourinitialreactiondoesn’talwaystellthewholestory.Rememberthatyoudon’treallydefinethebusinessthatyou’rein,yourcustomersdo.Theyplaceaseriesofdemandsonyourcompanyandthenevaluatehowwellitperformsagainstthosedemands.

Goodcustomersdothefollowing:

Askyoutodothingsthatyoudowell.

Placevalueonthethingsthatyoudoandarewillingtopayforthem.

Challengeyoutoimproveyourskills,expandyourknowledgeandfocusyourresources.

Takeyouinnewdirectionsthatareconsistentwithyourstrategyandplanning.

Badcustomersrepresenttheflipside.Theydothefollowing:

Askyoutodothingsthatyouaren’tequippedtodowell.

Distractyou,causingyoutoveerawayfromyourstrategyandyourbusinessplan.

Purchaseinsuchsmallquantitiesthatthecostofdoingbusinesswiththemfaroutweighsanyrevenuethattheygenerate.

Requiresomuchserviceandattentionthatyoucan’tfocusyoureffortsonmorevaluable(andprofitable)customers.

Remaindissatisfiedwithwhatyoudo,despiteallyourbestefforts.

Failtopayontime–ortopayatall!

Thepunditshavecomeupwithaprinciplethatwecanapplyhere:the80/20principle.Inthiscase,therulesaysthatifyousurveyallyourcustomers,20percentofthemaccountforabout80percentofyourbusiness.These20percentareyourgoodcustomers.Youobviouslywanttokeepthem–andkeepthemhappy!Butlookattheother80percentofyourcustomers,andyou’llprobablydiscoverafewwhomyou’dratherhandovertothecompetition.

Whenyouanalysewhatyoudoforthat80percentofcustomersandwhattheydoforyou,thesecustomersareoftenmoretroublethanthey’reworth.Theirshoestylesareneverinstock,andtheirspecialordersarealwaysreturned.Maybetheirfinancesareamess,whichmakesthemlateinpaying.Still,thelureofadditionalrevenueandmorecustomers–orthebeliefthatyoushouldneversaynotoanycustomer–oftenkeepsyouinvolvedwiththisgroup.Youwouldbebetteroffwithoutthesecustomers,though,andleavingyourcompetitorstohandlesuchbadbusinessimpairstheirabilitytocompetewithyouforgoodbusiness.

Tohandlebadcustomers,followthesesteps:

1.Figureoutwhotheyare,byestablishingwhetheryoucanmakeaprofitoutofdoingbusinesswiththem.2.Convertthemintogoodcustomers,byexploringwaysofturningloss-makingcustomersintoprofitableones.Forexample,byputtingupprices,introducingminimumordersizesorminimumdropquantitiesorbyencouragingthemtoorderonline.3.Alternatively,handthemovertosomeoneelse.Iftheydon’tacceptthechangestoyourservicethatyouintroducetoensurethattheymakeyoumoney,theywillsoonmoveontoothersuppliers.

Anoteofcaution:someofthisyear’sbadcustomersmaybecomenextyear’sgoodcustomers.Ensurethatyouonlydivestyourselfofpermanentlybadcustomers.

Theotherguy’scustomerYoumaythinkthatfocusingoncustomerswhomyou’veneverhadpointstoanothersortoffailureonyourpart,butactually,thesepeoplepresentanopportunity.Thefactthatyouhaven’tbeenabletoservethisgroupgivesyouachallenge:tofindoutwhatyourmarketreallythinksisimportant.Yourcompetitors’customersaretellingyouwhatyou’renot.Thisinformationisextremelyuseful,especiallywhenyou’reworkingonthebigpictureintheearlystagesofbusinessplanning,definingwhoyouareandwhoyouwanttoserve.

Unfortunately,gettinginformationoutofyourcompetitors’customersisoftenanexpensiveproposition.Youdon’tknowthem,andyoudon’thaveanongoingrelationshipwiththem.Marketresearchfirms,ofcourse,arealwayseagertoworkwithyou.Thesecompaniesarewillingtobringtogetherfocusgroupsandtalktoconsumersaboutallsortsofthingsthatrelatetoyourproductsincomparisontothecompetition.Thecatch,ofcourse,isthattheirservicesdon’tcomecheap.

Fortunately,youdon’thavetobequitethisformalabouttheinformation-gatheringprocess,atleastintheinitialstages.Aslongasyoucangetselectedpeopletoprovidesincereanswers,youprobablycanapproximatetheresultsofafocus-groupstudyonyourown.

Bankaccountsandthe80/20principleAlargeretailbankrecentlyundertookacomprehensivestudyofthosecustomersusingchequebooks.Theresultspresentedaclassic80/20situation:about19percentofthebank’scustomersweregenerating90percentofthetotalprofits,backinthedayswhenbanksactuallymadeprofitsthatis.Whatwasthechiefcharacteristicoftheother81percent?Mostofthosecustomershadaccountswithaveragebalancesoflessthan£250,yettheywrotelotsofcheques.Asaconsequence,thebankwaslosingseriousmoneyonthis

cheques.Asaconsequence,thebankwaslosingseriousmoneyonthiscustomergroup;internalprocessingcostsweresimplygreaterthantherevenuegeneratedfromtheuseoftheirdepositedfunds.

Thebankconductedfurtherresearch.Obviously,notalloftheseaccount-holderswerebadcustomers.Someofthemwereseniorcitizens,forexample,andapercentageofthemwerenewandwouldgoontobecomeprofitablecustomersovertime.Thebankwantedtonourishdevelopingrelationships,soitsetupincentivestoencouragenewcustomerstoaccumulatesavingsinrelatedsavingsaccounts.Butthebankalsoknewthatmanyofitscustomerswouldneverchangeandwouldsimplyremainadrainonprofits.Soitcreatedhurdlesto‘de-market’itslessprofitablecustomers,usinganewfeestructurethatpenalisedaccountswhenmonthlyaveragebalancesfellbelowcertainlevels,unlesscustomersmaintainedcertainbalancesinsavingsaccounts.

Anacquaintanceofoursusedtogointosupermarketsandhangaroundtheaislesinwhichhercompany’sgoodsweredisplayed.Whenacustomercamealongandpickedoutacompetingproduct,sheofferedtobuythatproductfromthestartledshopperformorethanthelistedprice!Shewouldofferaminimalamount(apenny,say)andthenworkherwayup,tryingtodeterminetheshopper’sdegreeofloyaltytothecompetingbrand.Finally,shewouldaskquestionstofindoutwhy.Asareward,shepaidtheshopperforthepriceoftheproductwhentheconversationwasover.

Gettingtoknowyourcompetitors’customersisoftendifficult,butnotimpossible.Checkouttheseideas:

Spendtimewherecustomersgather.Usetradeshows,usergroupsandindustryconferencestomakeinformalcontactsandbeginadialoguewithyournon-customers.

Askpointedquestionsofpeoplewhochoosecompeting

products.Didtheytakethetimetoseewhatwasavailableonthemarket?Havetheyevenheardofyourproductorservice?Iftheyhave,didtheyactuallytakethetimetolookatit?Ifnot,whynot?Ifso,whatweretheirimpressions?

Reallylistentowhattheyhavetosay,nomatterhowpainful.Don’tgetdefensivewhenpeoplesaynegativethingsaboutyourcompanyoryourproducts.

Informationaboutyourcustomersisvaluable,ifnotpriceless.Aconsultantchargesyouthousandsofpoundsforthesameinformation.

Afewpointstorememberwhencheckingoutwhoyourcustomersare:

Toplaneffectively,findoutasmuchaboutyourcustomersasyoucan.

Ofallyourcustomers,20percentarelikelytoaccountfor80percentofyourbusiness.

Someofyourcustomersmayactuallycostyoumoney.

Yourcompetitors’customerscantipyouofftonewopportunities.

DiscoveringWhyYourCustomersBuy

Perhapsthemostdifficult–anduseful–questionthatyoucanansweraboutyourcustomersiswhytheybuywhattheybuy.Whatactuallycompelsthemtoseekoutyourproductsorservicesinthemarketplace?What’simportanttothem?Whataretheyreallylookingfor?

Figure5-1:Abasicoverviewofpeople’sneeds.

lookingfor?

Understandingneeds

Whydopeoplebuythingsinthefirstplace?Psychologisttypestellusthatneedsfulfilmentisreallyattheheartofallconsumerbehaviour(seeFigure5-1,basedonthesocialpsychologistAbrahamMaslow’sfamous‘HierarchyofNeeds’model).Everybodyhasneedsandwants.Whenaneedisdiscovered,itcreatesthemotivationthatdriveshumanactivity.Here’sanoverviewofpeople’sneeds:

Survival,atthemostbasiclevel,resultsintheuniversalneedforgroceryshops,carpentersandtailors.

Theurgeforsafety,securityandstabilitygeneratestheneedforbankaccounts,disabilityhealthinsuranceandhomealarmsystems.

Thedesireforbelongingandacceptancecreatestheneedfordesigner-labelpoloshirts,members-onlyclubsandparticipationinexpensivedietprogrammes.

Theurgetoberecognisedandheldinesteemestablishestheneedforcompanybanquets,fastcarsandawardplaques.

Thedesireforself-achievementandfulfilmentresultsintheneedforadventureholidays,quizshowsandcorrespondencecourses.

DHL,forexample,isreallyinthereliabilitybusiness.Manyofitscustomersarebusinessesthatwanttheassurance–absolutely,positively–thattheirpreciousshipmentsaredeliveredearlythenextdayoreventhesameday.Thesecustomersaresomotivatedbythisneedthatthey’rewillingtopayasubstantialpremiumoverotheralternatives,simplyforabsolutereliabilityandtheirownpeaceofmind.

DeterminingmotivesMotivesareneedsthathavebeenawakenedandactivated,sotospeak.Motivessendpeoplescurryingintothemarketplace,searchingforproductsorservicesthatcanfulfilaparticularneed.Motivesaren’talwayswhattheyseemtobe.Hereareafewexamples:

Greetingcardcompaniesdon’tjustsellcutelittlejinglesprintedonglossypaperatexorbitantprices.Thepricesarejustifiedbecausethecompaniesareactuallysellingsmallinsurancepoliciesagainsttheircustomers’fearoffeelingguilty.Perhapsfearofguilt(overamissedbirthdayora

forgottenanniversary)isreallywhatpropelsthebuyerintothegreetingcardmarket.

RecentMBAgraduateshavebeenaskedtorankthethingsthataremostimportanttothemwhentheydecideamongvariousjoboffers.Whenaskedpoint-blank,asubstantialmajorityrankqualityoflife,communityandschoolsatthetopofthelistandplacestartingsalarysomewhereinthemiddle.AmorecarefulsurveyandanalysisoftheMBAselectioncriteria,however,usuallysettlesuponcompensationasbeingthesinglemostimportantvariableinacceptinganewpositionfreshoutofuniversity.

Mostofushaveaneedtobeacceptedandlikedbyotherpeople.Thispowerfulmotivationcreatesgreatmarketopportunitiesforthelikesofbeautysalons,gymsandbreath-mintcompanies.

Althoughmotivesobviouslyapplytoindividualconsumers,theyworkequallywellinthecontextofbusinessorcorporatebehaviour.Whenaparticularmanufacturingcompanycontractswithaprivatehealthandmedicalinsurancecompany,suchasBupa,forexample,isthecompanymotivatedtoimprovethehealthofitsemployees?Orisitmotivatedtoreducethecostofitshealthinsurancepremiumssothatitcanbettercompetewithforeigncompanies(fulfillingitsownneedtosurvive)?IfyourunBupa,howyouanswerthisquestionhasamajorimpactonyourinternalmanagementofcostsversustheoverallqualityofthehealthcarethatyouprovide.

Yourjob,ofcourse,istodigbeneaththeobviouscustomerresponsesandconsumptionpatternstodeterminewhatthebuyers’realmotivesareinpurchasinggoodsandservicesinyourownmarket.Whenyouunderstandwhat’sactuallydrivingcustomerbehaviour,you’reinamuchbetterpositiontotalkaboutyourownproductintermsthatcustomersrespondto.

Besuretokeepthesepointsinmind:

Besuretokeepthesepointsinmind:

Themostimportantquestiontoaskaboutyourcustomersiswhytheybuywhattheybuy.

Customerneedsrangefrombasicsurvivalandsecuritytotheurgeforself-improvement.

Motivessuchasvanity,status-seekingandguiltarethehotbuttonsthatcanreallygetcustomerstobuy.

MonitoringcomplaintsDiscoveringwhyyourcustomerswon’tbuyagainisasvaluableasknowingwhytheybuyinthefirstplace.Oneterrifyingstatisticisthat98percentofcomplaintsneverhappen.Peoplejustdon’tgetroundtomakingthecomplaint,orworsestill,theycanfindnoonetocomplainto.Youwouldhavetobeahermitnevertohaveexperiencedsomethingtocomplainabout,butjusttryfindingsomeonetocomplaintoat8p.m.onaSundayatPaddingtonStationandyougetafairimpressionofhowtheGobiDesertfeels.

Youcanneverbeconfidentthatjustbecauseyou’renothearingcomplaintsyourcustomersandclientsaren’tdissatisfiedandabouttodefect.Nordoessilencemeanthattheywon’trunaroundbadmouthingyouandyourbusinesstootherpeople.Youdowelltorememberthatonaveragepeoplesharetheircomplaintwithascoreofothers,whointurnareequallyeagertosharethetidingswithothers.Theviraleffectofemailhasthepotentialtomakeanyparticularlyjuicystoryrunaroundtheworldindaysifnothours.

Setupasystemtoensurethatyourcustomershaveampleopportunitytoletyouknowwhattheythinkaboutyourproductorservice.Thiscaninvolveashortquestionnaire,afollowupphonecalloranareaonyourwebsitedevotedtocustomerfeedback.Asabonus,youwillprobablygetgreat

ideasonhowtoimproveyourbusiness.

Oneentrepreneurwhoismorethanawareoftheproblems(andincidentallyopportunities)presentedbycomplaintsisJulianRicher,founderoftheretailhi-fichain,RicherSounds.Hismaximisthathisstaffshouldmaximisecustomers’opportunitiestocomplain.Theoperativewordinthatsentenceisopportunities,whichshouldnotbeconfusedwithreasons.Inordertoputthispolicyintoeffect,Richerhasarangeoftechniquesinplace.Thewholecustomersatisfactionmonitoringprocessstartsfromthemomentcustomersenteroneofhisretailoutlets.Abellnearthedoorinvitesthoseintheshoptoringitifthey’vehadparticularlygoodserviceorhelpwhileintheshop.Thathelpmaybesimplygettinggreatadvice,ormaybefindingaproducttheywanttobuyataverycompetitiveprice.Customersfind,whentheygettheirhi-fiequipmenthome,ashortquestionnaireonapostcardaskingthemfortheirimmediatepost-purchasefeelings.Doestheproductworkasspecified,isitdamagedinanyway,weretheydelightedwiththeservicethey’vehad?Thepostcardisaddressedto‘JulianRicher,Founder’andnot,asisthecasewithsomanyotherbigbusinesses,to‘CustomerServices,Department126754,POBox,blahblahblah’.Richerdoessurveysoncustomersatisfactionandencourageshisstafftocomeupwiththeirownideasformonitoringcustomerreactions.Infact,heinsiststhattheyhitminimumtargetsforgettingcustomerfeedback.Silenceonthecustomersatisfactionfrontisnotanoptionformanagementinhisbusiness.Richerisclearlyawareoftheothergreatstatisticwhenitcomestocomplainingcustomers.

Ninety-eightpercentofcustomerswhohaveacomplaintbuyfromyouagainifyouhandletheircomplainteffectivelyandpromptly.Notonlydotheybuyfromyouagain,butalsothey

spreadthegospelabouthowclevertheywereingettingyoutorespondtotheircomplaint.Nothingmakespeoplehappierthanhavingsomethingtocomplainaboutthatendsupcostingthemnexttonothing.

FindingOutHowYourCustomersMakeChoices

Howdocustomersmakechoicesinthemarketplace?Themostimportantthingtorememberisthatcustomersdecidetobuythingsbasedontheirownviewoftheworld–theirownperceptionsofreality.Fewcustomersbuywithoutthinking.Instead,theybringtheirperceptionsoftheworldintoadecision-makingprocessthat(ideally)leadsthemtopurchaseyourproductorserviceinsteadofotheroptions.

RealisingthatperceptionsarerealityCustomerperceptionsrepresentthemarket’sworldviewandincludenotonlywhatyourcustomersthinkofyourproductsandservices,butalsohowtheyseeyourcompanyandviewyourcompetitors.

Ascustomersturntothemarketplace,theyconfrontamind-bogglingarrayofcompetingproducts.Manyvariablesinfluenceyourcustomersastheyevaluatetheirchoices:advertising,endorsements,reviewsandsalesmanship,nottomentiontheirowngutreactions.Youneedtoknowhowcustomersrespondtoallthesestimuliifyouultimatelywanttoearnandkeeptheirbusiness.

Haveyoueverwondered,forexample,whysofewyellowjumpersareavailableinthemen’sdepartmentsofclothingshops?Marketresearchconsistentlyshowsthatamajorityofmenbelievethatthecolouryellowsuggestsweakness.Subconsciously,menfeelthattheymaybeperceivedasbeingwimpsiftheyhaveanythingtodo

theymaybeperceivedasbeingwimpsiftheyhaveanythingtodowiththecolour.Sotheyellow-jumperoptionisn’ttoopopular.

OrhaveyounoticedthatMadonnadoesn’tdomanyendorsements?Okay,shedoesn’tneedtheextraincome.Butcompaniesmayfeelthatherimageisjusttoocontroversial,resultinginnegativeperceptionsandtheriskthatpotentialbuyersaredrivenaway.

Neverlosesightofthemarketer’smotto:

Customerperceptionsarethemarketreality.

Peoplebuygoodsandservicesbasedonwhattheyperceivetobetrue,notnecessarilyonwhatyouknowtobethefacts.Tobesuccessfulinthemarketplace,youhavetodevelopaclearinsightintocustomers’perceptions,understandinghowbuyersreacttoproductsandservicesinyourmarketbeforeyoucompleteyourownbusinessplans.

Findingthefivestepstoadoption

Marketinggurusoftenrefertothecustomer’sdecision-makingprocessastheDMP(theacronymmakesthetermsoundmoreofficial).Inmanymarkets,theDMPinvolvesaseriesofwell-definedstepsthataredubbedtheconsumeradoptionprocess.(Okay,we’llcallittheCAP.)Inthiscase,ofcourse,adoptionreferstoanewlyformedrelationshipwithaproduct,notachild.

Byunderstandingthestepsthatconsumersoftengothrough,you’rebetterabletotakeadvantageofcustomers’behaviourandbuildstrategiesthathelpthemcompletetheadoptionprocess.Theprocessinvolvesfivemajorsteps,whicharedescribedinTable5-1.

Supposethatyou’reinastartupfirmwithatop-notchconsumer-softwaretitle.You’reafraid,however,thatcustomersarereluctanttogivetheprogramatry,forfearthatthesoftwaremaybedifficulttofathomorincompatiblewiththeircomputers.(Keepinmindthatpeopleactontheirperceptionsofrealityratherthanontherealityitself!)Tomovepotentialcustomerspasttheevaluationandintothetrialstepoftheadoptionprocess,youmaywanttoconsidersettingupafreenew-userhotlineandofferingamoney-back,no-questions-askedguarantee.

Table5-1TheConsumer’sFive-StepAdoptionProcess

Primarysteps

Descriptionofconsumer Yourtask

Awareness Awareofaproductorservicebutlackingdetailedknowledge

Developastrategythateducatesandexcitespotentialcustomers

Interest Curiousbecauseofpublicityandseekingmoreinformation

Providemoredetailedproductinformationandcontinuetobuildmomentum

Evaluation Decidingwhethertotesttheproductorservice Maketheproduct-evaluationprocessaseasyandrewardingaspossible

Trial Usingtheproductorserviceonatestbasis Makethetrialassimpleandrisk-freeasyoucan

Adoption Decidingtobecomearegularuser Developstrategiestoretaingoodcustomers

Soundslikeweneedasummaryofallthis:

Customersmakechoicesbasedontheirperceptions,notnecessarilyonthefacts.

Beforetheybuy,customersgothroughadistinctdecision-makingprocess.

Thefivestepsinmakingapurchaseareawareness,interest,evaluation,trialandadoption.

Ifyouunderstandhowcustomersmakechoices,you’veabettershotatgettingtheirbusiness.

RememberingtheBigPictureRememberthatoldsayingaboutnotseeingtheforestforthetrees?Well,whenyoufirststarttothinkaboutyourcustomers,youdon’twanttofallintoasimilartrap.Seeingonlythesmallnumberofindividualcustomerswhomyouknow,andfocusingontheirpersonalhabits,likesanddislikes,istemptingsometimes.Evenwhenyoubegintolookatmoregeneralcustomertrends,includingwhyyourcustomersbuyandhowtheymakechoices,gettingburiedinthedetailsstillisawfullyeasy.

Don’ttakethebait!Don’tviewyourcustomersandyourownbusinessactivitiestoonarrowly.Lookinsteadatthelargerforest–thosegeneralcustomerbehavioursandbasicneedsthatdefineyourmarket.

Ifyouthinkaboutyourbusinessonlyintermsofyourexistingproducts,forexample,yourisklosingsightofcustomerneedsthatyou’veoverlooked–needsthatacompetitorisnodoubtgoingtosatisfyatsomepoint.Youalsocreateashort-sightedviewofyourownstrategicchoicesthatcanresultinmissedmarketopportunitiesandwoefullyinadequatebusinessplans.

Unfortunately,companies(andevenentireindustries)stilllosesightofthebigpictureallthetime.Marketsareviewedtoonarrowly,andcustomerneedsareneglected–aclassicmanagementblunder.Checkouttheseexamples:

Companiesthatmakehome-improvementtoolsoftenview

theirbusinessintermsofproductcomponents–themakingandsellingof6mmdrillbits,forexample.Butwhenyouthinkaboutit,nobodyreallywantsorneeds6mmdrillbits(notevenyourdentist).Whatcustomersarereallylookingforare6mmholes.Thatbasicneedcreatesthepotentialopportunityforanynumberofpossiblesolutions.

Glassesmanufacturers–thecompaniesthatmaketheframesandlenses–continuetoseethemselvesasbeingintheglasses-fashionbusiness.Butthecustomers,frustratedbynotbeingabletoreadamenucloserthanthreefeetawaywhenthey’veforgottentheirglasses,simplywanttoseebetter.Themanufacturersarenowdiscoveringahardlessonwiththeadventoflasertechnologiesthatpromisetoimprovevisionbyreshapingthecornea–novisionproblems,noneedforglasses,nomorebusiness.

PoliticsandthemarketplaceBillClintonhadalittlesigntackeduponthebackwallofhis1992USpresidentialcampaignheadquartersthatread:

It’stheeconomy,Stupid!

CampaignmanagerJamesCarvillepostedthesignbecausehewantedeveryonetofocusnotsomuchontheproduct–MrClinton–asonthemarketplaceandcustomerneeds.

Inthiscase,ofcourse,themarketplacewastheelectionitself,andthecustomerswerethevotingpublic.Atthetime,workersintheUnitedStatesweresufferingthroughasteeprecession,worriedaboutforeigncompetitionandpetrifiedaboutthe‘newworldeconomy’.Asashrewdcampaignstrategist,Carvilleknewthattheroadtosuccesslayingettingbeyondthecandidatesthemselvesandappealingtothevoters’innermostneeds–thoseuniversal,underlyingissuesthatwouldultimatelyswaydecisionmakinginthepollingbooth.

Asabusinessplanner,youhavetodothesamething:focusonbeingmarket-drivenwhenyouapproachyourcustomers.

CharlesRevsonrevolutionisedthecosmeticsindustrywhenhequipped,‘Inthefactory,wemakecosmetics;inthestore,wesellhope.’AsthefounderofRevlon,heunderstoodthathewasofferinghiscustomerssomethingfarmoreimportantthansimplechemistry:theprospectofyouth,beauty,andsexappeal.

Thekeypointhereissimple:Ifyoudon’tknowwhatyourcustomersreallywant,youcan’tpossiblyfulfiltheirneedsinaneffectiveway.

Putyourselfinyourcustomer’sshoes:

Takeahardlookatoneofyourownproductsorservices,andhonestlyaskyourself,‘WhywouldIneedthisthing?’

Askthesamequestionofseveralpeoplewhoalsouseyourproductorservice.

Trytoimagineaworldwithoutyourproductorservice.Whatwouldyousubstituteforit?

Answeringquestionssuchasthesegoesalongwaytowardfosteringcreativity,generatingnewstrategiesandprovidingexpandedmarketopportunities.

DealingwithBusinessCustomersAlthoughwe’vementionedcompaniesthatsellprincipallytoothercompanies(asopposedtothosethatsellprimarilytoindividualconsumers),someofyouinthisso-calledbusiness-to-businessmarketmaythinkthatwe’reignoringyou.Wearen’t–honest!Inthis

section,youfinddetailsonhowcompanies,institutionsandgovernmentagenciesactwhentheythemselvesarethecustomers.Whatmakesthebusinessbuyerdifferent?Manythings.

Sizingupsecondhanddemand

Demandforgoodsandservicesinbusiness-to-businessmarketsisalmostalwaysderiveddemand.Inotherwords,businessespurchaseonlythosegoodsandservicesthattheycanusetobetterservetheirowncustomers.

Steel,forexample,isaproductthatnoend-userbuys.Whenwasthelasttimeyouhadtheurgetogooutandgetyourhandsonsomeflat-rolledsheeting?Steelpurchaserstendtobecarmanufacturers,constructionfirms,appliancecompaniesandthelike.Afterthesebusinessesusethesteeltomaketheirownproducts(cars,officeblocksandrefrigerators),wecomeintothepictureaspotentialcustomers.

Whataretheimplicationsforthesteelsellers?Ifasteelmakercutsitspricesacrosstheboard,forexample,shoulditexpectahugeincreaseinorders?Notnecessarily.Thesteelbuyerswillincreasetheirpurchasesonlyiftheythinkthattheycansellmoreofthethingsthattheymake,andtheirownsalesmaybeaffectedbymanyfactorsbeyondtheunderlyingpriceofsteel.Howmanyofusdashedouttobuyanewcarthelasttimesteelpriceswerereducedby10percent?

Inelasticdemandisatermthatnumbercrunchersusewhentheytalkaboutdemandforaparticularproductthatdoesn’tstretchorchangeautomaticallywhenthepriceoftheproductchanges.

Ifyouofferproductsorservicesinthebusiness-to-businessmarket,makesurethatyoutakethetimetothinkthroughwhatyourplanningdecisionsmeantoyourbusinessbuyers.Andthatmeansthinkingaboutyourcustomers’customersaswell.Youcandothisbyaskingyourself:

Doesapricereductiononyourpartresultinincreasedsalesforyourcustomers–andyourcompany?

Doyourcustomers(andtheircustomers)benefitifyouofferthemadditionalbellsandwhistleswhileraisingtheircosts?

Areyourcustomerslookingforcontinuityandpricestability?

Thinkingofdecisionmakingasaformalaffair

Purchasedecisionsinthebusiness-to-businessmarketplacetendtobemoreformal,rationalandprofessionalthaninmostconsumermarkets.Manypeoplefromdifferentpartsofthetargetcompanyareofteninvolvedinthedecision-makingprocess(DMP).Onedivisioninthecompanymayrecommendyourproductorservice,anothermayacquireit,yetanothermaypayforit,andallofthemdotheworkforaseparatecustomercentrethatactuallyusesthatproduct.Takentogether,thesedivisionsformthedecision-makingunit(orDMU)–anothermarketingtermfoistedoffonusnicefolksbymarketinggurus.

Table5-2describesthreewaysinwhichabusinessDMUmaybehavewhenthinkingaboutbuyingaproductorservice.

Table5-2HowBusinessesBehaveWhenTheyBuy

Table5-2HowBusinessesBehaveWhenTheyBuy

Buyingbehaviour

Descriptionofthecustomer’sDMP

Businessasusual

Continuestoordermoreoftheproductorservice,perhapsevenautomatingtheprocesssothatinventoriesdon’tfallbelowcertainlevels

Yes,but... Asksforchangesintheexistingsalesarrangement,modifyingoneormorepurchaseterms(suchaspricing,financing,quantitiesandoptions)andincludingvariouspeoplewhoarepartoftheDMU

Opportunityknocks

Purchasesaproductorserviceforthefirsttime,perhapsafterputtingoutarequestforproposal(RFP)toseveralpossiblesuppliersandmakingadeliberate,completedecisioninvolvingallpartiesintheDMU

JudgingtheforcestobereckonedwithInworkingwithbusinesscustomers,youmostlikelyhavetodealwithseveralpowerfulcustomerforcesthatyourarelyencounterinconsumermarkets.Ifyourbusiness-to-businessstrategiesaregoingtosucceedovertime,youmustfactortheseforcesintoyourbusinessplans.Considerthefollowingquestions:

What’sthestateofthecustomer’sbusiness?

•Isthecustomer’sbusinessbooming,mature,ordying?

•Isitfacingincreasedcompetitionorenjoyingrecordprofits?

•Isitoutsourcingbusiness,creatingnewopportunities?

•Doesitthreatentobecomeacompetitor?

Howdoesthecustomer’scompanyoperate?

•Doesthecustomerpurchasecentrally,ordoesithavebuyersscatteredaroundthecompany?

•Doesitrequireseverallevelsofapprovalbeforeadecisionismade?

•Doseniorexecutives(whomayormaynotknowalotabouttheproduct)maketheultimatepurchasedecisions?

Who’simportanttowhom?

•Dothecustomer’skeydecisionmakerstendtobeengineersormarketingpeople?

•Doesthecustomerusebothsmallandlargesuppliers?

•Doesithaveapolicyofrequiringmorethanonesupplierincriticalareas?

Asyoubegintodevelopstrategiesforyourbusinesscustomers,takethetimetoinvestigatetheforcesthatareuniqueinbusiness-to-businessmarkets:

Getoutintothefieldandtalktopotentialbusinessbuyers.

Readaboutcustomers’organisationsandtheirindustries.

Attendtheconferencesandconventionsthatyourcustomersattend,andfindoutaboutthecriticaleventsandforcesthatshapetheirthinking.

Alltheseactivitiestaketimeandresources,ofcourse,butyourinvestmentwillberewardedmanytimesoverwhenyouincorporatewhatyoudiscoverintoyourbusiness-to-businessplanning.

Rememberthefollowingwhendealingwithbusinesscustomers:

Someofyourcustomersmaybeotherbusinesses,andthewayinwhichtheybuyisdifferentfromthewaythatindividualsbuy.

Severalpeoplemaybeinvolvedinmakingthedecisiontobuyfromyou.

Sometimesyourbusinesscustomersaren’ttheendusers,so

youneedtounderstandyourcustomers’customersaswell.

PartIII

WeighingUpYourCompany’sProspects

Inthispart...Wheneveryoutacklesomethingnew,whetherit’sgoingbacktoschool,buyingahouse,changingjobs,startingabusiness,orplanningforchange–naggingquestionscomeup.Isthenew

strategyreallytherightdecision?Areyouuptothechallenge?Willthingsworkoutintheend?They’regoodquestions,becausetheyforceyoutobehonestaboutthecapabilitiesandqualitiesthatyoubringtothetable.

Inthispart,wehelpyoulookinthemirrorandmakeanhonestassessmentaboutwhatyousee.Wesetouttodiscoverallthecapabilitiesandresourcesthatyouhave.Wetrytodeterminewhichofthemarestrengthsandwhichareweaknessesbylookingatwhatyouneedtosucceedinyoursectorandindustry–andwhatopportunitiesandthreatsyouface.Wehelpyoufocusonwhatyourorganisationdoesbestbylookingattheareaswhereyouprovidethemostvaluetocustomers,andthenwehelpyoufigureouthowyoucanmaintainandextendthecompetitiveadvantagesyoualreadyhaveinthemarket.Finally,weturntoyourfinancesandhelpyoucreateanobjectiveportraitofyourbusinessbasedonyourincome,profits,assets,andcashposition,andthenwehelpyouusethemtocreateaforecastandabudget.

Chapter9

FocusingOnWhatYouDoBest

InThisChapterDescribingwhatyourcompanydoes

Constructingavaluechain

Searchingforyourcompetitiveadvantage

Focusingonyourcompany’scorecompetence

Sustainingacompetitiveadvantageovertime

Usingthevaluechaintoallocateresources

Everytimeyouleavethehousetogoshopping,yougearuptomakeacomplexsetofchoicesthattogetherdeterminewhatyoufinallycomehomewithattheendoftheday.Asyoulookdowntheshoppinglistovermorningcoffee,thedecisionsbegin:

Towncentreshopsortheout-of-townshoppingprecincts?

Specialityshopsoradepartmentstore?

Designerbrandsorstorelabels?

£25,£50or£100limit?

Ifyouhappentobeinthebusinessofproducingandsellingproductsinshops,thesearemake-or-breakdecisions.Howdoshoppersmaketheirchoices?Whydotheygointooneshopandnotthenext?Whatdetermineswheretheystoptobrowseandwhattheytakeasecondlookat?Howarecustomersdifferentfromoneanother?Inwhatwaysaretheythesame?Nomatterwhatindustryyou’rein,thesamekindsofquestionsarejustascrucial.

Astheygoaboutmakingdecisionsonwhattobuyandwheretoshop,customerscontinuallyweighvariouscombinationsofproductorservicebenefitsagainstprice.Whencustomersmaketheirchoicesbasedontheirowncalculationofthebestvaluetheycanfindinthemarketplace,they’reusingavalueequation.(CheckoutChapter7ifyouwanttoknowmoreaboutthatequation.)Butwhatdoesitactuallymeantohavethebestvalueoutthere?Ifyou’reoneofthecompetitors,youneedtoknowexactlywhereandhowyourproductsaddvalueintheeyesofyourcustomers.

Inthischapter,wetakeanotherlookathowyoucreatecustomervaluearoundyourownproductsandservices.Theapproachiscalledavalue-chainanalysisbypeoplewhotrytomakesomethingsimplesounddifficult,andweuseittoidentifywhichpartsofyourbusinessareresponsibleforaddingthegreatestvalueforcustomers.Weshowyouhowtouseyourvaluechaintohelpexplainwhyyoumayhaveacompetitiveadvantageinthemarketplace.Wealsousethevaluechaintopointoutyourcompany’scorecompetence.Wetalkabouthowyoucanworktomaintainyourcompetitiveadvantageoverthelongterm.Finally,weshowyouhowtouseanunderstandingofyourvaluechainandcorecompetencetomakethemostofyourcompany’shumanandfinancialresourcesasyoucreateyourbusinessplan.

DescribingWhatYouDoYou’dthinkthatitwouldbeeasytodescribewhatyourcompanydoes,summarisingyourkeybusinessactivitiesinafewwell-chosensentencesorinacleardiagramortwo.It’snot.Fromtheinsideofyourbusinesslookingout,it’smuchharderthanyoumaythinktopushawaytheeverydaydetailstogetatthecoreofwhatactuallykeepsyouinbusinessfromonedaytothenext.

That’swhyconsultantshangaroundalot.Manyofthemwouldlikenothingbetterthantohelpyoudescribewhatyoudo.Theirlittlesecret,ofcourse,isthatthey’renotreallyanysmarterthanyouare.Consultantsseemtohaveaclearerviewofyourbusinesssimplybecausethey’reontheoutsidelookingin.

Butchancesarethatyou’veabuilt-inunderstandingofyourownbusinessandwhatreallymakesyourcompanysuccessful–youjustneedtounlockwhatyoualreadyknow.

TomFarmer,thesonofaLeithshippingclerkwhoearned£5aweek,launchedKwik-Fit,acompanythatgrewintoa£418millionpubliccompanywithalmost1,000outlets,beforehesoldouttoFordfor£1billion.Inhisownwords,theenduringphilosophybehindhisbusinesstowhichheascribesitssuccessis‘100percentcustomersatisfaction.Justgivingservice–phoningbackinhalfanhourifyousayyouwill,standingbypromises–putsyoumilesaheadofanyoneelseinthefield.’KnowingthatserviceisasimportantastheexhauststhemselvesiswhathasprovidedKwik-Fitwithalastingcompetitiveadvantage.

Thiscannybusinessmanhadarealfeelingforwhyhewassuccessfulatwhathedid.Givenalittleguidance,youcantakethesamegut-levelunderstandingofyourownbusinessanddevelopachainofactivitiesthatcaptureswhatyourcompanyreallydoestostayinbusiness.Inparticular,wefocusoncreatingcustomervalue,anddivideyourbusinessintothespecificareasandactivitiesthatbuildvalueintotheproductsandservicesthatyouoffer.

Kwik-Fithasbeenratherlesssuccessfulundernewownership.FrenchprivateequityfirmPAIPartnersboughtKwik-Fitin2005for£800million,sellingitoninMarch2011toItochu,aJapaneseconglomerateforjust£637million.

Constructingatypicalvaluechain

Figure9-1:Acompany’svaluechainhastwotypesoflinks:primaryactivitiesandsupportactivities.

Constructingatypicalvaluechain

Yourcompanyconstructsitsvaluechainfromthesequenceofactivitiesthatitengagesintoincreasethevalueofyourproductsandservicesintheeyesofyourcustomers.(SeeFigure9-1.)Thechainconnectsyoutothemarketplace,makingsurethatyoudon’tstraytoofarfromthecustomersyouserve.

Thelinksinavaluechainhelpyoutounderstandyourcompany’sactivities.

Primarylinksinthevaluechainarethebusinessfunctionsthatareattheheartofwhatyourcompanydoes.Primarylinksareusuallysequential.They’retheessentialstagesthatyourcompanygoesthroughindeveloping,producingandgettingproductstomarketandtheyofteninvolvethefollowing:

Researchanddevelopment

Operations

Marketingandsales

Distributionanddelivery

Service

Supportinglinksinthevaluechaincontributetotheoverallsuccessofthebusinessbystrengtheningyourcompany’sprimarylinks.Supportinglinksareoftenspreadthroughoutyourorganisation.Theyassistandtietogetheralltheprimarybusinessfunctions,aswellassupportoneanother.Theactivitiesofteninvolvethefollowing:

Management

Organisation

Strategyandplanning

Financialcontrol

Trytoconcentrateonorganisingyourbasicbusinessfunctionsaroundcustomervalueandthebrightideathateverythingyoudoinyourcompanyshouldsomehowcontributetothateffort.Avalue-chainanalysisallowsyoutotakeyourcompanyapartandputitbacktogether,makingsurethateachlinkinthechaincontributestothevaluethatcustomersseewhentheybuyyourproductorservice.

ComparingdifferentvaluechainsYoucanfindoutagreatdealaboutacompanybycheckingoutitsvaluechain:whereandhowthecompanycreatescustomervalue.In

fact,thevaluechainisarelativelygoodwaytocompareandcontrastcompetitorsinyourownindustry.Youmayevenwanttousethisinformationtorevisityourstrategicgroupsofcompetitors.(SeeChapter7tofindoutwhatthephraseastrategicgroupofcompetitorsmeans.)

Toseehowtocomparevaluechains,takeacloserlookattheairlineindustry.TheexperienceofflyingfromLondon,HeathrowtoBelfast,forexample,isusuallymeasuredsomewhereintherangeoftolerabletoterrible.Airtravelalwaysseemstogeneratemetaphorsthatinvolvecattletrucks,theundergroundatrushhourandGuinnessrecordsthathavetodowithpeoplecrammedintotelephoneboothsorVolkswagens.Butwithintheseconstraints,sotospeak,airlinesdoinfactcompeteforyourskybusinessindifferentways.

RyanairandeasyJet,forexample,aremajorplayersintheso-called‘budget’segment.Comparedwithotherairlines,thesecompaniescanmakeseveraladditionalflightsadayineachairplane,basedontheircapabilitytoturntheplanearound–unload,reloadandtakeoff–inabout20minutes.Mostofthecostsintheairlineindustryaretiedupinthingssuchasaircraftandbuildings,soextraflightsadaymeanextraprofitsforanairline–orlowerpricesforcustomers.Thesecompaniescaterprimarillytopeoplewhohavetopayfortraveloutoftheirownpocketsandarelookingforthebestdeal.Howdobudgetairlinesmaketheirbusinesseswork?AquickglanceateasyJet’svaluechainhighlightsseveralimportantvalue-addingactivities.Keylinksinclude:

Operations:Budgetairlineshaveefficientpersonnel,acegroundcrewsandstate-of-the-artequipmentthatallowthemtogetplanesinandoutofairportsasfastashumanlypossible,meettightflightschedulesandreduceoverallcosts.

Distribution:Theseairlineshavebuiltupregionalroutesystemsthattendtobypassthemostcrowdedairportsandoverlycompetitivedestinations.Periodicreviewsofpassengertrafficandcompetitionsuggestexpansionopportunitiesthatareinlinewiththecarrier’slow-coststrategy.

Management:Theyhaveputtogetherteamsofmanagersandprofessionalswhohavetheskills,aptitudeandtemperamenttodealwithconsiderablejobstressandwhoworkwelltogether.

Bycontrast,BritishAirwaysisaglobal,full-servicecarrierattheoppositeendoftheairlinespectrumfromthebudgetcrew.Thecompanyserveshundredsofdestinationsdailyandoffersfrequentlyscheduledflightstomostmajorcommercialairportsintheworld.

Itsextensivenationalnetworkfeedsintointernationalroutesthatspantheglobe.BAhasafreephonereservationsnumber,closerelationshipswithtravelagents,afrequent-flyerprogrammeofferingworldwideawardsandcreditcardstiedtoitsmileageprogramme.CustomerscountonBAtoprovidein-flightmealsonlongerflights,films,totransfertheirbagsandtocatertothemifanythinggoeswrongalongtheway.Whoarethesecustomers?Manyofthemarebusinesspassengersandotherwell-heeledtravellerswhoarewillingtopaythepricetocoverthecostsofalltheseaddedservices.

AlthoughgettingeachplaneturnedaroundquicklyonthegroundcertainlyisimportanttoBritishAirways,thecompanydoesn’tdependonitthesamewaythateasyJetdoes.Infact,theservicesthatBA’spassengersdemandmakeitalmostimpossibleforitsairlinecrewstokeepupwitheasyJetontheground.BA’svaluechainpointsouttheareasinwhichtheairlineaddscustomervalue.Keylinksincludethefollowing:

Researchanddevelopment:Whetherdevelopingmorecomfortablebusiness-classseats,betterin-flightentertainment,orInternetconnectionsat35,000feet,BritishAirwaysworkstopleaseitsmostdemandingcustomers.Atthesametime,itsreservationsystemandyield-managementsoftwareallowtheairlinetomaximiserevenueandmatchfareswithotherairlinesincertaincompetitivemarkets.

Marketingandsales:Thecompanyspendssignificanttimeandresourcesinpromotingitsimageandworldwidebrand.BAadvertisesinawiderangeofglobalmedia,sponsorsallsortsofspecialeventsandmaintainsstrongtieswithtravelagenciesacrossthecountryandtheworld.

Service:CustomerserviceisamajorlinkinBA’svaluechain.Thecompanymakeseveryefforttocreatealastingrelationshipwithitsmostloyalcustomersthroughitsfrequent-flyerprogramme.Anditmakessurethatthesevaluedcustomersarepamperedwithspecialairportlounges,hassle-freecheckinandcheckedbaggagethatalwaysarrivesfirstinthebaggageclaim.

Financialcontrol:BritishAirwaysmaintainsthefinancialresourcesandflexibilitytofundcontinuedinvestmentsintheextensivegroundfacilitiesandhugefleetofaircraftthatallowittoserveaglobalnetworkofroutesanddestinations.

BotheasyJetandBritishAirwaysareinthebusinessoftransportingpassengersfromonelocationtoanotherbyusingaircraftonregularlyscheduledflights,yettheirvaluechainsandtheimportantlinksincreatingcustomervaluearequitedifferent.

Valuechainsdon’tstandstill.InApril2011,Ryanairintroducedseatreservationonsomeflights,aimedatsmoothingthetravelexperienceforbusinessflyers.EarlierintheyeartheyopenedaBusinessLoungeatStanstedofferingwi-

Figure9-2:Thevalue-chainframework.

fi,printing,scanningandfaxfacilitiesaswellasbarandbistro.InSeptember2011,easyJetenhanceditsFlexiFareticket,introducedtogivebusinesstravellersbenefitssuchasspeedyboarding,unlimitedticketchangesandonepieceofholdluggage,toincludeanoffertothosewhosearrivalsaredelayedbymorethan15minutesofafreeleisuretickettoanywhereoneasyJet’snetwork.

ForgingyourownvaluechainTodevelopyourcompany’sownvaluechain–thesequenceofactivitiesthatyougothroughintheprocessofaddingcustomervaluetoyourproductsandservices–youneedalistofyourcompany’scapabilitiesandresources.TakealookatChapter8ifyouneedhelp.

Youcanconstructaframeworkforyourvaluechainbycreatingagridthatdividesyourbusinessintovalue-creatingareas(seeFigure9-2).Thenyouplaceactivitiesinthegridbasedonwhetherthey’repartofyourprimarybusinessfunctionsorareassociatedwithsupportingareas.

Followthesestepstocreatethegridthatshapesyourvaluechain:

1.Listallthekeybusinessareasthataredirectlyinvolvedinputtingtogetheryourowncompany’sproductsandservicesandgettingthemouttocustomers.IncludesuchthingsasR&D,operations,marketing,sales,distribution,deliveryandservice.

2.Arrangethelistofkeybusinessareasinorder,fromthefirstgoodideaoutofR&Dtothefinishedproductorservice.3.Listthegeneralbusinessareasinyourcompanythatsupporttheprimarybusinessfunctions.Includesuchthingsasmanagement,organisationandhumanresources,strategyandplanning,andfinancialcontrol.

4.ConstructagridsimilartotheoneinFigure9-2,usingyourownlistsofprimaryandsupportingbusinessareas.

Yourvaluechainmaynotlookexactlylikeallthoseorganisationchartsthatarefloatingaroundyourcompany.Theprimaryandsupportingbusinessfunctionsthatendupaddingcustomervaluemaybeframeddifferently,dependingonwhomyouask,somakesurethatyoutalktocustomersaswellastoco-workers.Askyourcustomerstodescribeyourbusinessastheyseeit.Yourcustomersjustmayhaveabettervantagepoint.

AblueprintforchangeAnarchitecturalandengineeringfirminthenortheast,thatwe’llcallNAE,usedtoprideitselfonbeingafull-servicebuildingconsultant.Itsprofessionalstaffrangedfromstructuralengineerstointeriordesignersandeveryoneinbetween.Thecompanymaintainedacompleteproject-budgetingdepartmentandafullin-houseblueprintingoperation;infact,thefirmroutinelyturneddownrequestsbysmalloutsidecontractorstotakeoverandsupply

downrequestsbysmalloutsidecontractorstotakeoverandsupplyblueprintingservices.Businesswasbooming,thecompanywasgrowinganditsclientscouldn’thavebeenhappier.

Allthatchangedin2008.AmajorandsustaineddownturninthepropertymarkethitNAEquitehard,andthecompanywasforcedtothinkaboutwaystocutcostsasitsverysurvivalwasatstake.Aspartoftherestructuringeffort,NAEtookahardlookatitsinternalblueprintingoperations,anditdiscoveredthatitshouldhavetakenthebidsfromoutsidesuppliersmoreseriously.IndependentcontractorscouldprovidethequalityandreliabilitythatNAEdemandedandsubstantiallylowerthefirm’sblueprintingcostsatthesametime.

WhenNAEaskeditsmostimportantcustomerswhattheythoughtabouttheproposedchanges,theanswersweresurprising.Noonechosethecompanybecauseofthequalityofitsblueprints;clientssawrealvalueinthebreadthandexpertiseofthecompany’sprofessionalstaff.Byreviewingthevaluechain,NAEhadanopportunitytorefocusitsresourcesandenergyontheactivitiesandlinksinthechainthatprovidedthemostvaluetoitscustomers.Doingsoalsohelpedittostayafloatwhilelessobservantcompetitorssankwithouttrace.

Tofillinthevalue-chaingrid,youhavetofillinallthespecificvalue-addingactivities–thecapabilitiesandresourcesthatyourcompanyusestoincreasethevalueofyourproductsandservicesintheeyesofyourcustomers.Followthesesteps:

1.Gothroughthelistsofcapabilitiesandresources,andhaveafirstgoatplacingtheminthevalue-chaingrid.2.Intheboxesontheleftsideofthevalue-chaingrid,placevalue-addingactivitiesthatdirectlycontributetoyourprimarybusinessfunctions.Theseactivitiesmakeuptheprimarylinksinyourvaluechain.

3.Placevalue-addingactivitiesthatareassociatedwithsupportingfunctionsingridboxesacrossfromtheprimaryfunctionsthattheysupport.Theseactivitiesarethesupportinglinksinthevaluechain.

4.Onthegrid,includeadescriptionofthecustomervaluethat’saddedateachlink,aswellashowthatvalueisadded.

Thevaluechainoffersyouauniquelookatyourcompanythroughyourcustomers’eyes.Everylinkinthevaluechainissomethingthatyoudoasacompany.Everylinkisanactivitythatyouspendmoneyon.Thevaluechainallowsyoutoseeexactlywhatvaluecustomersaregettingoutofeachlink.Avalue-chainanalysisgivesyouarelativelyclearpictureofwhyyoustayinbusiness,aswellaswhereyoucanbedoingabetterjob.

Afewthingstorememberaboutthevaluechain:

Thevaluechaindescribesallthethingsthatyoudotoaddvaluetotheproductsandservicesthatyouoffercustomers.

Valueisintheeyesofthecustomer.

Bycomparingthevaluechainsofothercompaniesinyourindustry,youfindoutaboutthecompetitivelandscapeandhowyoufitin.

Avaluechainshowsexactlywhatvalueyourcustomersaregettingfromeachofyourbasicbusinessfunctions.

StayinginBusinessCompaniesdon’tjuststayinbusinessyearafteryearbyaccident.Oh,maybeamanagersomewheregetsluckyeveryonceinawhile,makingabrilliantmovewithouthavingaclueastowhythemoveissobrilliant.Butthatkindofluckneverlastslong,especiallywhenthecompetitionisintense.Companiessucceedoverthelonghaulbecausetheyunderstandwhattheircustomersplacethemostvalue

becausetheyunderstandwhattheircustomersplacethemostvalueon,andtheytranslatethatknowledgeintoproductsandservicesthatconsistentlymeetorexceedcustomers’expectations,oftenattheexpenseofunsuspectingcompetitors.

Usingavaluechainforyourowncompanyenablesyoutopinpointthebusinessareasandactivitiesinwhichmostofyourcustomervalueiscreated.Thosekeyareasandactivitiestellyouaboutyourcompany’sadvantageinthemarketplaceandhowitachievedthatadvantage.Thevaluechainmayhighlighttheimportanceofyourcostadvantageinthemarket,forexample,andpointoutthatyourcompanyachievedthatadvantagethroughcareful,continuousimprovementsinmanufacturingefficiency.Ormaybeyourvaluechainflagsthecalibreofyourprofessionalstaffasbeingakeyadvantageinthemarketplace,achievedthroughacommitmenttorecruit,developandsupportthemostcapablepeopleoutthere.

Takeacloselookatwhatitmeanstohaveanadvantageoverthecompetitioninyourmarketplace,wheretheadvantagecomesfrom,andhowyoucanworktomaintainitoverthelonghaul.

SearchingforcompetitiveadvantageWeallknowpeoplewholiketotakecartrips–maybeuptotheLakeDistrictforawalkingweekendoroffinthefamilycaravanwhenevertheweather’snice.Ifyouaskthemwheretheystopalongtheway,theyalwayshaveaspecialburgervan,afavouritepuborcafé,oracertainice-creamplacethattheywouldneverdreamofmissing.Whydothesetravellersdevelopsuchaffectionforspecificstopsontheirroutewhenhundredsofotherplacesareavailablealongtheway?Whatmakesparticularestablishmentssounique?

Ifyoupushthem,thesetravellerscomeupwithallsortsofreasons.Theymaytellyouthatthey’vebeenstoppingatthesameplacesforyears,thattheylovethefood,thattheyliketheatmosphere,thattheyknowtheowners,thattheycancountontheservice...whatever.Nodoubtallthesethingsaretrue.Buttakeacarefullookatthevaluechainformanyofthesebusinesses,andoneimportant

atthevaluechainformanyofthesebusinesses,andoneimportantlinkthatjumpsrightoutatyouislikelytobelocation.Distancesanddrivingtimesmostlikelyarethemajorreasonwhymanyoftheircustomersfindthesebusinessesinthefirstplace;theshopfrontsliterallyhappentobeintherightplaceattherighttime.Locationprovidesasignificantcompetitiveadvantageinthison-the-movemarketplace.

Competitiveadvantagemeansexactlywhatitsays:acompanyhassomesortofadvantageoverthecompetition.Wheredoesitcomefrom?Usually,outofthedistinctandspecialvaluethatthecompanycanofferitscustomers–andfromthepremiumthatcustomersplaceonthatvalue.Askyourselfthisbasicquestion:

Whydocustomerschoosemycompanyanditsproductswhenothercompetitorsintheindustryhavemore-or-lesssimilarofferings?

Youcanfindtheanswerinthestrongestlinksofyourvaluechain.Thelinksthatproducethebulkofyourcustomervalue–whetherthisvalueislocation,service,imageorproductfeatures–arethelinksthatcreateyourcompetitiveadvantageinthemarketplace.

Inthebeginning,Microsoftwasapartnershipoftwo:BillGatesandPaulAllen.Theystartedoutcompetingagainstahostofbrightyoungentrepreneurslikethemselvesandeventuallyhadtogohead-to-headwithIBMitself.Today,Microsofthasover20,000employeesand£5.18billioninrevenueandoffersawidearrayofsoftwareproducts,rangingfromwordprocessingprogramsandspreadsheetapplicationstolanguagetoolsandoperatingsystems.ItsWindowsprogramalonehassoldmorethan100millionunits.Microsoft’scompetitiveadvantages:

Standards:Microsoft’sprogramsprettymuchsetthestandardsinthePCworld.Microsoftoffersthestandard

operatingsystemandthestandardsuiteofofficeapplications.Althoughothercompaniessellbetterproductshereandthere,Microsoftisseenasbeingthesafeandsensiblechoiceacrosstheboard.

Compatibility:Microsoftprogramspromisetoworkwithoneanotherandwiththeoperatingsystem.Youdon’thavetoworrythatyourfavouriteapplicationwillbecomeanoutcastorsomehowmisbehaveinsideyourcomputer.

Productrange:Younameit,andMicrosoftprobablyhasaproductthatcandoit.Thecompanycontinuestoaggressivelydevelopnewsoftwaretomeettheneedsofrapidlychangingmarkets.Mostrecently,thecompanytargetedInternetuserswithahostofnewproducts.

Serviceandsupport:WithMicrosoft,youknowwhatyou’regetting.Ifsomethingdoesn’twork,thecompanytrieshardtofixit.Inthemeantime,it’scomfortingtoknowthatyoucanalwaysfindotherpeoplewhohavethesameproblem.

Hertzisbyfarthelargestcar-rentalagencyintheworld.Thecompanyhasrentallocationsinmorethan150countriesandboastsafleetofmorethan500,000vehicles.ButHertzfacescompetitionatalllevels,fromthefamily-runrentalcompaniesatpopularholidayspotstoregionalagenciessuchaseasyCar,anoffshootofeasyJetandotherglobalcompanies,includingAvisandNational.HertzCorporation’scompetitiveadvantages:

One-stopreservations:WhenyoucalltheHertzfreenumber,yougainimmediateaccesstothecompany’sworldwidefleet.Youcanquicklyandconvenientlybookthekindofcarthatyouwant,whenandwhereyouwantit.Changingyourmindisjustaseasy.

Internationalpresence:Nomatterwhereorwhyyouneedthecar–forasafariinAfrica,atourofItaly,orabusiness

triptoBirmingham–youcansafelybetthatHertzcanrentyouwhatyouneed.

Peaceofmind:WithHertz,youdon’thavetoworrythatthecarwon’tbethere,thattherategoingtodouble,orthatyou’llenduppayingforarent-a-dentthat’sobviouslyayearold.Also,tohelpyoufindyourwayaround,thecompanyofferspersonalisedmapsandisintroducinganewonboardnavigationsystem.

Rewardsforloyalty:AsaloyalHertzcustomer,you’rerewardedwithmembershipinaclubthatprovidesextraservice,attentionandthechancetoapplythepoundsthatyouspendtowardfreerentaldays.

Biggestisuseful,butbestisbetterAccordingtoasurveyinOctober2010byCondéNastTraveler,Hertz,Enterprise,andAvistopthelistofbestcarhirefirms.Theresultstakeintoaccountrates,reliabilityandlocations.Buttostayattheforefrontofnewdevelopmentsintheindustry,Hertzrecentlyintoducedone-wayrentalsallowingcustomerstodropoffacaratanairportinsteadofanoriginalpick-upspot,avaluablebenefitforbusinessusers.EnterpriseandAvis,ontheotherhand,arepioneeringelectriccarrentals,appealingtothegreenandcostconsciousmarkets.

FocusingoncorecompetenceYourcompetitiveadvantageiscreatedinthemarketplace.Thatadvantagehaseverythingtodowithyourcustomers,withtherelativevaluethattheyplaceonyourproductsandservices,andwiththepurchasedecisionsthattheyfinallymake.Butwhatisitaboutyourcompanythatallowsyoutoachievethiscompetitiveadvantage?Whatinternalcapabilitiesandresourcesdoyouhave,andwhatbusinessactivitiesdoyouengageinthatleaddirectlytoyourcompetitiveadvantage?

yourcompetitiveadvantage?

Youprobablyalreadyhavetheanswer.Gobacktoyourcompany’svaluechain,andfocusonthoselinksthataremostresponsibleforyourowncompetitiveadvantage.Whenyoudo,youcomefacetofacewithsomethingthattheguruscallyourcorecompetence.Simplydefined,corecompetenceisyourcompany’sspecialcapabilitytocreateacompetitiveadvantageforitselfinthemarketplace.Inalmostallcases,thisgiftisspecifictoyourcompany.ThinkofcorecompetenceasbeingcorporateDNA.Unlikeyourpersonalgeneticcode,however,yourcompany’scorecompetenceisthereforyoutobuildon–ortolose,dependingonhowattentiveyouaretoyourmarketsandyourbusiness.

Thesection‘Searchingforcompetitiveadvantage’earlierinthischapterexaminedtwowell-knowncompanies,eachofwhichisahouseholdname.CanyouidentifythecorecompetencebehindthatcompetitiveadvantageforbothMicrosoftandHertz?

Microsoft’scorecompetenceisbuilton:

Visionaryexecutives:Theexecutiveteamhasabroadvisionofthefuture,enablingthecompanytoforgetoday’ssoftwarestandardsandshapetomorrow’s.

Top-notchdevelopmentteam:Thecompanyiscommittedtosupportingadream-teamcorpsofdevelopersandprogrammerswhoarechargedwithcreatingandmaintainingastate-of-the-artproductline.

Managementofcomplexity:Microsoftmanagesacomplexrelatedsetofsoftwareproductsthatallhavetobehaveandworktogether.

Capabilitytochangedirection:Thecompanyhasthecapacitytoredirectresourcesandenergieswhenthefast-

movingmarketplaceshiftscourseandtherulesofthegamesuddenlychange.

HertzCorporation’scorecompetenceconsistsof:

Informationsystems:Asophisticatedcomputerdatabaseallowsthecompanytokeeptrackofcustomerprofilesandmatchthemagainstanever-changingsupplyofrentalcarsaroundtheworld.

Globallogistics:Thecompanyhasthecapabilitytotrack,distribute,arrangeandrearrangeahugefleetofvehiclesinallshapesandsizesonaworldwidebasis.

Scaleofoperations:Thecompanyusesitssheersizeandbusinessvolumetonegotiatefavourabletermswhenitcomestonew-carpurchasesandeveninsurancepremiums.

Relationshipsandtie-ins:Hertzhastheresourcestoworkcloselywithtravelagenciesandthetravelindustrytocreatenewbusinessbyexpandingcar-rentaloptionsandopportunities.

Sometimes,acompany’scorecompetencecanpointthewaytowardnewmarketopportunities.Honda,forexample,usedacorecompetenceindesigningenginestoexpanditsmarkets.Thecompanycreatedproductlinesinlawnmowers,snowthrowers,snowmobilesandall-terrainvehicles,tonamejustafewofitsmotor-basedbusinesses.Hondabenefitsfromarelatedcompetitiveadvantageineachofthesedistinctmarkets.Takeanotherlookatyourowncompany’scorecompetencetoseewhetheryoucancomeupwithanynewbusinessdirections,basedonthosethingsthatyoualreadydowell.

SustaininganadvantageovertimeEverycompanythatmanagestostayinbusinessfromonemonthto

Everycompanythatmanagestostayinbusinessfromonemonthtothenexthassomesortofcompetitiveadvantageandcorecompetencetodrawupon;otherwise,itsimplywouldn’tbethere.Butthemillion-dollarquestionhastodowithhowtorenewandsustainthatcompetitiveadvantageoveryearsandevendecades.Customersandtheirneedsshiftovertime,competitiongetsmoreintenseandindustriesevolve,soyourcompetitiveadvantageandthecorecompetencethatsupportsitaren’tguaranteedtostayaround.Yourentthem;youdon’townthem.Youwanttomakesurethatyoukeepalong-termleaseonboth.

Sustainedcompetitiveadvantage–thebusinessworld’sHolyGrail–isacompany’scapabilitytorenewacompetitiveadvantageoverandoveragaininthefaceofaconstantlychangingbusinessenvironmentandmarketplace.Butifyouwanttosustainacompetitiveadvantageovertime,youneedtohavealong-termstrategyinplace.Chapter7introducesthreecommonalternativescalledgenericstrategiesandgivesyouahandleonwhatyourcompetitorsmaybeupto.Chapter13takesamuchcloserlookatyourownstrategicoptions.

Spendtimethinkingaboutthingsthatyourcompanycandoonanongoingbasistoseethatyourcorecompetenceispreservedorevolvestomeetchangedmarketneeds.Howcanyousustainthecompetitiveadvantagethatyourcompanyalreadyhas?Getablanksheetofpaperandjotdownanswerstothesekeyquestions:

Wherewillchangesinyourbusinessmostlikelycomefrom?

Howarethosechangeslikelytoaffectyourcompany’scompetitiveadvantage?

Whatcanyourcompanydotomaintaincorecompetenceinthefaceofchange?

Focusoneachofthemajorforcesthatfuelchangeinyourownindustry:

Yourcustomersandtheirchangingneedsandrequirements.

Yourcompetitorsandtheirchangingcapabilities,strategiesandgoals.

Yourcompany,itsvaluechainanditsshiftingstrengthsandweaknesses.

Asyoucreateyourbusinessplan,makesurethatyoucontinuetotracktheseforcessothattheydon’tthreatenthecorecompetenceyou’veworkedsohardtoachieveorsothatyourcorecompetenceevolves.

Soundslikeasummaryisinorder:

Yourcorecompetence–whatsetsyouapart–isbasedonthestrongestlinksinyourvaluechain.

Competitiveadvantageinthemarketplaceisadirectresultofyourcompany’sdistinctcorecompetence.

Stayingaheadofthecompetitionmeanssustainingyourcompetitiveadvantage,whichrequiresalong-termstrategy.

WhateverhappenedtoDaddy’sDaimler?DaimlerusedtobeasynonymformakingitintheUK.WhenaDaimlerwasparkedinfrontofsomeone’shouse,itmeantthattheyhadfinallyarrived.Infact,you’dhavebeenhardpressedtothinkofanotherproductthatcouldbestowquiteasmuchstatusonitsowner.Thecarwasbuiltforultimatecomfort,anditconveyedanimageofwealthandluxury.Daimlerownerswereanintenselyloyalbunch,typicallyorderingnewmodelseveryfewyears,justtoburnishthatimage.

Dailmerownersarestillloyaltoday,butnottothatbrand.Inthe1980s,anewgenerationofcarbuyersbegantolookfornewstatussymbols.Theyoungand

generationofcarbuyersbegantolookfornewstatussymbols.TheyoungandwealthybegantochaseforeigncarswithnamessuchasBMW,MercedesandVolvo(orLexus,InfinitiandAcura).WhateverhappenedtoDaimler’senviablepositionintheluxury-carmarket?Competition,ofcourse,andafailureonDaimler’sparttorespondquicklytochangingtastes.Theimageofluxuryandintensebrandloyaltythatthecarusedtoenjoysimplyweren’tpassedalongtothenextgenerationofbuyers,andaonce-powerfulcompetitiveadvantagequietlyslippedaway.

EarmarkingResourcesThevaluechainpaintsaportraitofyourcompanyasyourcustomersseeit.Linksinthechainreflectthevaluethatcustomersplaceonaspectsofyourproductsandservices.Thestrongestlinkscaptureyourcompetitiveadvantageinthemarketanddefineyourcorecompetenceasabusiness.Becausethevaluechainissogoodatweighingtheimportanceofthethingsthatyourcompanydoes,italsocomesinhandywhenyouplanhowyourresourcesaregoingtobeused.

Haveyoueverbeentoahorserace?Ifyouhave,youknowthatyou’reboundtoseeagroupofregularshangingaroundthestandsorclusteredatthefence.Thesepeopleareseriousabouthorseracing.Theyspendtimeporingoverformsheetsandnewspapers,circlingthis,checkingthat.Theypacebackandforth,occasionallydisappearingforawhiletodosomethingorother.Whataretheyupto?

Well,they’replacingbets,ofcourse.Butthey’recertainlynotrelyingonLadyLuckalonetokeepthemflush.Instead,they’reusingalltheinformationavailable–theconditionofthetrack,thehorse’shealth,thejockey’srecordandthebettingodds–toplacetheircashonlyonthosewagersthataremostlikelytoresultinthebestpayoffsandthebiggestwinnings.

payoffsandthebiggestwinnings.

Bettingonthehorsesisaseriousbusinessforthesecommittedprofessionals.Maybethosepunterscantellyousomethingabouthowtodivvyupworkingassets.Isitsensibletospreadyourcompany’slimitedresourcesequallyamongalltheareasthatmakeupyourbusiness?Probablynot.Eachtimeyousetasidetimeandmoneyforaparticularbusinessactivity,you’replacingabet.Whatyou’rebettingisthattheresourcesyoucommitaregoingtocontributetoyourbusiness,addvaluetowhatyoudo,andeventuallycomebackaroundtogeneraterevenueandprofits.

Chapters10and11helpyouporeoverthenumbers(financialstatements,ratiosandbudgets)thatkeeptrackofwhereyouspendmoneyandthentellyouwhetheryou’rewinning.Inshort,yourfinancialstatementstellyouagreatdealabouthowyoumanageyourcash,whatbetsyouplaceandhowwellyoudoatthetrack.Butyourfinancialstatementsalonedon’ttellyouwhattodo.Sohowdoyouknowwheretoplaceyourbetsinthefirstplace?

Youguessedit:yougobacktoyourcompany’svaluechain.Considerthissimplewaytocheckyourresourceallocationbasedonyourownvaluechain:

1.Lookatwhereyourcompanycurrentlyspendsmoney.Makeaquick-and-dirtyestimateofhowyearlyexpensesaredivviedupamongbusinessactivities–fromR&Dtodeliveryandservice–andjotthenumbersdownonyourvalue-chaingrid.Tokeepthingssimple,usepercentages.Makesurethatthenumbersaddupto100percent.

2.Lookatwherecustomersthinkthatyou’reprovidingthemvalue.Takethetotalvaluethatcustomersthinkyouprovide,anddivvyitupamongyourbusinessactivities.Ifcustomerspay£100tobuyyourwidget,forexample,howmuchofthataretheywillingtopayforfeatures,howmuchforserviceandhowmuchforconvenience?Again,usepercentages,andjotthenumberson

convenience?Again,usepercentages,andjotthenumbersonthesamevalue-chaingrid.Makesurethatthenumbersaddupto100percent.

3.Asareminder,highlighttheboxesonthevalue-chaingridthatrepresentyourcorecompetenceandaccountforyourcompetitiveadvantageinthemarketplace.4.Analysethecompletedgrid.Ifthepercentageslineupandareconcentratedinthehighlightedboxes,you’reinfairlygoodshape.Butifyoufindaglaringmismatchintermsofwhereyou’respendingmoney,whatyourcorecompetenceis,andwhereyourcustomersthinkthatyourproductsgettheirvalue,taketimetoreassesswhereyourcompany’sresourcesaredirected.

Thevaluechainisinvaluablewhenitcomestimeforyoutoearmarkresourcesforyourbusinessactivities.Aclearunderstandingofyourcorecompetenceandcompetitiveadvantagehelpsyoumakeinformeddecisionswhenyouhavetoallocatescarceresources.

Checkoutthesepointsaboutthevaluechain:

Valuechainscomeinhandywhenitcomestoplanningthebestwaytoallocateyourcompany’sresources.

Avaluechainhighlightsmismatchesbetweencurrentspendingandtheareasthatprovidethemostvaluetocustomers.

PartV

APlanner’sToolkit

Inthispart...Whateverthetaskyou’reinvolvedin,nomatterhowbigorsmall,therecomesatimewhenyouhavetorollupyoursleevesandgetdowntotherealbusinessathand.Onceyouknowwhereyou’reheadedandwhatyou’regoingtodo,youmustgooutanddothetaskitself.Thebestplansintheworldaren’tworthanythingifyoucan’tcarrythemout.

Inthispart,wehelpyouputyourbusinessplantowork.First,welookatwaystoorganiseyourcompany,anddeveloptheproceduresandsystemsthatallowyoutocarryoutyourplanasefficientlyandeffectivelyaspossible.Second,wetalkaboutwaystoencourageleadership,developbusinessskills,andcreateacompanyculturesothatyoucanachieveyourplan.Third,welookatfinancingyourplanandplanningtobowoutgracefully.Finally,weshowyouasamplebusinessplan,sothatyouhaveabetterideaofexactlywhatliesaheadforyourcompany.

Chapter17

LearningfromOthers:ASampleBusinessPlanInThisChapter

Viewingasamplebusinessplan Followingabusiness-plantemplate LearningaboutthetourismindustrySometimes,youhavetoseesomethingupcloseandpersonalbeforeyoureallyunderstandwhatit’sallabout.Viewingareallivebusinessplanshouldgetyoumuchclosertoputtingyourownplandownonpaper.

Yourwrittenbusinessplansayssomethingaboutalltheimportantpartsofyourcompany.Afterall,youwanttoconvincepeople–andyourself–thatyourcompanyknowswhatit’sdoing.Ifyouwanttopersuadepeopleofanything,however,theyhavetoactuallysitdownandreadwhat’sinfrontofthem.Soyouwanttobeclear,conciseandtothepoint,anditdoesn’thurttospendsometimewithyourprose,either.

Inthischapter,weshowyouasamplebusinessplan.(Wechangedthenamesandsomeofthenumberstoprotecttheinnocent.)Byreviewingtheplaninsomedetail,youcandiscoverabitabouthowtoconstructabusinessplanofyourown,andasabonus,youcanpickupsometipsonthetourismindustry.Butpleasedon’trelyonanyofthedata;weprovideitsimplytoillustratethebusinessplanandnottohelpyoukickstartyourwayintothetourismbusiness.

Thereisnosuchthingasauniversalbusinessplanbutyoucanusethetableofcontentsbelowasaroughguideastowhattoputintointoyourownbusinessplan,asasortoftemplate.Buteverybusinessisdifferentasisthesituationthebusinessisplanningfor.

SafariEurope:BusinessPlanPreparedinJuly2009

ByKarenKehoe

ContactDetails:Mob:009912244:Email:kk@safari.com:Website:www.safarieurope.org

Chapter18

TenQuestionstoAskAboutYourPlan

InThisChapterLookingoverwhatyou’vedone

Makingthenecessarychanges

Itneverhurtstostepbackeveryonceinawhileandtakestockofwhereyoustand.Withthatinmind,we’vefilledthischapterwithallsortsofquestionstomulloverbeforeyoushareyourbusinessplanwiththeworld.

AreYourGoalsTiedtoYourMission?

Lookatthegoalsthatyousetforyourbusiness.Thesegoalsaretheresultsthatyouabsolutely,positivelyintendtoachieve,andtoalargeextent,thesegoalsdeterminehowyousetprioritiesandhowyourunyourbusiness.Yourgoalshavetobeconsistentwithoneanothersothatyou’renotrunningindifferentdirectionsatthesametime.Inaddition,youhavetotieyourgoalstoyourcompany’smissionsothatyou’reheadinginthedirectioninwhichyoureallywanttogo.

CanYouPointtoMajorOpportunities?

Opportunities?Ifyouwantyourbusinesstogrowandprosperinthelonghaul,youhavetotakeadvantageofopportunitiesastheycomealong.Don’tgettoofixatedonshort-termeconomicproblems,howeversevere;trytolookoverthehorizonusingyourbusinessplantohighlightthemajoropportunitiesthatyouseeheadingyourway(intechnology,marketsanddistribution,forexample)andoutlinetheactionsthatyourcompanyintendstotakenowsoastobeinapositiontotakeadvantageofthoseopportunitiesdowntheroad.

HaveYouPreparedforThreats?Youcaneasilypaintarosypictureofwhatthefutureholdsforyourcompany,buthavingarosypicturedoesn’tnecessarilymeanthatit’sgoingtocometrue.Yourcompanyisinmuchbettershapeifyoupaintanobjectivepicture–includingthebadnewsalongwiththegood.Thatway,you’repreparedforthedangersthatareboundtobethere.

Yourbusinessplanshouldpointoutthebiggestthreatsthatloomonthehorizon(amarketslowdown,newregulations,orincreasingcompetition,forexample)andofferwaystoprepareforthem.Ifyourecognisethreatsbeforeanybodyelsedoes,youcanoftenturnathreatintoarealbusinessopportunity.UseChapter15tohelpspoteconomicturningpoints.

HaveYouDefinedYourCustomers?Themoreyouknowaboutyourcustomers–whotheyare,howtheyact,whattheywant–themoreyouknowaboutyourcompany.Customerstellyouhowtosucceedinthemarketplace.

Describingyourcustomersismucheasierifyouthinkaboutdividingthemintoseparategroups.Eachgroup,ormarketsegment,hasitsownuniqueprofileandplacesitsownsetofdemandson

hasitsownuniqueprofileandplacesitsownsetofdemandsonyourcompany.

Yourcustomersaresoimportanttoyourcompanythatyoucan’taffordtoleavethemoutofyourbusinessplan.Youshouldanswerthreequestions:

Whoisbuying?

Whatdotheybuy?

Whydotheybuy?

Yourplanshouldexplainhowyourcompanyintendstoservethosecustomersbetterthananyoneelseoutthere.

CanYouTrackYourCompetitors?Yourcompetitorsarearoundtomakelifeinteresting.They’rethecompaniesthatalwaystrytowooyourcustomersaway,promisingproductsorservicesthathavebettervalue(morebenefits,lowerprices),andyoucan’tignorethem.Youhavetobeabletoidentifywhoyourcompetitorsare,whatthey’redoingandwheretheyplantogointhefuture.

Competitionrepresentsabigpieceofyourbusinessenvironment.Yourbusinessplanshouldcoverwhatyouknowaboutyourcompetitorsand–moreimportant–howyouintendtokeeptrackofthemonanongoingbasis.Yourplanshouldalsoaddresshowyouintendtousewhatyoufindouttochoosecompetitivebattlesthatyoucanwin.

WhereAreYouStrong(andWeak)?Youmayfindithardtobeobjectiveinmakinganhonestassessmentofwhatyourcompanydoeswellandwhatitcoulddo

assessmentofwhatyourcompanydoeswellandwhatitcoulddobetter.Butyourcompany’sstrengthsandweaknessesdetermineitsoddsofsuccessasyoulookahead.Strengthsandweaknessesrefertoyourcompany’scapabilitiesandresourcesandhowwelltheymatchupwiththecapabilitiesandresourcesthatyourcompanyreallyneedstohaveinplacetobesuccessful.CheckoutChapter8formoretipsoncarryingoutaSWOT(Strenths,Weaknesses,OpportunitiesandThreats)analysis.

Yourbusinessplanshouldlistyourcompany’scapabilitiesandresources–frommanagementskillsorresearchexpertisetooperationsanddistributionstrengthorloyalcustomers.Buttheplanmustgoontodescribehoweachofthesecapabilitiesorresourcesisastrengthorapotentialweakness,givenyourbusinesssituationandtheindustryinwhichyoucompete.

DoesYourStrategyMakeSense?Strategyhastodowithhowyouintendtomakeyourbusinessplanhappen.Forstarters,youhavetopulltogetheryourcompany’sstrengthsandweaknesses,theopportunitiesandthreatsthatyourcompanyfacesandthebusinessgoalsthatyouset.Then,givenallthesepiecesofthepuzzle,youhavetofigureoutawaytogetwhereyouwanttobe,inspiteofallthethingsthatstandinyourway.

Itshouldbeclear,frombeginningtoend,thatyourbusinessplanisbasedonanoverallstrategythatmakessense.Yourcompanyshouldhaveastrategythat’sgroundedinrealityandthatmakesreasonableassumptionsaboutwhat’shappeningandwhat’sabouttohappen–astrategythat’slogicalandrationalaboutwhatcanbeaccomplishedandhowlongit’sgoingtotake.

CanYouStandBehindtheNumbers?Thinkaboutallyourfinancialstatementsasyourcompany’sreport

Thinkaboutallyourfinancialstatementsasyourcompany’sreportcard–onethatanswerssomebigquestions.Doyourcustomersloveyou?Doyourcompetitorsrespectyou?Areyoumakingtherightbusinesschoices?Aprofitandlossaccountpresentsthebottomline,thebalancesheetshowsyourbusiness’sfinancialhealthandthecash-flowstatementkeepstrackofthemoney.

Yourcurrentfinancialstatementstelleverybodyhowwellyou’redoing.Butmanypeoplearemoreinterestedinyourfinancialforecasts,whichsaywhatyouexpecttohappeninthefuture.Justbecausetheseforecastsincludeofficial-lookingnumbers,however,doesn’tmeanthatthepredictionswillnecessarilycometrue.Ifyouwanttopaintanhonestpictureofyourcompany,yourbusinessplanshouldincludearealisticfinancialportrait,basedonassumptionsthatyoubelieveinandnumbersthatyoutrust.

AreYouReallyReadyforChange?Ifonethingremainsconstantinthebusinessworld,it’schange.Althoughsomeindustrieschangefasterthanothers,everythingaroundyou–fromtechnologytocompetitiontoyourmarket–isgoingtobealittledifferenttomorrowthanitistoday,nomatterwhatbusinessyou’rein.Ifyouwanttokeepup,youhavetothinktwoorthreestepsahead.Youmustlookcarefullyandcontinuallyatwhatmayhappenintheworldandhowitmayaffectyourcompany.

Althoughyourbusinessplanpaintsanhonestpictureofhowyouseeyourcompanyandwhatyouseehappeningdowntheroad,theplanshouldalsoacknowledgethefactthatyoudon’thaveacrystalball.Sopresentsomeoptions.Includeoneortwoalternativebusinessscenarios,asking–andanswering–thequestion‘Whatif...?’

IsYourPlanClear,ConciseandCurrent?

Current?Yourplanshouldcertainlycaptureallthethingsthatyouthinkareessentialtoknowaboutyourcompanyanditssituation–everythingimportantthatyoudiscoverintheprocessofplanningyourcompany.Butnoneoftheinformationthatyoupresentisgoingtobeofanyusetoanyoneelseifyourbusinessplanistoolong,impossibletoread,oroutofdate.

Readoveryourownplan.Isiteasytounderstand?Isiteasytonavigate?Howlongdidittakeyoutoread?Didyouknowwheretofindallthedetails?Didthedetailsgetintheway?

Toaccessthecheatsheetspecificallyforthisbook,gotowww.dummies.com/cheatsheet/businessplansuk.

Findout"HOW"atDummies.com

UnderstandingBusinessAccountingForDummies®,3rdEdition

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AbouttheAuthorsJohnATracyisProfessorofAccounting,Emeritus,intheCollegeofBusinessandAdministrationattheUniversityofColoradoinBoulder.Beforehis35-yeartenureatBoulderhewasonthebusinessfacultyforfouryearsattheUniversityofCaliforniainBerkeley.HehasservedasstaffaccountantatErnst&Youngandistheauthorofseveralbooksonaccounting,includingTheFastForwardMBAinFinanceandHowToReadaFinancialReport.DrTracyreceivedhisMBAandPhDdegreesfromtheUniversityofWisconsinandisaCPAinColorado.

ColinBarrowwasuntilrecentlyHeadoftheEnterpriseGroupatCranfieldSchoolofManagement,wherehetaughtentrepreneurshipontheMBAandotherprogrammesandwhereheisstillavisitingfellow.HeisalsoavisitingprofessoratbusinessschoolsintheUS,Asia,FranceandAustria.HisbooksonentrepreneurshipandbusinesshavebeentranslatedintoovertwentylanguagesincludingRussianandChinese.HeworkedwithMicrosofttoincorporatethebusinessplanningmodelusedinhisteachingprogrammesintothesoftwareprogram,MicrosoftBusinessPlanner,bundledwithOffice.Heisaregularcontributortonewspapers,periodicalsandacademicjournalssuchasTheFinancialTimes,TheGuardian,ManagementTodayandtheInternationalSmallBusinessJournal.

ThousandsofstudentshavepassedthroughColin’sstart-upandbusinessgrowthprogrammes,raisingmillionsinnewcapitalandgoingontorunsuccessfulandthrivingenterprises.SomehavemadeittoTheSundayTimesRichList.Hehasbeenanon-executivedirectoroftwoventurecapitalfunds,ontheboardofseveralsmallbusinesses,andservesonanumberofGovernmentTaskForces.Currentlyheisanon-executivedirectorinseveralprivatefirmsandworkswithfamilybusinessesintheMiddleEastonsuccessionplanning.

Dedication

DedicationForallmygrandchildren.

JohnATracy

Authors’AcknowledgmentsFromJohn:I’mdeeplygratefultoeveryoneatWileywhohelpedproducethisbook.Theirprofessionalismandtheirunfailingsenseofhumourandcourtesyweremuchappreciated.IoweadebtofgratitudetoafacultycolleagueatBoulder,anaccomplishedauthorinhisownright,ProfessorEdGac.Heofferedverysageadvice.EdwasalwaysreadywithawordofencouragementwhenIneededone,andI’mveryappreciative.

IoftenthinkaboutwhyIliketowritebooks.IbelieveitgoesbacktoanaccountingclassinmyundergraduatedaysatCreightonUniversityinOmaha.InacoursetaughtbytheDeanoftheBusinessSchool,DrFloydWalsh,Iturnedinatermpaperandhesaidthatitwasverywellwritten.Ihaveneverforgottenthatcompliment.Ithinkhewouldbeproudofthisbook.

FromColin:IwouldliketothankeveryoneatWileyfortheopportunitytowritethisbook,aswellastheirhelp,encouragement,feedbackandtirelessworktomakethisallhappen.

Publisher’sAcknowledgements

We’reproudofthisbook;pleasesendusyourcommentsthroughourDummiesonlineregistrationformlocatedatwww.dummies.com/register/.

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TableofContents

Introduction

AboutThisBookConventionsUsedinFinancialReportsFoolishAssumptionsHowThisBookIsOrganised

PartI:AccountingBasicsPartII:GettingaGriponFinancialStatementsPartIII:AccountinginManagingaBusinessPartIV:FinancialReportsintheOutsideWorldPartV:ThePartofTensPartVI:Appendixes

IconsUsedinThisBookWheretoGofromHere

PartI:AccountingBasics

Chapter1:IntroducingAccountingtoNon-Accountants

AccountingEverywhereYouLook

TheBasicElementsofAccountingAccountingandFinancialReportingStandards

Theemergenceofinternationalfinancialreportingstandards(IFRS)WhyaccountingrulesareimportantIncometaxandaccountingrulesFlexibilityinaccountingstandards

EnforcingAccountingRules

Protectinginvestors:Sarbanes-Oxleyandbeyond

TheAccountingDepartment:WhatGoesOnintheBackOfficeFocusingonBusinessTransactionsandOtherFinancialEventsTakingaCloserLookatFinancialStatements

ThebalancesheetTheprofitandlossaccountThecashflowstatement

AccountingasaCareer

Charteredaccountant(CA)Thefinancialcontroller:ThechiefaccountantinanorganisationAccountingbranches:Treasury,taxandaudit

Chapter2:Bookkeeping101:FromShoeBoxestoComputers

BookkeepingversusAccountingPedallingthroughtheBookkeepingCycle

ManagingtheBookkeepingandAccountingSystem

Categoriseyourfinancialinformation:ThechartofaccountsStandardisesourcedocumentformsandproceduresDon’tbepenny-wiseandpound-foolish:Theneedforcompetent,trainedpersonnelProtectthefamilyjewels:InternalcontrolsKeepthescalesinbalancewithdouble-entryaccountingCheckyourfigures:End-of-periodprocedureschecklistKeepgoodrecords:Happyaudittrailstoyou!LookoutforunusualeventsanddevelopmentsDesigntrulyusefulaccountingreportsformanagers

Double-EntryAccountingforNon-Accountants

Thetwo-sidednatureofabusinessentityanditsactivitiesRecordingtransactionsusingdebitsandcredits

MakingSuretheBooksDon’tGetCooked

Chapter3:Taxes,TaxesandMoreTaxes

TaxingWagesandProperty

Puttingthegovernmentonthepayroll:EmployertaxesTaxingeverythingyoucanputyourhandson:PropertytaxesWorkingfromhome

GettingtoGripswithValueAddedTaxTaxingYourBottomLine:CompanyTaxes

DifferenttaxratesondifferentlevelsofbusinesstaxableincomeProfitaccountingandtaxableincomeaccountingDeductibleexpensesNon-deductibleexpensesEquitycapitaldisguisedasdebt

Chapter4:AccountingandYourPersonalFinances

TheAccountingViceYouCan’tEscapeTheInsandOutsofFiguringInterestandReturnonInvestment(ROI)

IndividualsasborrowersIndividualsassaversIndividualsasinvestors

AnAccountingTemplateforRetirementPlanning

PartII:GettingaGriponFinancialStatements

Chapter5:ProfitMechanics

SwoopingProfitintoOneBasicEquationMeasuringtheFinancialEffectsofProfit-MakingActivities

Preparingthebalancesheetequation

ExploringtheProfit-MakingProcessOneStepataTime

MakingsalesoncreditDepreciationexpenseUnpaidexpensesPrepaidexpensesStock(orInventory)andcostofgoodssoldexpense

SoWhere’sYourHard-EarnedProfit?ReportingProfittoManagersandInvestors:TheProfitandLossAccount

Reportingnormal,ongoingprofit-makingoperationsReportingunusualgainsandlossesPuttingtheprofitandlossaccountinperspective

Chapter6:TheBalanceSheetfromtheProfitandLossAccountViewpoint

CouplingtheProfitandLossAccountwiththeBalanceSheetSizingUpAssetsandLiabilities

SalesrevenueanddebtorsCostofgoodssoldexpenseandstockSAandGexpensesandthefourbalancesheetaccountsthatareconnectedwiththeexpensesFixedassetsanddepreciationexpenseDebtandinterestexpenseIncometaxexpenseThebottomline:netprofit(netincome)andcashdividends(ifany)

FinancingaBusiness:Owners’EquityandDebtReportingFinancialCondition:TheClassifiedBalanceSheet

Current(short-term)assetsCurrent(short-term)liabilities

CostsandOtherBalanceSheetValues

GrowingUp

Chapter7:CashFlowsandtheCashFlowStatement

TheThreeTypesofCashFlowSettingtheStage:ChangesinBalanceSheetAccountsGettingattheCashIncreasefromProfit

Gettingspecificaboutchangesinassetsandliabilities

PresentingtheCashFlowStatement

Abetteralternativeforreportingcashflowfromprofit?

SailingthroughtheRestoftheCashFlowStatement

InvestingactivitiesFinancingactivities

FreeCashFlow:WhatonEarthDoesThatMean?ScrutinisingtheCashFlowStatement

Chapter8:GettingaFinancialReportReadyforPrimeTime

ReviewingVitalConnectionsStatementofChangesinOwners’EquityandComprehensiveIncomeMakingSurethatDisclosureIsAdequate

TypesofdisclosuresinfinancialreportsFootnotes:NettlesomebutneededOtherdisclosuresinfinancialreports

KeepingItPrivateversusGoingPublicNudgingtheNumbers

Fluffingupthecashbalanceby‘windowdressing’SmoothingtheroughedgesoffprofitStickingtotheaccountingconventions

BrowsingversusReadingFinancialReports

PartIII:AccountinginManagingaBusiness

Chapter9:ManagingProfitPerformance

RedesigningtheExternalProfitandLossAccountBasicModelforManagementProfitandLossAccount

VariableversusfixedoperatingexpensesFromoperatingprofit(EBIT)tothebottomline

TravellingTwoTrailstoProfit

Firstpathtoprofit:ContributionmarginminusfixedexpensesSecondpathtoprofit:Excessoverbreak-evenvolume×contributionmarginperunitCalculatingthemarginofsafety

DoingWhat-IfAnalysis

Lowerprofitfromlowersales–butthatmuchlower?ViolentprofitswingsduetooperatingleverageCuttingsalesprice,evenalittle,cangutprofitImprovingprofitCuttingpricestoincreasesalesvolume:Averytrickygametoplay!Cashflowfromimprovingprofitmarginversusimprovingsalesvolume

AFinalWordorTwo

Chapter10:BusinessBudgeting

TheReasonsforBudgeting

ThemodellingreasonsforbudgetingPlanningreasonsforbudgetingManagementcontrolreasonsforbudgetingOtherbenefitsofbudgeting

BudgetingandManagementAccountingBudgetinginAction

DevelopingyourprofitstrategyandbudgetedprofitandlossaccountBudgetingcashflowfromprofitforthecomingyear

CapitalBudgeting

DeducingpaybackDiscountingcashflowCalculatingtheinternalrateofreturnArrivingatthecostofcapital

ReportingOnVariances

Flexingyourbudget

StayingFlexiblewithBudgets

Chapter11:ChoosingtheRightOwnershipStructure

FromtheTopLinetotheBottomLineWhatOwnersExpectforTheirMoney

CompaniesPartnershipsandlimitedpartnershipsSoleproprietorshipsLimitedcompanies(Ltd)andpubliclimitedcompanies(plc)

ChoosingtheRightLegalStructureforTaxPurposes

CompaniesPartnerships,limitedliabilitypartnershipsandsoleproprietorshipsDecidingwhichlegalstructureisbest

Chapter12:CostConundrums

PreviewingWhat’sComingDowntheRoadWhatMakesCostSoImportant?SharpeningYourSensitivitytoCosts

DirectversusindirectcostsFixedversusvariablecostsBreakingevenRelevantversusirrelevant(sunk)costsSeparatingbetweenactual,budgetedandstandardcostsProductversusperiodcosts

PuttingTogetherthePiecesofProductCostforManufacturers

MindingmanufacturingcostsAllocatingcostsproperly:Noteasy!CalculatingproductcostFixedmanufacturingcostsandproductioncapacityExcessiveproductionoutputforpuffingupprofit

AViewfromtheTopRegardingCosts

Chapter13:ChoosingAccountingMethods

Decision-MakingBehindtheScenesinProfitandLossAccountsCalculatingCostofGoodsSoldandCostofStock

TheFIFOmethodTheLIFOmethodTheaveragecostmethod

IdentifyingStockLosses:NetRealisableValue(NRV)ManagingYourStockPositionAppreciatingDepreciationMethodsCollectingorWritingOffBadDebtsReconcilingCorporationTaxDealingWithForeignExchange

TransactionexposureTranslationexposureComparingperformance

TwoFinalIssuestoConsider

PartIV:FinancialReportsintheOutsideWorld

Chapter14:HowInvestorsReadaFinancialReport

FinancialReportingbyPrivateversusPublicBusinessesAnalysingFinancialReportswithRatios

GrossmarginratioProfitratioEarningspershare,basicanddiluted

Price/earnings(P/E)ratioDividendyieldBookvaluepershareReturnonequity(ROE)ratioGearingorleverageCurrentratioAcid-testratioKeepingtrackofstockanddebtorlevelsReturnonassets(ROA)ratioUsingcombinedratiosAppreciatingthelimitsofratios

FrolickingthroughtheFootnotesCheckingforOminousSkiesontheAuditReportFindingFinancialFacts

PubliccompanyaccountsPrivatecompanyaccountsScoringcreditUsingFAME(FinancialAnalysisMadeEasy)

Chapter15:ProfessionalAuditorsandAdvisers

WhyAudits?Who’sWhointheWorldofAuditsWhatanAuditorDoesbeforeGivinganOpinionWhat’sinanAuditor’sReport

Trueandfair,acleanopinionOtherkindsofauditopinions

DoAuditsAlwaysCatchFraud?

Lookingforerrorsandfraud

Whathappenswhenauditorsspotfraud

AuditorsandtheRulesFromAuditstoAdvising

PartV:ThePartofTens

Chapter16:TenWaysSavvyBusinessManagersUseAccounting

MakeBetterProfitDecisionsUnderstandThataSmallSalesVolumeChangeHasaBigEffectonProfitFathomProfitandCashFlowfromProfit

ProfitaccountingmethodsarelikehemlinesTherealstuffofprofit

GovernCashFlowBetterCalltheShotsonYourManagementAccountingMethodsBuildBetterBudgetsOptimiseCapitalStructureandFinancialLeverageDevelopBetterFinancialControlsMinimiseTaxExplainYourFinancialStatementstoOthers

Chapter17:TenPlacesaBusinessGetsMoneyFrom

StockMarketsPrivateEquityBusinessAngelsCorporateVentureFundsBanksBonds,DebenturesandMortgages

LeasingandHire-PurchaseFactoringandInvoiceDiscountingGrants,IncentivesandCompetitionsUsingthePensionFund

Chapter18:Ten(PlusOne)QuestionsInvestorsShouldAskWhenReadingaFinancialReport

DidSalesGrow?DidtheProfitRatiosHold?WereThereAnyUnusualorExtraordinaryGainsorLosses?DidEarningsPerShareKeepUpwithProfit?DidtheProfitIncreaseGenerateaCashFlowIncrease?AreIncreasesinAssetsandLiabilitiesConsistentwiththeBusiness’sGrowth?CantheBusinessPayItsLiabilities?AreThereAnyUnusualAssetsandLiabilities?HowWellAreAssetsBeingUtilised?WhatIstheReturnonCapitalInvestment?WhatDoestheAuditorSay?

Chapter19:TenWaystoGetaBetterHandleontheFinancialFuture

SalesForecastsversusSalesObjectivesDealingwithDemandCurvesMathsMattersAveragingOutAveragesLookingforCausesStraddlingCyclesSurveyingFutureTrendsTalkingToTheTroopsSettingOutAssumptionsMakingRegularRevisions

PartVI:Appendixes

AppendixA:Glossary:SlashingthroughtheAccountingJargonJungleAppendixB:AccountingSoftwareandOtherWaystoGettheBooksinGoodOrder

Sourcingaccountingandbookkeepingsoftware

CheatSheet

IntroductionWelcometoUnderstandingBusinessAccountingForDummies,3rdEdition.We’vewrittenthisbookforpeoplewhoneedtounderstandaccountinginformationandfinancialreports,quickly.Unsurprisinglythebusinessclimateattheendofthefirstdecadeofthe21stCenturyhasmadethisahottopic–notquiteintheStiegLarssonleaguebuteverybitasscaryinitsownway.Whileit’snotforaccountantsandbookkeepers,theyshouldfindthisbookveryinterestingandagoodrefreshercourse.Thisbookisforpeoplewhoneedtouseandunderstandaccountinginformation–businessmanagersandentrepreneurs,forexample,whoneedtoraisemoney,makeprofit,turnprofitintocashflowandcontroltheassetsandliabilitiesoftheirventure.Ifyou’rerunningabusinessoryou’reabusinessunitmanager,we’reprobablypreachingtotheconvertedwhenwesaythatyouneedabasicfamiliaritywithaccountingandfinancialstatementsinordertomakegoodbusinessdecisions.

Businessinvestors,lawyers,businessconsultants–prettymuchanyonewhoreads(oraspirestoread)TheFinancialTimes–canalsobenefitfromasolidunderstandingofhowtoreadfinancialreportsandhowaccountingworks.

AboutThisBookUnderstandingBusinessAccountingForDummies,3rdEditionliftstheveilofobscureterminologyandlaysbarethemethodsofaccounting.Thisbooktakesyoubehindthescenesandexplainsthelanguageandmethodsofaccountinginadown-to-earthandlight-heartedmanner–andinplainEnglish.

Eachchapterinthisbookisdesignedtostandonitsown.Eachchapterisself-contained,andyoucanjumpfromchaptertochapterasyouplease(althoughweencourageyoutotakeaquicktourthroughthechaptersintheorderthatwepresentthem).Webet

throughthechaptersintheorderthatwepresentthem).Webetyou’lldiscoversomepointsthatyoumaynothaveexpectedtofindinabookaboutaccounting.

ConventionsUsedinFinancialReports

Muchofthisbookfocusesonprofitandhowabusinessmakesprofit.Becauseprofitandotherfinancialaspectsofabusinessarereportedinfinancialstatements,understandingsomebasicnotationsandconventionsusedinthesefinancialreportsisimportant.

Weusethefollowingcondensedprofitandlossaccounttoillustratesomeconventionsthatyoucanexpecttoseewhenreadingfinancialreports.(Theactualformatofaprofitandlossaccountincludesmoreinformationaboutexpensesandprofit.)Theseconventionsarethecommonwaysofshowingfiguresinfinancialreportsjustassayinghelloandshakinghandsarecommonconventionsthatyoucanexpectwhenyougreetsomeone.

Youreadafinancialstatementfromthetopdown.Inthissampleprofitandlossaccount,forexample,salesrevenueislistedfirstfollowedbycostofgoodssoldexpensebecausethisparticularexpenseisthefirstexpensedeductedfrom

salesrevenue.Theothertwoexpensesarelistedbelowthefirstprofitline,whichiscalledgrossmargin.

Thesampleprofitandlossaccountincludestwocolumnsofnumbers.Notethatthe6,000,000totalofthetwoexpensesintheleftcolumnisenteredintherightcolumn.Somefinancialstatementsdisplayallfiguresinasinglecolumn.

Anamountthatisdeductedfromanotheramount–likecostofgoodssoldexpenseinthissampleprofitandlossaccount–mayhaveparenthesesaroundtheamounttoindicatethatitisbeingsubtractedfromtheamountjustaboveit.Or,financialstatementsmaymaketheassumptionthatyouknowthatexpensesaredeductedfromsalesrevenue–sonoparenthesesareputaroundthenumber.Youseeexpensespresentedbothwaysinfinancialreports.Butyouhardlyeverseeaminusornegativesigninfrontofexpenses–it’sjustnotdone.

Noticetheuseofpoundsignsinthesampleprofitandlossaccount.Notallnumbershaveapoundsigninfrontofthenumber.Financialreportingpracticesvaryonthismatter.Weprefertousepoundsignsonlyforthefirstnumberinacolumnandforacalculatednumber.Insomefinancialreports,poundsignsareputinfrontofallnumbers,butusuallytheyaren’t.

Toindicatethatacalculationisbeingdone,asingleunderlineisdrawnunderthebottomnumber,asyouseebelowthe15,000,000costofgoodssoldexpensenumberinthesampleprofitandlossaccount.

Thefinalnumberinacolumnisusuallydoubleunderlined,asyoucanseeforthe£4,000,000profitnumberinthesampleprofitandlossaccount.Thisisaboutascarriedawayasaccountantsgetintheirwork–adoubleunderline.Again,actualfinancialreportingpracticesarenotcompletelyuniformonthispoint–insteadofadoubleunderlineonabottom-linenumber,thenumbermayappearinbold.

Sometimesstatementsnotethattheamountsshownareinthousands(thispreventscloggingupneatlittlecolumnswithloadsofnoughts).Soifastatementnoting‘amountsinthousands’shows£300,itactuallymeans£300,000.Andthatcanmakequiteadifference!

Whenwepresentanaccountingformulathatshowshowfinancialnumbersarecomputed,weshowtheformulaindented,likethis:

Assets=Liabilities+Owners’Equity

Terminologyinfinancialreportingisreasonablyuniform,thankgoodness,althoughyoumayseeafairamountofjargon.Whenweintroduceanewterminthisbook,weshowtheterminitalicsandflagitwithanicon(seethesection‘IconsUsedinThisBook’laterinthisIntroduction).YoucanalsoturntoAppendixAtolookupatermthatyou’reunfamiliarwith.

FoolishAssumptionsWhilethisbookisdesignedforallofyouwhohavethatnaggingfeelingthatyoureallyshouldknowmoreaboutaccounting,wehavemadeafewassumptionsaboutyou.

Youdon’twanttobeanaccountant,nordoyouhaveanyaspirationsofeversittingfortheFCA(FellowoftheInstituteofCharteredAccountants)exam.Butyouworrythatignoranceofaccountingmayhamperyourdecision-making,andyouknowdeepdownthatlearningmoreaboutaccountingwouldhelp.

Weassumethatyouhaveabasicfamiliaritywiththebusinessworld,butwetakenothingforgrantedinthisbookregardinghowmuchaccountingyouknow.Evenifyouhavesomeexperiencewithaccountingandfinancialstatements,wethinkyou’llfindthisbookuseful–especiallyforimprovingyourcommunicationwithaccountants.

Weassumethatyouneedtouseaccountinginformation.Manydifferenttypesofpeople(businessmanagers,investorsandsolicitors,tonamebutthree)needtounderstandaccountingbasics–notallthetechnicalstuff,justthefundamentals.

Weassumethatyouwanttoknowsomethingaboutaccountingbecauseit’sanexcellentgatewayforunderstandinghowbusinessworks,anditgivesyouanindispensablevocabularyformovingupinthebusinessandinvestmentworlds.Findingoutmoreaboutaccountinghelpsyouunderstandearningsreports,mergersandtakeovers,fraudsandpyramidschemes,andbusinessrestructurings.

Letuspointoutoneotherverypracticalassumptionthatwehaveregardingwhyyoushouldknowsomeaccounting.Wecallitthedefensivereason.Alotofpeopleoutthereinthecold,cruelfinancialworldmaytakeadvantageofyou,notnecessarilybyillegalmeans,butbywithholdingkeyinformationandbydivertingyourattentionawayfromunfavourableaspectsofcertainfinancialdecisions.Theseunscrupulouscharacterstreatyouasalambwaitingtobefleeced.Thebestdefenceagainstsuchtacticsistolearnsomeaccountingbasics,whichcanhelpyouasktherightquestionsandunderstandthefinancialpointsthattrickstersdon’twantyoutoknow.

HowThisBookIsOrganisedThisbookisdividedintoparts,andeachpartisfurtherdividedintochapters.Thefollowingsectionsdescribewhatyoucanfindineachpart.

PartI:AccountingBasicsPartIofUnderstandingBusinessAccountingForDummies,3rdEditionintroducesaccountingtonon-accountantsanddiscussesthebasicfeaturesofbookkeepingandaccountingrecord-keepingsystems.Thispartalsotalksabouttaxesofallkindsthatareinvolvedinrunningabusiness,aswellasaccountingintheeverydaylivesofindividuals.

PartII:GettingaGriponFinancialStatementsPartIImovesontotheendproductofthebusinessaccountingprocess–financialstatements.Threemainfinancialstatementsarepreparedeveryperiod–oneforeachfinancialimperativeofbusiness:makingprofit,keepingfinancialconditioningoodshapeandcontrollingcashflow.ThenatureofprofitandthefinancialeffectsofprofitareexplainedinChapter5.Theassets,liabilitiesandowners’capitalinvestedinabusinessarereportedinthebalancesheet,whichisdiscussedinChapter6.CashflowfromprofitandthecashflowstatementareexplainedcarefullyinChapter7.Thelastchapterinthispart,Chapter8,explainswhatmanagershavetodotogetfinancialstatementsreadyfortheannualfinancialreportofthebusinesstoitsowners.

PartIII:AccountinginManagingaBusinessBusinessmanagersshouldknowtheirfinancialstatementslikethebacksoftheirhands.However,justunderstandingthesereportsisnottheendofaccountingformanagers.Chapter9kicksoffthispartwithanextraordinarilyimportanttopic–buildingabasicprofitmodel–thatclearlyfocusesonthekeyvariablesthatdriveprofit.

model–thatclearlyfocusesonthekeyvariablesthatdriveprofit.Thismodelisabsolutelycriticalfordecision-makinganalysis.

Chapter10discussesaccounting-basedplanningandcontroltechniques,especiallybudgeting.Businessmanagersandownershavetodecideonthebestbusinessownershipstructure,whichwediscussinChapter11.Managersinmanufacturingbusinessesshouldbewaryofhowproductcostsaredetermined–asChapter12explains.Thischapteralsoexplainsothereconomicandaccountingcoststhatbusinessmanagersuseinmakingdecisions.Chapter13identifiesandexplainsthealternativeaccountingmethodsforexpensesandhowthechoiceofmethodhasamajorimpactonprofitfortheperiod,andonthecostofstockandfixedassetsreportedinthebalancesheet.

PartIV:FinancialReportsintheOutsideWorldPartIVexplainsfinancialstatementreportingforinvestors.Chapter14presentsaspeed-readingapproachthatconcentratesonthekeyfinancialratiostolookforinafinancialreport.Thescopeoftheannualauditandwhattolookforintheauditor’sreportareexplainedinChapter15,whichalsoexplainstheroleofauditorsasenforcersoffinancialaccountinganddisclosurestandards.

PartV:ThePartofTensThispartofthebookpresentsfourchapters.Chapter16presentssomepracticalideasformanagerstohelpthemputtheiraccountingknowledgetousewhileChapter17listsvarioussourcesoffinanceavailabletothebusiness.Chapter18givesbusinessinvestorssomehandytipsonthingstolookforinafinancialreport–tipsthatcanmakethedifferencebetweenmakingagoodinvestmentandanot-so-goodone.Chapter19providesourtakeonreadingthestars.Sure,nooneknowseverythingaboutthefinancialfuture,buthereweoutlinesomewaysyoucanspotacloudbeforeitbecomesathunderstorm.

PartVI:AppendixesAtthebackofthebook,youcanfindtwohelpfulappendixesthatcanassistyouonyouraccountingsafari.AppendixAprovidesyouwithahandy,succinctglossaryofaccountingterms.AppendixBfillsyouinontheaccountingsoftwareprogramsavailableforyourbusiness.

IconsUsedinThisBookForDummiesbooksalwaysincludelittleiconsinthemarginstodrawyourattentiontoparagraphsofparticularsignificance:

Thisiconcallsyourattentiontoparticularlyimportantpointsandoffersusefuladviceonpracticalfinancialtopics.Thisiconsavesyouthecostofbuyingayellowhighlighterpen.

Thisiconservesasafriendlyreminderthatthetopicathandisimportantenoughforyoutoputanoteaboutitinthefrontofyourwallet.Thisiconmarksmaterialthatyourlecturermightputontheboardbeforetheclassstarts,notingtheimportantpointsthatyoushouldrememberattheendoftheclass.

Accountingisthelanguageofbusiness,and,likealllanguages,thevocabularyofaccountingcontainsmanyspecialisedterms.Thisiconidentifieskeyaccountingtermsandtheirdefinitions.Youcanalsochecktheglossary(AppendixA)tofinddefinitionsofunfamiliarterms.

Thisiconisacautionsignthatwarnsyouaboutspeedbumpsandpotholesontheaccountinghighway.Takingspecialnoteofthismaterialcansteeryouaroundafinancialroadhazardandkeepyoufromblowingafiscaltyre.Inshort–watchout!

Weusethisiconsparingly;itreferstoveryspecialisedaccountingstuffthatisheavygoing,whichonlyanFCAcouldgetreallyexcitedabout.However,youmayfindthesetopicsimportantenoughtoreturntowhenyouhavethetime.Feelfreetoskipoverthesepointsthefirsttimethroughandstaywiththemaindiscussion.

Thisiconalertsyouthatwe’reusingapracticalexampletoillustrateandclarifyanimportantaccountingpoint.Youcanapplytheexampletoyourbusinessortoabusinessinwhichyouinvest.

Thisiconpointsoutespeciallyimportantideasandaccountingconceptsthatareparticularlydeservingofyourattention.Thematerialmarkedbythisicondescribesconceptsthatarethebuildingblocksofaccounting–conceptsthatyoushouldbeveryclearabout,andthatclarifyyourunderstandingofaccountingprinciplesingeneral.

WheretoGofromHereIfyou’renewtotheaccountinggame,byallmeans,startwithPartI.However,ifyoualreadyhaveagoodbackgroundinbusinessandknowsomethingaboutbookkeepingandfinancialstatements,youmaywanttojumprightintoPartIIofthisbook,startingwithChapter5.PartIIIisonaccountingtoolsandtechniquesformanagersandassumesthatyouhaveahandleonthefinancialstatementsmaterialinPartII.PartIVstandsonitsown;ifyourmaininterestinaccountingistomakesenseofandinterpretfinancialstatements,youcanreadthroughPartIIonfinancialstatementsandthenjumptoPartIVonreadingfinancialreports.Ifyouhavequestionsaboutspecificaccountingterms,youcangodirectlytotheglossaryinAppendixA.

We’vehadalotoffunwritingthisbook.Wesincerelyhopethatithelpsyoubecomeabetterbusinessmanagerandinvestor,andthatitaidsyouinyourpersonalfinancialaffairs.Wealsohopethatyouenjoythebook.We’vetriedtomakeaccountingasfunaspossible,eventhoughit’safairlyserioussubject.Justrememberthataccountantsneverdie;theyjustlosetheirbalance.(Hey,accountantshaveasenseofhumour,too.)

Chapter2

Bookkeeping101:FromShoeBoxestoComputers

InThisChapterUnderstandingthedifferencebetweenbookkeepingand

accounting

Followingthestepsinthebookkeepingcycle

Managingthebookkeepingandaccountingsystem

Gettingdownthebasicsofdouble-entryaccounting

Deterringanddetectingerrors,irregularitiesandoutrightfraud

Mostpeopleareprettyterriblebookkeepersjustbecausetheyreallydon’tdomuchbookkeeping.Admitit.Maybeyoubalanceyourchequebookagainstyourbankstatementeverymonthandsomehowmanagetopulltogetheralltherecordsyouneedforyourannualincometaxreturn.Butyouprobablystuffyourbillsinadrawerandjustdragthemoutonceamonthwhenyou’rereadytopaythem.(Hey,that’swhatwedo.)Andyoualmostcertainlydon’tprepareadetailedlistingofallyourassetsandliabilities(eventhoughalistingofassetsisagoodideaforinsurancepurposes).Wedon’tprepareasummarystatementofourearningsandincomefortheyearorabreakdownofwhatwespentourmoneyonandhowmuchwesaved.Whynot?Becausewedon’tneedto!Individualscangetalongquitewellwithoutmuchbookkeeping–buttheexactoppositeistrueforabusiness.

Onekeydifferencebetweenindividualsandbusinessesisthatabusinessmustprepareperiodicfinancialstatements,theaccuracyof

whichiscriticaltothebusiness’ssurvival.Thebusinessusestheaccountsandrecordsgeneratedbyitsbookkeepingprocesstopreparethesestatements;iftheaccountingrecordsareincompleteorinaccurate,thefinancialstatementswillbeincompleteorinaccurate.Andinaccuracysimplywon’tdo.

Obviously,then,businessmanagershavetobesurethatthecompany’sbookkeepingandaccountingsystemisadequateandreliable.Thischaptershowsmanagerswhatbookkeepersandaccountantsdo–mainlysothatyoucanmakesurethattheinformationcomingoutofyouraccountingsystemiscomplete,timelyandaccurate.

BookkeepingversusAccounting

Bookkeepingisessentiallytheprocess(somewouldsaythedrudgery)ofrecordingalltheinformationregardingthetransactionsandfinancialactivitiesofabusiness–therecord-keepingaspectsofaccounting.Bookkeepingisanindispensablesubsetofaccounting.Thetermaccountinggoesmuchfurther,intotherealmofdesigningthebookkeepingsysteminthefirstplace,establishingcontrolstomakesurethatthesystemisworkingwell,andanalysingandverifyingtherecordedinformation.Bookkeepersfolloworders;accountantsgiveorders.

Accountingcanbethoughtofaswhatgoesonbeforeandafterbookkeeping.Accountantspreparereportsbasedontheinformationaccumulatedbythebookkeepingprocess–financialstatements,taxreturnsandvariousconfidentialreportstomanagers.Measuringprofitisaveryimportanttaskthataccountantsperform,ataskthatdependsontheaccuracyoftheinformationrecordedbythebookkeeper.Theaccountantdecides

Figure2-1:Thebasicstepsandsequenceofthebookkeepingcycle,includingtheaccountinginputsandoutputs.

informationrecordedbythebookkeeper.Theaccountantdecideshowtomeasuresalesrevenueandexpensestodeterminetheprofitorlossfortheperiod.Thetoughquestionsaboutprofit–whereitisandwhatitconsistsof–can’tbeansweredthroughbookkeepingalone.

Therestofthisbookdoesn’tdiscussbookkeepinginanydetail–notalkofdebitsandcreditsandallthatstuff.Allyoureallyneedtoknowaboutbookkeeping,asabusinessmanager,iscontainedinthischapteralone.

PedallingthroughtheBookkeepingCycle

Figure2-1presentsanoverviewofthebookkeepingcycleside-by-sidewithelementsoftheaccountingsystem.Youcanfollowthebasicbookkeepingstepsdowntheleft-handside.Theaccountingelementsareshownintheright-handcolumn.Thebasicstepsinthebookkeepingsequence,explainedbriefly,areasfollows.(Seealso‘ManagingtheBookkeepingandAccountingSystem,’laterinthischapter,formoredetailsonsomeofthesesteps.)

1.Recordtransactions–theeconomicexchangesbetweenabusinessandtheotherpeopleandbusinessesthatitdealswith.Transactionshavefinancialeffectsthatmustberecorded–thebusinessisbetteroff,worseofforatleast‘differentoff’astheresultofitstransactions.Examplesoftypicalbusinesstransactionsincludepayingemployees,makingsalestocustomers,borrowingmoneyfromthebankandbuyingproductsthatwillbesoldtocustomers.Thebookkeepingprocessbeginsbyidentifyingalltransactionsandcapturingtherelevantinformationabouteachtransaction.

2.Prepareandcollectsourcedocuments–transactiondocumentationthatthebookkeeperusestorecordthetransactions.Whenbuyingproducts,abusinessgetsapurchaseinvoicefrom

thesupplier.Whenborrowingmoneyfromthebank,abusinesssignsforanoverdraft,acopyofwhichthebusinesskeeps.Whenacustomerusesacreditcardtobuythebusiness’sproduct,thebusinessgetsthecreditcardslipasevidenceofthetransaction.Whenpreparingpayrollcheques,abusinessdependsonsalaryschedulesandtimecards.Allofthesekeybusinessformsserveassourcesofinformationintothebookkeepingsystem–inotherwords,informationthebookkeeperusesinrecordingthefinancialeffectsofthetransaction.

3.Recordoriginalentries(thefinancialeffectsofthetransactions)intojournalsandaccounts.

Usingthesourcedocument(s)foreverytransaction,thebookkeepermakesthefirst,ororiginal,entryintoajournalandthenintothebusiness’saccounts.Onlyanofficial,establishedbookofaccountsshouldbeusedinrecordingtransactions.Ajournalisachronologicalrecordoftransactionsintheorderinwhichtheyoccur–likeaverydetailedpersonaldiary.Incontrast,anaccountisaseparaterecordforeachasset,eachliabilityandsoon.Onetransactionaffectstwoormoreaccounts.Thejournalentryrecordsthewholetransactioninoneplace;theneachpieceisrecordedinthetwoormoreaccountschangedbythetransaction.Here’sasimpleexamplethatillustratesrecordingofatransactioninajournalandthenpostingthechangescausedbythetransactionintheaccounts.Expectingabigdemandfromitscustomers,aretailbookshoppurchases,oncredit,50copiesofUnderstandingBusinessAccountingForDummiesfromthepublisher,JohnWiley&Sons,Ltd.Thebooksarereceivedandplacedontheshelves.(50copiesarealottoputontheshelves,butourrelativespromisedtorushdownandbuyseveralcopieseach.)ThebookshopnowownsthebooksandalsoowesJohnWiley£600.00,whichisthecostofthe50copies.Youlookonlyatrecordingthepurchaseofthebooks,notrecordingsubsequent

salesofthebooksandpayingthebilltoJohnWiley.Thebookshophasestablishedaspecificstockoraccountcalled‘Stock-TradePaperbacks’forbookslikethis.Andthepurchaseliabilitytothepublishershouldbeenteredintheaccount‘Creditor-Publishers’.Sothejournalentryforthispurchaseisrecordedasfollows:Stock-TradePaperbacks+£600.00Creditor-Publishers+£600.00

Thispairofchangesisfirstrecordedinonejournalentry.Then,sometimelater,eachchangeisposted,orrecorded,intheseparateaccounts–oneanassetandtheotheraliability.Notsolongago,bookkeepershadtorecordtheseentriesbyhand,andeventodaythere’snothingwrongwithagoodhand-entry(manual)bookkeepingsystem.Butbookkeeperscannowusecomputerprogramsthattakeovermanyofthetediouschoresofbookkeeping.Computershavecometotherescue–ofcourse,typinghasreplacedhandcrampswithrepetitivestraininjury,butatleasttheworkgetsdonemorequicklyandwithfewererrors!(SeeAppendixBformoreaboutpopularaccountingsoftwarepackagesforpersonalcomputers.)

Wecan’texaggeratetheimportanceofenteringtransactiondatacorrectlyandinatimelymanner.Forexample,animportantreasonthatmostretailersthesedaysusecashregistersthatreadbar-codedinformationonproductsistomoreaccuratelycapturethenecessaryinformationandtospeeduptheentryofthisinformation.

4.Performend-of-periodprocedures–preliminarystepsforpreparingtheaccountingreportsandfinancialstatementsattheendofeveryperiod.Aperiodcanbeanystretchoftime–fromonedaytoonemonthtoonequarter(threemonths)tooneyearandisdeterminedbytheneedsofthebusiness.Ayearisusuallythelongestperiodof

timethatabusinesswouldwaittoprepareitsfinancialstatements.Asamatteroffact,mostbusinessesneedaccountingreportsandfinancialstatementsattheendofeachquarter,andmanyneedmonthlyfinancialstatements.

Beforetheaccountingreportscanbepreparedattheendoftheperiod(seeFigure2-1),thebookkeeperneedstobringtheaccountsofthebusinessup-to-dateandcompletethebookkeepingprocess.Onestep,forexample,isrecordingthedepreciationexpensefortheperiod(seeChapter6formoreondepreciation).Anotherstepisgettinganactualcountofthebusiness’sstocksothatthestockrecordscanbeadjustedtoaccountforshoplifting,employeetheftandsoon.Theaccountantneedstotakethefinalstepandcheckforerrorsinthebusiness’saccounts.Dataentryclerksandbookkeepersmaynotfullyunderstandtheunusualnatureofsomebusinesstransactionsandmayhaveenteredtransactionsincorrectly.Onereasonforestablishinginternalcontrols(discussedin‘Protectthefamilyjewels:Internalcontrols’,laterinthischapter)istokeeperrorstoanabsoluteminimum.Ideally,accountsshouldcontainveryfewerrorsattheendoftheperiod,buttheaccountantcan’tmakeanyassumptionsandshouldmakeafinalcheckforanyerrorsthatfellthroughthecracks.

5.Preparetheadjustedtrialbalancefortheaccountants.Afteralltheend-of-periodprocedureshavebeencompleted,thebookkeeperpreparesacompletelistingofallaccounts,whichiscalledtheadjustedtrialbalance.Modest-sizedbusinessesmaintainhundredsofaccountsfortheirvariousassets,liabilities,owners’equity,revenueandexpenses.Largerbusinesseskeepthousandsofaccounts,andverylargebusinessesmaykeepmorethan10,000accounts.Incontrast,externalfinancialstatements,taxreturnsandinternalaccountingreportstomanagerscontainarelativelysmallnumberofaccounts.Forexample,atypicalexternalbalancesheetreports

only20to25accounts,andatypicalincometaxreturncontainslessthan100accounts.Theaccountanttakestheadjustedtrialbalanceandtelescopessimilaraccountsintoonesummaryamountthatisreportedinafinancialreportortaxreturn.Forexample,abusinessmaykeephundredsofseparatestockaccounts,everyoneofwhichislistedintheadjustedtrialbalance.Theaccountantcollapsesalltheseaccountsintoonesummarystockaccountthatispresentedintheexternalbalancesheetofthebusiness.Inshort,thelargenumberofspecificaccountslistedintheadjustedtrialbalanceiscondensedintoacomparativelysmallnumberofaccountsthatarereportedinfinancialstatementsandtaxreturns.Ingroupingtheaccounts,theaccountantshouldcomplywithestablishedfinancialreportingstandardsandincometaxrequirements.

6.Closethebooks–bringthebookkeepingforthefiscalyearjustendedtoacloseandgetthingsreadytobeginthebookkeepingprocessforthecomingfiscalyear.Booksisthecommontermforaccounts.Abusiness’stransactionsareaconstantstreamofactivitiesthatdon’tendtidilyonthelastdayoftheyear,whichcanmakepreparingfinancialstatementsandtaxreturnschallenging.Thebusinesshastodrawaclearlineofdemarcationbetweenactivitiesfortheyear(the12-monthaccountingperiod)endedandtheyearyettocomebyclosingthebooksforoneyearandstartingwithfreshbooksforthenextyear.

Thebusinessmayhaveanaccountingmanualthatspellsoutingreatdetailthespecificaccountsandproceduresforrecordingtransactions.Butallbusinesseschangeovertime,andtheyoccasionallyneedtoreviewtheiraccountingsystemandmakerevisions.Companiesdonottakethistasklightly;discontinuitiesintheaccountingsystemcanbemajorshocksandhavetobecarefullythoughtout.Nevertheless,bookkeepingandaccountingsystemscan’tremainstaticforverylong.Ifthesesystemswereneverchanged,bookkeeperswouldstillbesittingonhighstoolsmaking

entrieswithquillpensandinkinleather-boundledgers.

ManagingtheBookkeepingandAccountingSystem

Inourexperience,fartoomanybusinessmanagerseitherignoretheirbookkeepingandaccountingsystemsortakethemforgranted–unlesssomethingobviousgoeswrong.Themanagersassumethatifthebooksareinbalance,theneverythingisokay.Thesection‘Recordingtransactionsusingdebitsandcredits’,laterinthischapter,coversjustexactlywhat‘thebooksbeinginbalance’means–itdoesnotnecessarilymeanthateverythingisokay.

Todeterminewhetheryourbookkeepingsystemisuptoscratch,checkoutthefollowingsections,which,takenasawhole,provideachecklistofthemostimportantelementsofagoodsystem.

Categoriseyourfinancialinformation:ThechartofaccountsSupposethatyou’retheaccountantforacompanyandyou’refacedwiththedauntingtaskofpreparingtheannualincometaxreturnforthebusiness.Thisdemandsthatyoureportthefollowingkindsofexpenses(andthislistcontainsjusttheminimum!):

Advertising

Baddebts

Charitablecontributions

Compensationofdirectors

Costofgoodssold

Depreciation

Employeebenefits

Interest

Pensionsandprofit-sharingplans

Rents

Repairsandmaintenance

Salariesandwages

Taxesandlicenses

Youmustprovideadditionalinformationforsomeoftheseexpenses.Forexample,thecostofgoodssoldexpenseisdeterminedinaschedulethatalsorequiresstockcostatthebeginningoftheyear,purchasesduringtheyear,costoflabourduringtheyear(formanufacturers),othercostsandstockcostatyear-end.

Wheredoyoustart?Well,ifit’sMarch1andthetaxreturndeadlineisMarch15,youstartbypanicking–unlessyouweresmartenoughtothinkaheadaboutthekindsofinformationyourbusinesswouldneedtoreport.Infact,whenyouraccountantfirstdesignsyourbusiness’saccountingsystem,heorsheshoulddissecteveryreporttomanagers,theexternalfinancialstatementsandthetaxreturns,breakingdownalltheinformationintocategoriessuchasthosewejustlisted.

Foreachcategory,youneedanaccount,arecordoftheactivitiesinthatcategory.Anaccountisbasicallyafocusedhistoryofaparticulardimensionofabusiness.Inbookkeepingthismeansabasiccategoryofinformationinwhichthe

financialeffectsoftransactionsarerecordedandwhichservesasthesourceofinformationforpreparingfinancialstatements,taxreturnsandreportstomanagers.

Thetermgeneralledgerreferstothecompletesetofaccountsestablishedandmaintainedbyabusiness.Thechartofaccountsisatermusedtodescribeaformalindexoftheseaccounts–thecompletelistingandclassificationoftheaccountsusedbythebusinesstorecorditstransactions.Generalledgerusuallyreferstotheactualaccountsandoftentothebalancesintheseaccountsatsomeparticulartime.

Thechartofaccounts,evenforarelativelysmallbusiness,normallycontains100ormoreaccounts.Largerbusinessorganisationsneedthousandsofaccounts.Thelargerthenumber,themorelikelythattheaccountsaregivennumbercodesaccordingtosomescheme–allassetsmaybeinthe100–300range,allliabilitiesinthe400–500rangeandsoon.

Asabusinessmanager,youshouldmakesurethatthepersoninchargeofaccounting(orperhapsanoutsidecharteredaccountant)reviewsthechartofaccountsperiodicallytodeterminewhethertheaccountsareup-to-dateandadequateforthebusiness’sneeds.Overtime,incometaxruleschange,thecompanymaygointonewlinesofbusiness,thecompanycoulddecidetoofferadditionalemployeebenefitsandsoon.Mostbusinessesareinconstantflux,andthechartofaccountshastokeepupwiththesechanges.

Standardisesourcedocumentformsand

StandardisesourcedocumentformsandproceduresBusinessesmoveonpaperwork.Whetherplacinganordertobuyproducts,sellingaproducttoacustomerordeterminingtheearningsofanemployeeforthemonth–virtuallyeverybusinesstransactionneedspaperwork,knownassourcedocuments.Sourcedocumentsserveasevidenceofthetermsandconditionsagreeduponbythebusinessandtheotherpersonororganisationthatit’sdealingwith.Bothpartiesreceivesomekindofsourcedocument.Forexample,forasaleatacashregister,thecustomergetsasalesreceipt,andthebusinesskeepsarunningrecordofalltransactionsintheregister.

Clearly,anaccountingsystemneedstostandardisetheformsandproceduresforprocessingandrecordingallnormal,repetitivetransactionsandshouldcontrolthegenerationandhandlingofthesesourcedocuments.

Fromthebookkeepingpointofview,thesebusinessformsanddocumentsareveryimportantbecausetheyprovidetheinputinformationneededforrecordingtransactionsinthebusiness’saccounts.Sloppypaperworkleadstosloppyaccountingrecords,andsloppyaccountingrecordsjustwon’tdowhenthetimecomestopreparetaxreturnsandfinancialstatements.

Checkoutabusinessoffice-supplystoretoseethekindsofformsthatyoucanbuyrightofftheshelf.Youcanfindmany–maybeall–ofthebasicformsanddocumentsthatyouneedforrecordingbusinesstransactions,althoughmostfirmshavetodesignatleastsomeoftheirownforms.Also,personalcomputeraccountingsoftwarepackages(seeAppendixBformoredetail)providetemplatesforcommonbusinessforms.

Don’tbepenny-wiseandpound-foolish:

Don’tbepenny-wiseandpound-foolish:Theneedforcompetent,trainedpersonnel

Whatgoodismeticulouslycollectingsourcedocumentsiftheinformationonthosedocumentsisn’tenteredintoyoursystemcorrectly?Youshouldn’ttrytosaveafewpoundsbyhiringthelowest-paidpeopleyoucanfind.Bookkeepersandaccountants,likeallotheremployeesinabusiness,shouldhavetheskillsandknowledgeneededtoperformtheirfunctions.No-brainer,right?Well,determiningwhatthatleveliscanbedifficult.Herearesomeguidelinesforchoosingtherightpeopletoenterandmanipulateyourbusiness’sdataandformakingsurethatthosepeopleremaintherightpeople:

Universitydegree:Manyaccountantsinbusinessorganisationshaveadegreeinaccounting.However,asyoumovedowntheaccountingdepartmentyoufindthatmoreandmoreemployeesdonothaveadegreeandperhapsevenhaven’ttakenanycoursesinaccounting.

ACA,ACCAorCIMA:Themainprofessionalaccountingcredentialsare:ACAsponsoredbytheInstituteofCharteredAccountants;ACCAsponsoredbytheAssociationofCharteredCertifiedAccountants;andCIMAsponsoredbytheCharteredInstituteofManagementAccountants.Allofthesequalificationsareevidencethatthepersonhaspassedtoughexamsandhasagoodunderstandingofbusinessaccountingandincometax.TheAssociationofCharteredCertifiedAccountants(www.accaglobal.com,clickon‘PublicInterest’andthenon‘FindanAccountant’)andtheInstituteofCharteredAccountants(www.icaewfirms.co.uk)haveonlinedirectoriesofqualifiedaccountants.Youcansearchthesedirectoriesbyname(usefulifyouhaveapersonal

recommendationfromacolleagueyourespect),location(handyifyoujustwantsomeonenearby),thebusinesssectoryou’rein(helpfulfortappingintospecialistskills)oranyspecificaccountancyskillsorknowledgeyou’relookingfor.

Accountingtechnicians:Thesepeopleassistcharteredaccountantsintheirwork,orcanjoinacharteredinstitutethemselvesafterfurtherstudy.TheAssociationofAccountingTechnicians’website(www.aat.org.uk,thenclickon‘Employers’and‘Recruitment’)providesguidanceonpaystructuresandtipsonhowtofindanaccountant.

Bookkeepers:Thesearethelowest-costplayersinthisgame.Theyperformthebasicentryworkcoveringanythingfromsimplyrecordingthetransactionsinyourbooksthroughtoproducingaccounts,preparingtheVATreturnordoingthePayroll.TheInternationalAssociationofBookkeepers(www.iab.org.uk)andtheInstituteofCertifiedBookkeepers(www.bookkeepers.org)offerfreematchingservicestohelpsmallbusinessesfindabookkeepertosuittheirparticularneeds.

Continuingeducation:Manyshort-termcourses,e-learningandhome-studyprogrammesareavailableatveryreasonablecostsforkeepinguponthelatestaccountingdevelopments.Accountancybodiesthatgivepractisingcertificates,whichallowaccountantstoworkwithbusinessesinpublicpractice,willexpectthemtotakecontinuingeducationinapprovedcoursesinordertokeeptheirpractisingcertificates.

Integrity:What’spossiblythemostimportantqualitytolookforisalsothehardesttojudge.Bookkeepersandaccountantsneedtobehonestpeoplebecauseoftheamountofcontroltheyhaveoveryourbusiness’sfinancialrecords.

Protectthefamilyjewels:Internalcontrols

Protectthefamilyjewels:InternalcontrolsEveryaccountingsystemshouldestablishandvigorouslyenforceinternalcontrols–basically,additionalformsandproceduresoverandabovewhat’sstrictlyneededtomoveoperationsalong.Theseadditionalcontrolsservetodeteranddetecterrors(honestmistakes)andallformsofdishonestybyemployees,customers,suppliersandevenmanagersthemselves.Internalcontrolsarelikeapublicweighbridgethatmakessurethataheavygoodsvehicle’sloaddoesn’texceedthelimitsandthatthevehiclehasavalidlicence.You’rejustcheckingthatyourstaffareplayingbytherules.

Forexample,topreventorminimiseshoplifting,mostretailersnowhavevideosurveillance,tagsthatsetoffthealarmsifthecustomerleavesthestorewiththetagstillontheproduct,andsoon.Likewise,abusinesshastoimplementcertainproceduresandformstoprevent,asmuchaspossible,anytheft,embezzlement,scamsandfraud(andsimplemistakes)byitsownemployeesandmanagers.

Inourexperience,smallerbusinessestendtothinkthatthey’reimmunetoembezzlementandfraudbytheirloyalandtrustedemployees.Yetarecentstudyfoundthatsmallbusinessesarehitthehardestbyfraudandusuallycanleastaffordtheconsequences.Yourbusiness,too,shouldputchecksandbalancesintoplacetodiscouragedishonestpracticesandtouncoveranyfraudandtheftassoonaspossible.Forexample,virtuallyeveryretailerthatdealswiththegeneralpublicinstallsprotectionagainstshoplifting.Likewise,everybusinessshouldguardagainst‘internalshoplifting’orfraudbyitsemployeesandmanagers.

Keepthescalesinbalancewithdouble-entryaccounting

entryaccountingAbusinessneedstobesurethatbothsidesoftheeconomicexchangearerecordedforallitstransactions.Economicexchangesinvolveagiveandtake,orsomethinggivenforsomethingreceived.Businesses(andotherentitiesaswell)usethedouble-entryaccountingmethodtomakesurethatbothsidesoftheirtransactionsarerecordedandtokeeptheirbooksinbalance.Thismethod,whichhasbeenusedforhundredsofyears,involvesrecordingcertainchangesasdebitsandthecounterbalancingchangesascredits.See‘Double-EntryAccountingforNon-Accountants,’laterinthischapter,formoredetails.

Checkyourfigures:End-of-periodprocedureschecklist

Likeapilotbeforetake-off,anaccountantshouldhaveaclearchecklisttofollowattheendofeachperiodandespeciallyattheendoftheaccountingyear.Twomainthingshavetobedoneattheendoftheperiod:

Normal,routineadjustingentriesforcertainexpenses:Forexample,depreciationisn’tatransactionassuchandthereforehasn’tbeenrecordedasanexpenseintheflowoftransactionsrecordedintheday-to-daybookkeepingprocess.(Chapter6explainsdepreciationexpense.)Similarly,certainotherexpensesandsomerevenuesmaynothavebeenassociatedwithaspecifictransactionandwillnothavebeenrecorded.Thesekindsofadjustmentsarenecessaryforprovidingcompleteandaccuratereports.

Carefulsweepofallmatterstocheckforotherdevelopmentsthatmayaffecttheaccuracyoftheaccounts:

Forexample,thecompanymayhavediscontinuedaproductline.Theremainingstockoftheseproductsmayhavetoberemovedfromtheassetaccount,withalossrecordedintheperiod.Orthecompanymayhavesettledalong-standinglawsuit,andtheamountofdamagesneedstoberecorded.Layoffsandseverancepackagesareanotherexampleofwhatthechiefaccountantneedstolookforbeforepreparingreports.

Lestyoustillthinkofaccountingasdryanddull,letustellyouthatend-of-periodaccountingprocedurescanstirupcontroversyoftheheated-debatevariety.Theseproceduresrequirethattheaccountantmakedecisionsandjudgmentsthatuppermanagementmaynotagreewith.Forexample,theaccountantmaysuggestrecordingmajorlossesthatwouldputabigdentintheprofitfortheyearorcausethebusinesstoreportaloss.Theoutsideauditor(assumingthatthebusinesshasanauditofitsfinancialstatements)oftengetsinthemiddleoftheargument.Thesekindsofdebatesarepreciselywhyyoubusinessmanagersneedtoknowsomeaccounting:toholdupyourendoftheargumentandparticipateinthegreatsportofyellingandname-calling–strictlyonaprofessionalbasis,ofcourse.

Keepgoodrecords:Happyaudittrailstoyou!

Thehappytrailsthataccountantsliketowalkarecalledaudittrails.Goodbookkeepingsystemsleavegoodaudittrails.

Anaudittrailisaclear-cutpathofthesequenceofeventsleadinguptoanentryintheaccounts;anaccountantstartswiththesourcedocumentsandfollowsthroughthebookkeepingstepsinrecordingtransactionstoreconstructthispath.Evenifabusinessdoesn’thaveanoutsideaccountantdoanannualaudit,thefirm’smanagementaccountanthasfrequentoccasiontogobacktothesourcedocumentsandeitherverifycertaininformationintheaccountsorreconstructtheinformationinadifferentmanner.Forexample,supposethatasalespersonisclaimingsomesuspicious-lookingtravelexpenses;theaccountantwouldprobablywanttogothroughallthisperson’stravelandentertainmentreimbursementsforthepastyear.

IfHMRevenueandCustomscomesinforafieldauditofyourbusiness,you’dbetterhavegoodaudittrailstosubstantiateallyourexpensedeductionsandsalesrevenuefortheyear.Rulesexistaboutsavingsourcedocumentsforareasonableperiodoftime(usuallyatleastfiveyears)andhavingawell-definedprocessformakingbookkeepingentriesandkeepingaccounts.Thinktwicebeforethrowingawaysourcedocuments.Also,askyouraccountanttodemonstrate,andlayoutforyourinspection,theaudittrailsforkeytransactions–suchascashcollections,sales,cashdisbursements,stockpurchasesandsoon.Evenincomputer-basedaccountingsystems,theimportanceofaudittrailsisrecognised.Well-designedcomputerprogramsprovidetheabilitytobacktrackthroughthesequenceofstepsintherecordingofspecifictransactions.TheHMRevenueandCustomswebsite(gotowww.hmrc.gov.ukandclickon‘Businessesandcorporations’)givesyouthelowdownonwhichbookstokeepandforhowlong.Youcansearchforinfoaboutanyunlistedtopicsbyusingthesearchpanelatthetopofthehomepage.

LookoutforunusualeventsanddevelopmentsBusinessmanagersshouldencouragetheiraccountantstobealerttoanythingoutoftheordinarythatmayrequireattention.Supposethatthedebtorbalanceforaparticularcustomerisrapidlyincreasing–thatis,thecustomerisbuyingmoreandmorefromyourcompanyoncreditbutisn’tpayingforthesepurchasesquickly.Maybethecustomerhasswitchedmoreofhisorhercompany’spurchasestoyourbusinessandisbuyingmorefromyouonlybecauseheorsheisbuyinglessfromotherbusinesses.Butmaybethecustomerisplanningtostuffyourbusinessandtakeoffwithoutpayinghisorherdebts.Ormaybethecustomerissecretlyplanningtogointobankruptcysoonandisstockpilingproductsbeforethecompany’screditratingheadssouth.Tosomeextent,accountantshavetoactastheeyesandearsofthebusiness.Ofcourse,that’soneofyourmainfunctionsasbusinessmanager,butyouraccountingstaffcanplayanimportantroleaswell.

DesigntrulyusefulaccountingreportsformanagersWehavetobecarefulinthissection;wehavestrongopinionsonthismatter.Wehaveseentoomanyhit-and-missaccountingreportstomanagers–difficulttodecipherandnotveryusefulorrelevanttothemanager’sdecision-makingneedsandcontrolfunctions.

Partoftheproblemlieswiththemanagersthemselves.Asabusinessmanager,haveyoutoldyouraccountingstaffwhatyouneedtoknow,whenyouneedit,andhowtopresentitinthemostefficientmanner?Probablynot.Whenyousteppedintoyourpositionyouprobablydidn’thesitatetorearrangeyourofficeandmaybeeveninsistedonhiringyourownsupportstaff.Yetyoumostlikelylaydownlikealapdogregardingyouraccountingreports.Maybeyou’veassumedthatthereportshavetobedoneacertainwayandthatarguingforchangeisnouse.

wayandthatarguingforchangeisnouse.

Ontheotherhand,accountantsbearagoodshareoftheblameforthepoorreports.Accountantsshouldproactivelystudythemanager’sdecision-makingresponsibilitiesandprovidetheinformationthatismostuseful,presentedinthemosteasilydigestiblemanner.

Indesigningthechartofaccounts,theaccountantshouldalsokeepinmindthetypeofinformationneededformanagementreports.Toexercisecontrol,managersneedmuchmoredetailthanwhat’sreportedontaxreturnsandexternalfinancialstatements.And,asChapter9explains,expensesshouldberegroupedintodifferentcategoriesformanagementdecision-makinganalysis.Agoodchartofaccountslookstoboththeexternalandtheinternal(management)needsforinformation.

Sowhat’stheanswerforamanagerwhoreceivespoorlyformattedreports?Demandareportformatthatsuitsyourneeds!SeeChapter9forausefulprofitanalysismodel(andmakesurethatyouraccountantreadsthatchapteraswell).

Double-EntryAccountingforNon-Accountants

Abusinessisatwo-sidedentity.Itaccumulatesassetsononeside–byborrowingmoney,persuadinginvestorstoputmoneyinthebusinessasowners,purchasingassetsoncreditandmakingprofit.Profit(netincome)isessentiallyanincreaseinassets,notfromincreasingliabilitiesandnotfromadditionalcapitalinfusionfromowners,butratherasthenetresultofsalesrevenuelessexpenses.

Assetsdon’tfallonabusinesslikemannafromheaven.Assetshavesources,andthesesourcesareclaimsofonesortoranotherontheassetsofabusiness.Abusinessneedstokeeptrackofthesourcesofassets,accordingtothetypeofclaimeachsourcehasagainsttheassets.Thisispreciselythereasonforandnatureofdouble-entryaccounting.

Thetwo-sidednatureofabusinessentityanditsactivitiesInanutshell,double-entryaccountingmeanstwo-sidedaccounting.Boththeassetsofabusinessandthesourcesofandclaimsonitsassetsareaccountedfor.Supposethatabusinessreports£10millionintotalassets.Thatmeansthetotalsourcesofandclaimsonitsassetsarealsoreportedatatotalof£10million.Eachassetsourcehasadifferenttypeofclaim.Someliabilitieschargeinterestandsomedon’t;somehavetobepaidsoon,andotherloanstothebusinessmaynotcomedueforfiveortenyears.Owners’equitymaybemainlyfromcapitalinvestedbytheownersandverylittlefromretainedearnings(profitnotdistributedtotheowners).Orthemixofowners’equitysourcesmaybejustthereverse.

Thesourcesofandclaimsontheassetsofabusinessfallintotwobroadcategories:liabilitiesandowners’equity.Withafewtechnicalexceptionsthatwewon’tgointo,theamountofliabilitiesthatthebusinessreportsaretheamountsthatwillbepaidtothecreditorsatthematuritydatesoftheliabilities.Inotherwords,theamountsofliabilitiesaredefiniteamountstobepaidatcertainfuturedates.

Incontrast,theamountsreportedforowners’equityarehistoricalamounts,basedonhowmuchcapitaltheownersinvestedinthebusinessinthepastandhowmuchprofitthebusinesshasrecorded.Owners’equity,unliketheliabilitiesofabusiness,hasnomaturitydateatwhichtimethemoneyhastobereturnedtotheowners.Whenlookingattheamountofowners’equityreportedinabalancesheet,don’tthinkthatthisamountcouldbetakenoutofthe

business.Owners’equityistiedupinthebusinessindefinitely.

Soonereasonfordouble-entryaccountingisthetwo-sidednatureofabusinessentity–assetsareononesideandthesourcesofandclaimsonassetsareontheotherside.Thesecondreasonfordouble-entryaccountingistheeconomicexchangenatureofbusinessactivities,referringtothegive-and-receivenatureofthetransactionsthatabusinessengagesintopursueitsfinancialobjectives.Considerafewtypicaltransactions:

Abusinessborrows£10million.Itreceivesmoney,sothecompany’scashincreases.Inexchange,thebusinesspromisestoreturnthe£10milliontothelenderatsomefuturedatesothecompany’sdebtincreases.Interestontheloanispaidinexchangefortheuseofthemoneyovertime.

Thebusinessbuysproductsthatitwilllaterreselltoitscustomers:Itgivesmoneyfortheproducts(thecompany’scashdecreases)andreceivestheproducts(thecompany’sstockincreases).

Thebusinesssellsproducts:Itreceivescashorpromisesofcashtocomelater(thecompany’sdebtorsincrease),anditgivestheproductstothecustomer(thecompany’sstockdecreases).Ofcourse,thebusinessshouldselltheproductsformorethancost.Theexcessoftheamountreceivedoverproductcostiscalledgrossprofit,fromwhichmanyotherexpenseshavetobededucted.(Chapter5explainstheprofit-makingtransactionsleadingtobottom-lineprofitorloss.)

Recordingtransactionsusingdebitsandcredits

Usingdebitsandcreditsisamarvelloustechniqueformakingsurethatbothsidesofexchangesarerecordedandforkeepingbothsidesoftheaccountingequationinbalance.Therecordingofeverytransactionrequiresthesamevalueforthedebitsononesideandthecreditsontheotherside.Justthinkbacktomathsclassinyourschooldays:Whatyouhaveononesideoftheequalsign(inthiscase,intheaccountingequation)mustequalwhatyouhaveontheothersideoftheequalsign.

Seethetableforhowdebitsandcreditsworkinthebalancesheetaccountsofabusiness.Therulesofdebitsandcredits:

Note:Salesrevenueandexpenseaccounts,whicharen’tlisted,alsofollowdebitandcreditrules.Arevenueitemincreasesowners’equity(thusisacredit),andanexpenseitemdecreasesowners’equity(thusisadebit).

Asabusinessmanager,youdon’tneedtoknowallthemechanicsandtechnicalaspectsofusingdebitsandcredits.Here’swhatyoudoneedtoknow:

Thebasicpremiseoftheaccountingequation:Assetsequalthesourcesoftheassetsandtheclaimsontheassets.Thatis,thetotalofassetsontheonesideshouldequalthesumoftotalliabilitiesandtotalowners’equityontheotherside.

Theimportantdifferencebetweenliabilitiesandowners’equityaccounts:Liabilitiesneedtobepaidoffatdefiniteduedatesinthefuture.Owners’equityhasnosuchclaimsfordefinitepaymentsatdefinitedates.Assuch,thesetwoaccountsmustbekeptseparate.

Balancedbooksdon’tnecessarilymeancorrectbalances:Ifdebitsequalcredits,theentryforthetransactioniscorrectasfarasrecordingequalamountsonbothsidesofthetransaction.However,evenifthedebitsequalthecredits,othererrorsarepossible.Thebookkeepermayhaverecordedthedebitsandcreditsinawrongaccount,ormayhaveenteredwrongamounts,ormayhavemissedrecordinganentryaltogether.Havingbalancedbookssimplymeansthatthetotalofaccountswithdebitbalancesequalsthetotalofaccountswithcreditbalances.Theimportantthingiswhetherthebooks(theaccounts)havecorrectbalances,whichdependsonwhetheralltransactionsandotherdevelopmentshavebeenrecordedandaccountedforcorrectly.

MakingSuretheBooksDon’tGetCooked

Cookedisacatch-allterm;we’reusingtheterminitsbroadestsensetoincludeanytypeofdishonest,unethical,immoralorillegalpractice.Ourconcernhereiswiththeeffectsofdistortiononabusiness’saccountingrecords,notwiththebroadersocialandcriminalaspectsoffraudulentaccounting–whichareveryserious,ofcourse,butwhichareoutsidethescopeofthisbook.

Abusinessshouldcaptureandrecordfaithfullyalltransactionsinitsaccountingrecords.Havingsaidthis,wehavetoadmitthatsomebusinessactivitiesaredeliberatelynotaccountedfororareaccountedforinawaythatdisguisestheirtruenature.Forexample,moneylaunderinginvolvestakingmoneyfromillegalsources(suchasdrugdealing)andpassingitthroughabusinesstomakeitlooklegitimate–togivethemoneyafalseidentity.Thismoneycanhardlyberecordedas‘revenuefromdrugsales’intheaccountsofthebusiness.

Fraudoccursinlargecorporationsandinone-owner/manager-controlledsmallbusinesses–andeverysizebusinessinbetween.Sometypesoffraudaremorecommoninsmallbusinesses,includingsalesskimming(notrecordingallsalesrevenue,todeflatethetaxableincomeofthebusinessanditsowner)andtherecordingofpersonalexpensesthroughthebusiness(tomaketheseexpensesdeductibleforincometax).Somekindsoffraudarecommittedmainlybylargebusinesses,includingpayingbribestopublicofficialsandenteringintoillegalconspiraciestofixpricesordividethemarket.Thepurchasingmanagersinanysizebusinesscanbetemptedtoacceptkickbacksandunder-the-tablepayoffsfromvendorsandsuppliers.

Weshouldmentionanotherproblemthatputsaccountantsinthehotseat:Inmanysituations,twoormorebusinessesarecontrolledbythesamepersonorthesamegroupofinvestors.Revenueandexpensescanbearbitrarilyshiftedamongthedifferentbusinessentitiesundercommoncontrol.Foronepersontohaveacontrollingownershipinterestintwoormorebusinessesisperfectlylegal,andsuchan

arrangementoftenmakesgoodbusinesssense.Forexample,aretailbusinessrentsabuildingfromapropertybusiness,andthesamepersonisthemajorityownerofbothbusinesses.Theproblemariseswhenthatpersonarbitrarilysetsthemonthlyrenttoshiftprofitbetweenthetwobusinesses;ahighrentgeneratesmoreprofitforthepropertybusinessandlowerprofitfortheretailbusiness.Thiskindofmanoeuvremayevenbeperfectlylegal,butitraisesafundamentalaccountingissue.

Readersoffinancialstatementsareentitledtoassumethatallactivitiesbetweenthebusinessandtheotherpartiesitdealswitharebasedonwhat’scalledarm’s-lengthbargaining,meaningthatthebusinessandtheotherpartieshaveapurelybusinessrelationship.Whenthat’snotthecase,thefinancialreportshould–butusuallydoesn’t–usethetermrelatedpartiestodescribepersonsandorganisationswhoarenotatarm’slengthwiththebusiness.Accordingtofinancialreportingstandards,youraccountantshouldadviseyou,thebusinessmanager,todiscloseanysubstantialrelated-partytransactionsinyourexternalfinancialstatements.

Inshort,fraudoccursinthebusinessworld.Mostoftheseschemesrequirecookingthebooks–whichmeansalteringentriesintheaccountstocoverthefraudorsimplynotrecordingcertainentriesthatshouldberecorded.Ifyousawanexpenseaccountcalledbribes,youwouldtendtobealittlesuspicious,butunethicalbookkeepersandaccountantsareusuallyatadclevererthanthat.Youcanfindseveraltipsonuncoveringandpreventingfraudin‘ManagingtheBookkeepingandAccountingSystem’earlierinthischapter.

Whenthebookshavebeencooked,thefinancialstatementspreparedfromtheaccountsaredistorted,incorrectandprobablymisleading.Lenders,othercreditorsandtheownerswhohavecapitalinvestedinthebusinessrelyonthecompany’sfinancialstatements.Also,abusiness’smanagersandboardofdirectors(thegroupofpeoplewhooverseeabusinessenterprise)maybemisled–assumingthatthey’renotapartytothefraud,ofcourse–andmayalsohaveliabilitytothird-partycreditorsandinvestorsfortheirfailuretocatchthefraud.Creditorsandinvestorswhoendupsufferinglosseshavelegalgroundstosuethemanagersanddirectors(andperhapstheauditorswhodidnotcatchthefraud)fordamagessuffered.

TheSarbanes-OxleyAct,anewsetofrulesandregulationsdesignedtoensuretruthfulaccountingincompanieslistedontheAmericanstockmarket,cameintoforcein2002.Chapter1givesyouinformationaboutSarbanes-Oxley.

Chapter3

Taxes,TaxesandMoreTaxes

InThisChapterPayingtaxesasanemployerandapropertyowner

PuttingonyourtaxcollectorhatandcollectingValueAddedTax(VAT)

Determininghowmuchofbusinessprofitgoestothegovernment

Allowingcompanytaxmethodstooverridegoodaccountingmethods

Lookingatthedifferentwayscompanytaxworksfordifferentbusinessstructures

Asanemployer,abusinesspaystaxes.Asapropertyowneroroccupier,abusinesspaystaxes.Asasellerofgoodsandservices,abusinesscollectsValueAddedTaxpaidbycustomersandremitstheamountstothegovernment’sCustomsandExciseDepartment.And,ofcourse,abusiness,oritsowners,mustpaycorporateincometax.Yikes!Istherenoescapingthetaxmillstone?

Nope,afraidnot(shortofresortingtoillegalactivityoraslymovetoanothercountry–you’llhavetofindanotherbooktotellyouaboutthoseoptions).Butyoucantakeadvantageofthemanyoptionsintaxlawsthatcanminimisehowmuchyoupayanddelayyourpayment(aperfectlylegalstrategyknownastaxavoidance).Thischapterstartsyouonyourwaybyexplainingthevarioustypesoftaxationthatabusinessfaces.

Wesaythatthischapter‘startsyouonyourway’becausewecan’t

possiblyprovideyouwithexhaustivedetailinonechapter.Andbesides,noonecangiveyougoodtaxadvicewithoutfirstlookingatyourspecificsituation–consultaprofessionaltaxexpertforthat.

TaxingWagesandPropertyEvenifyoudon’tearnaprofitinyourbusiness,youstillhavetopaycertaintaxes.Unlikecorporationtax,whichisacontingentorconditionaltaxthatdependsonwhetherabusinessearnstaxableincomefortheyear,thetwomajortypesofnon-incometaxes–employerpayrolltaxesandbusinessrates–alwayshavetobepaid.(See‘TaxingYourBottomLine:CompanyTaxes,’laterinthischapter,formoreaboutincometax.)

Puttingthegovernmentonthepayroll:EmployertaxesInadditiontodeductingincometaxfromemployees’wagesandremittingthoseamountstothepropergovernmentagencies,businessesneedtopayNationalInsuranceforallemployees,yourselfincluded.(Actually,NationalInsuranceisn’treallyatax,butwewon’tgettechnical.)

NationalInsurance

Mostpeopledon’trealisethattheyusuallypaylessthanhalfoftheirNationalInsurancebill–theemployerpicksuptherestofthetab.Theideaisthattheburdenshouldbesharedalmostevenly,butwiththeemployergenerallypickingupalittlemoreofthetab.

Wedon’twanttogetintoadebateabouttheNationalInsurancesystemandthefinancialproblemsit’sfacing;we’lljustsaythattheamountyou’llpayinNationalInsurancealmostcertainlywon’tdiminishinthefuture.Here’sanideaofwhatabusinesspaysinNationalInsurance:In20011/12,thefirst£5,315ofannualwageswereexemptfromanyNationalInsurancecharges.Then,uptoaceilingof£42,475,theemployerpays13.8percent.

Employmenttax

EmployingpeoplerequiresyoutomanageaPAYE(PayAsYouEarn)system.Ifyourbusinessisalimitedcompany,theowner(you)isalsoliableforPAYE.YouwillalsohavetodeductNationalInsurance.Boththesetaskswillinvolvesomeadditionalrecordkeeping,as,onceagain,owner-managersarebeingaskedtoactasunpaidtaxcollectors.Thereareseriouspenaltiesforgettingitwrong.

PAYE

IncometaxiscollectedfromemployeesthroughthePAYEsystem,orPayAsYouEarn.Theemployee’sliabilitytoincometaxiscollectedasitisearnedinsteadofbytaxassessmentatsomelaterdate.Ifthebusinessisrunasalimitedcompany,thenthedirectorsofthecompanyareemployees.PAYEmustbeoperatedonallsalariesandbonusespaidtothem,yourselfincluded.

Thewaytoanemployee’sheartisthroughthepayrolldepartment

Rememberthefirsttimeyoureceivedarealpaycheque?Yourjawdroppedwhenyoucomparedthegrosswages(theamountbeforedeductions)andthenet,ortake-homepay(theamountyouactuallyreceived),right?Abusiness’saccountantsneedtotrackhowmuchofthefollowing,bylaw,todeductfromemployees’paycheques:

NationalInsurance.

PayAsYouEarn(PAYE)taxesonincome,whichgototheGovernment.

Other,non-tax-relatedwithholdingsthattheemployeeagreesto(suchasuniondues,pensionplancontributions,andhealthinsurancecostspaidbytheemployee).

Othernon-tax-relatedwithholdingsrequiredbyacourtorder(forexample,abusinessmaybeorderedtowithholdpartorallofanemployee’swagesandremittheamounttoalegalagencyoracreditortowhichtheemployeeowesmoney).

Forallthesedeductions,abusinessservesasacollectionagentandremitstheappropriateamountofwagestotheappropriateparty.Asyoucanimagine,thistaskrequireslotsofadditionalaccountingandrecord-keeping.

HMRevenueandCustomsnowissuesbookletsinreasonablyplainEnglishexplaininghowPAYEworks.ThemaindocumentsyouneedtooperatePAYEare:

FormP11,adeductionworkingsheetforeachemployee.

ThePAYETables.Therearetwobooksoftaxtablesingeneraluse,whichareupdatedinlinewiththeprevailingtaxrates.

•PayAdjustmentTablesshowtheamountthatanemployeecanearninanyparticularweekormonthbeforethepaymentoftax.

•TaxablePayTablesshowthetaxdueonanemployee’staxablepay.

FormP45,whichisgiventoanemployeewhentransferringfromoneemploymenttoanother.

FormP46,whichisusedwhenanewemployeedoesnothaveaP45fromapreviousemployment(forexample,aschool-leaverstartingworkforthefirsttime).

FormP60,whichisusedsothattheemployercancertifyanemployee’spayattheendoftheincometaxyearinApril.

FormP35,theyear-enddeclarationandcertificate.ThisisusedtosummariseallthetaxandNationalInsurancedeductionsfromemployeesforthetaxyear.

FormP6,thetaxcodesadvicenoticeissuedbytheInspectorofTaxestellingyouwhichtaxcodenumbertouseforeachemployee.

YoucanfindtablesgivingdetailsofPAYEandNICratesandlimitsforthecurrenttaxyear,foreveryconceivablecategory,attheHMRevenueandCustomswebsite(www.hmrc.gov.uk/employers/).

Taxingeverythingyoucanputyourhandson:PropertytaxesBusinessesandotheroccupiersofnon-domesticpropertiespayNon-DomesticRates(alsoknownasBusinessRates)todirectlycontributetowardsthecostsoflocalauthorityservices.Non-

contributetowardsthecostsoflocalauthorityservices.Non-domesticpropertiesarebusinesspropertiessuchasshops,offices,warehousesandfactories,andanyotherpropertythatisnotclassedasdomesticproperty.Insomecases,propertiesmaybeusedforbothdomesticandnon-domesticpurposes(forexample,ashopwithaflataboveit),inwhichcasebothcounciltax,thetaxchargedonpersonalproperties,andBusinessRateswillbecharged.

Apartfromthefewluckypropertiessuchaschurches,agriculturalland,sewers,publicparks,certainpropertyusedfordisabledpeople,andswingingmooringsforboats,whichareallexemptfromBusinessRates,eachnon-domesticpropertyhasarateablevalue.ThevaluationofficersoftheValuationOfficeAgency(VOA)settherateablevalues.TheVOAisapartofHMRevenueandCustoms.Itdrawsupandmaintainsafulllistofallrateablevalues.

TheValuationOfficeAgencycarriesoutarevaluationeveryfiveyearssothatthevaluesintheratinglistscanbekeptup-to-date.ThetotalamountofBusinessRatescollecteddoesnotchangeexcepttoreflectinflation,butrevaluationsmakesurethatthisisspreadfairlybetweenratepayers.ThemostrecentrevaluationtookplaceinApril2005.

Therateablevaluebroadlyrepresentstheyearlyrentthepropertycouldhavebeenletforontheopenmarketonaparticulardate.YourlocalcouncilworksoutyourBusinessRatesbillbymultiplyingyourrateablevaluebythemultiplieror‘poundage’whichtheGovernmentsetsfrom1AprileachyearforthewholeofEngland.Forexample,ifthemultiplier(whichisoftencalledtheuniformbusinessrateorUBR)wassetat43.3p(43.7inCentralLondon)andyourrateablevaluewas£10,000,thelocalauthoritywouldmultiplythisby43.3pandyour‘propertytax’billfortheyearwouldbe£4,330.

Yourpropertymayqualifyforexemptionundervarious

nationalandlocalregulationsormaybeeligibleforspecialreductions.

Youmaybeabletogetreliefifoneofthefollowingappliestoyou:

Yourbusinessissmall.AUBRof42.6pappliestocertainbusinesseswithrateablevaluesbelow£6,000.Therulesarecomplexandoperateonaslidingscale.

Yourpropertyisemptyandunused.Forthefirstthreemonthsthatabusinesspropertyisempty,councilsdon’tchargeBusinessRatesfortheproperty.Forindustrialandwarehousepropertytherate-freeperiodissixmonths.Afterthis,a100percentbusinessratechargeusuallyapplies.

Yourbusinessisinaruralvillagewithapopulationbelow3,000.Thetypesofbusinessthatqualifyforthisreliefare:

•Theonlyvillagegeneralstoreorpostofficeaslongasithasarateablevalueofupto£8,500.

•Afoodshopwitharateablevalueofupto£8,500.

•Theonlyvillagepubandtheonlypetrolstationaslongasithasarateablevalueofupto£12,500.

Thesepremisesareentitledtoa50percentreductionintheBusinessRatesbill,ormoreifthecouncilbelievesyouneedit.

Ifyouareabusinessinaqualifyingruralvillagewitharateablevalueofupto£16,500,yourlocalcouncilmaydecidetogiveyouupto100percentrelief,aslongasyourbusinessisofbenefittothecommunity.

YouaresufferingseverehardshipandcannotpayyourBusinessRatesbill.Yourlocalcouncilmaydecidetogiveyouupto100percentrelief–thedecisionisuptothem.Theynormallyonlydothisinextremecasesofhardshipandforbusinessesthatareparticularlyimportanttothelocalcommunity.Thistakesaccountofthefactthatlocalcouncil

taxpayerswillcoverpartofthecostoftherelief.

Ifyouthinkyoumayqualifyforanyofthesetypesofrelief,youshouldcontacttheBusinessRatessectionofyourlocalcouncilformoreinformationandadviceonhowtoapply.

Workingfromhome

Ifyouworkfromhome,yourlocalcouncilmaychargeBusinessRatesforthepartofthepropertyusedforwork,andyouwillhavetopaycounciltaxfortherestoftheproperty(althoughyourproperty’svaluationbandmaychange).ItwilldependonthecircumstancesofeachcaseandyoushouldaskyourlocalofficeoftheValuationOfficeAgencyforadvice.

Propertytaxescantakeabigchunkoutofabusiness’sprofit.Inlargeorganisations,anin-houseaccountantwhodealswithpropertytaxesandknowsthetaxlawlanguageandmethodsisresponsiblefordevelopingstrategiestominimisepropertytaxes.Small-businessownersmaywanttoconsultaratingadviser.MembersoftheRoyalInstitutionofCharteredSurveyors(RICS)andtheInstituteofRevenuesRatingandValuation(IRRV)arequalifiedandareregulatedbyrulesofprofessionalconductdesignedtoprotectthepublicfrommisconduct.

Youcanfinddetailsoftheseorganisationsandtheirmembersontheirwebsites:

RICS–www.rics.org

IRRV–www.irrv.org.uk

YoucanfindthelatestinformationonbusinessratesontheofficialGovernmentwebsiteatwww.businesslink.gov.uk.

Beforeyouemployaratingadviser,youshouldcheckthattheyhavethenecessaryknowledgeandexpertise,aswellasappropriateindemnityinsurance.Youshouldalsobewaryoffalseormisleadingclaims.

GettingtoGripswithValueAddedTax

Mostgovernments,andtheUKGovernmentisnoexception,levysalestaxesoncertainproductsandservicessoldwithintheirjurisdictions.IntheUKthistaxisknownastheValueAddedTax(VAT).ThefinalconsumeroftheproductorservicepaystheVAT–inotherwordsthetaxistackedontotheproduct’spricetagattheveryendoftheeconomicchain.ThebusinessthatissellingtheproductorservicecollectstheVATandremitsittotheappropriatetaxagency(HMRevenueandCustomsintheUK).Businessesthatoperateearlierintheeconomicchain(thatis,thosethatsellproductstootherbusinessesthatinturnreselltheproducts)generallydonotenduppayingVATbutsimplycollectitandpassiton.

Forexample,whenyouruntoyourlocalchemistforsomeheadachepillsafterallthistaxbusiness,youpaythechemistthecostofthepillsplusVAT.ButthechemistcanreclaimtheVATitpaidtothewholesaler(andsoon,backalongtheretailchain).Onlyyou,thefinalconsumer,paystheVAT.(Luckyyou!)

VATisacomplicatedtax.Currently,youmustregisterifyourtaxableturnover,thatis,sales(notprofit),exceeds£73,000inany12-monthperiod,orlooksasthoughitmightreasonablybeexpectedtodoso.Thisrateisreviewedeachyearinthebudgetandisfrequentlychanged.(TheUKissignificantlyoutoflinewithmanyothercountriesinEurope,whereVATentryratesaremuchlower.)Thegeneralruleisthatallsuppliesofgoodsandservicesaretaxableatthestandardrate(20percent)unlesstheyarespecificallystatedbythelawtobezero-ratedorexempt.Indecidingwhetheryourturnoverexceedsthelimityouhavetoincludethezero-ratedsales(thingslikemostfoods,booksandchildren’sclothing),astheyaretechnicallytaxable;it’sjustthattherateoftaxis0percent.Youleaveoutexemptitems.Asadesignatedtaxcollector,thebusinessdoesnotpayVATongoodsandservicesitbuysfromotherVATregisteredbusinessesthataredestinedtobesoldtoitscustomers.

Ifyouareasmallbusinessowner/manager,beawarethatifyouoverlookthisroleimposedonthebusinessbythegovernment,you’restillresponsibleforpayingthetaxovertothegovernment.Supposeyoumakeasalefor£100butdon’taddthe£20.00VAT,whichistheratecurrentlyapplyingintheUK.BigBrothersaysyoudidcollecttheVAT,whetheryouthinkyoudidornot.SoyoustillhavetopaythegovernmenttheVATelementinthe£100(£16.67),whichleavesyouwithonly£83.33insalesrevenue.

TherearethreefreebookletsissuedbyHMRevenueandCustoms:asimpleintroductorybookletcalledShouldyouberegisteredforVAT?andtwomoredetailedbookletscalledGeneralGuideandScopeandCoverage.Ifindoubt(andthelanguageisnoteasytounderstand)askyouraccountantorthelocalbranchofHMRevenueandCustoms;afterall,theywouldratherhelpyoutogetitrightinthefirstplacethanhavetosortitoutlaterwhenyouhavemadeamess

ofit.

Eachquarter,youhavetocompleteareturn,whichshowsyourpurchasesandtheVATyoupaidonthem,andyoursalesandtheVATyoucollectedonthem.TheVATpaidandcollectedareoffsetagainsteachotherandthebalancesenttoHMRevenueandCustoms.IfyouhavepaidmoreVATinanyquarterthanyouhavecollected,youwillgetarefund.Forthisreasonitsometimespaystoregisterifyoudon’thaveto–ifyou’resellingmostlyzero-rateditemsforexample;also,beingregisteredforVATmaymakeyourbusinesslookmoreprofessionalandlessamateurishtoyourpotentialcustomers.

TrackingandrecordingValueAddedTaxisabigresponsibilityformanybusinesses,especiallyifthebusinessoperatesacrossseveralEuropeancountries.Havingwell-trainedaccountingstaffmanagethissideofthebusinessiswellworththecost.YoucanchecktheHMRevenueandCustomswebsiteforthelatestrules(gotowww.hmrc.gov.ukandclickon‘VAT’).

YoucanfindausefulVATcalculatoronthesmallbusinessportalwww.bytestart.co.uk.Clickon‘TaxandAccounting’andthenon‘VATCalculator’.

TaxingYourBottomLine:CompanyTaxes

Thischapterfocusesonthetaxdimensionsofbusinessentities.Chapter4presentsabasicincometaxmodelforindividuals(seethesection‘TheAccountingViceYouCan’tEscape’).

Everybusinessmustdetermineitsannualtaxableincome,whichistheamountofprofitsubjecttocorporatetaxorincometaxifthebusinessisnotalimitedcompany.Todetermineannualtaxableincome,youdeductcertainallowedexpensesfromgrossincome.Corporationtaxlawrestsveryroughlyonthepremisethatallincomeistaxableunlessexpresslyexempted,andnothingcanbedeductedunlessexpresslyallowed.

Whenyoureadaprofit-and-lossaccountthatsummarisesabusiness’ssalesrevenueandexpensesforaperiodandendswithbottom-lineprofit,keepinmindthattheaccrualbasisofaccountinghasbeenusedtorecordsalesrevenueandexpenses.Theaccrualbasisgivesamoretrustworthyandmeaningfulprofitnumber.Butaccrual-basedsalesrevenueandexpensenumbersarenotcashinflowsandoutflowsduringtheperiod.Sothebottom-lineprofitdoesnottellyoutheimpactoncashfromtheprofit-makingactivitiesofthebusiness.Youhavetoconverttherevenueandexpenseamountsreportedintheprofit-and-lossaccounttoacashbasisinordertodeterminethenetcashincreaseordecrease.Well,actually,youdon’thavetodothis–thecashflowstatementdoesthisforyou,asChapter7explains.

Althoughyoudetermineyourbusiness’staxableincomeasanannualamount,youdon’twaituntilyoufileyourtaxreturntomakethatcalculationandpayment.Instead,corporationtaxlawrequiresyoutoestimateyourcorporationincometaxfortheyearand,basedonyourestimate,tomaketwohalf-yearlyinstalmentpaymentsonyourcorporationtaxduringtheyear,oneattheendofJanuaryandoneattheendofJuly.Ratherthancalculatingthetaxdueyourself,

oneattheendofJuly.Ratherthancalculatingthetaxdueyourself,youcanrelyonHMRevenueandCustomstodothesumsforyouifyousendinacompletedtaxreturnbeforethe30Septemberfortheyearinquestion.Whenyoufilethefinaltaxreturn–withtheofficial,ratherthantheestimated,taxableincomeamount–afterthecloseoftheyear,youpayanyremainingamountoftaxyouoweorclaimarefundifyouhaveoverpaidyourcorporationtaxduringtheyear.Ifyougrosslyunderestimateyourtaxableincomefortheyearandthusenduphavingtopayalargeamountoftaxaftertheendoftheyear,youprobablywillowealatepaymentpenalty.Afteryourfirstyearinbusiness,thetaxyouhavetopaywillbebasedonyourprofitsfortheprevioustaxyear.Ataxyearrunsfrom6Aprilto5April.

AwordoncashbasisaccountingforValueAddedTax

Cashbasisaccounting(alsoknownaschequebookaccounting)isn’tgenerallyacceptableintheworldofbusiness,butispermittedbyValueAddedTaxlawforsomebusinesses.TousecashbasisVATaccounting,abusinessmustkeepthesefactorsinmind:

Cashaccountingisopentoyouifyouarearegisteredtraderwithanexpectedturnovernotexceeding£1,350,000inthenext12months.Thereisa25percenttolerancebuiltintothescheme.Thismeansthatonceyouareusingcashaccounting,youcannormallycontinuetouseituntiltheannualvalueofyourtaxablesuppliesreaches£1,600,000.

Themainaccountingrecordyoumustkeepwillbeacashbooksummarisingallpaymentsmadeandreceived,withaseparatecolumnfortherelevantVAT.Youwillalsoneedtokeepthecorrespondingtaxinvoicesandensurethatthereisasatisfactorysystemofcross-referencing.

TheseVATrecordsmustbekeptforsixyears,unlessyouhaveagreeduponashorterperiodwithyourlocalVAToffice.

Thelongerthetimelagbetweenyourissuingsalesinvoicesand

receivingpaymentfromyourcustomers,themorebenefitcashaccountingislikelytobetoyou.Ifyouareusuallypaidassoonasyoumakeasale(e.g.ifyouusearetailscheme)youwillnormallybeworseoffundercashaccounting.Thesameappliestothesituationwhereyouregularlyreceivere-paymentsofVAT(e.g.becauseyoumakezero-ratedsupplies).

Onemajoradvantageoftheschemeisthatitsimplifiesyourbookkeepingrequirements,andmanybusinessescanbecontrolledsimplybyusinganappropriatelyanalysedcashbook.

Forthegreatmajorityofbusinesses,cashbasisaccountingisnotacceptable,eitherforreportingtoHMRevenueandCustomsorforpreparingfinancialstatements.Sothislastadvantageofcash-basedVATaccountingisillusory.Thismethodfallsshortoftheinformationneededforevenarelativelysmallbusiness.Accrualbasisaccounting,describedinChapters5and6,istheonlyrealoptionformostbusinesses.Evensmallbusinessesthatdon’tsellproductsshouldcarefullyconsiderwhethercashbasisisadequatefor:

Preparingexternalfinancialstatementsforborrowingmoneyandreportingtoowners.

Dividingprofitamongowners.

Forallpracticalpurposes,onlysoleproprietorships(one-ownerbusinesses)thatselljustservicesandnoproductscanusecashbasisVATaccounting.Otherbusinessesmustusetheaccrualbasis–whichprovidesamuchbetterincomestatementformanagementcontrolanddecision-making,andamuchmorecompletepictureofthebusiness’sfinancialcondition.

Youmustkeepadequateaccountingrecordstodetermineyourbusiness’sannualtaxableincome.Ifyoureportthewrongtaxableincomeamount,youcan’tpleadthatthebookkeeperwasincompetentorthatyouraccountingrecords

wereinadequateorpoorlyorganised–infact,thegoodoldtaxmanmaydecidethatyourpooraccountingwasintentionalandisevidenceofincometaxevasion.Ifyouunder-reportyourtaxableincomebytoomuch,youmayhavetopayinterestandpenaltiesinadditiontothetaxthatyouowe.

Whenwetalkaboutadequateaccountingrecords,we’renottalkingabouttheaccountingmethodsthatyouselecttodetermineannualtaxableincome–Chapter13discusseschoosingamongalternativeaccountingmethodsforcertainexpenses.Afteryou’veselectedwhichaccountingmethodsyou’llusefortheseexpenses,yourbookkeepingproceduresmustfollowthesemethodsfaithfully.Choosetheaccountingmethodsthatminimiseyourcurrentyear’staxableincome–butmakesurethatyourbookkeepingisdoneaccuratelyandontimeandthatyouraccountingrecordsarecomplete.Ifyourbusiness’sincometaxreturnisaudited,HMRevenueandCustomsagentsfirstlookatyouraccountingrecordsandbookkeepingsystem.

Furthermore,youmuststandreadytopresentevidenceforexpensedeductions.Besuretoholdontoreceiptsandotherrelevantdocuments.InanHMRevenueandCustomsaudit,theburdenofproofisonyou.HMRevenueandCustomsdon’thavetodisproveadeduction;youhavetoprovethatyouwereentitledtothededuction.Noevidence,nodeductionistheruletokeepinmind.

Thefollowingsectionspaintaroughsketchofthemaintopicsofbusinessincometaxation.(Wedon’tgointothemanytechnicaldetailsofdeterminingtaxableincome,however.)

DifferenttaxratesondifferentlevelsofbusinesstaxableincomePersonaltaxes,whichapplytosoletradersandpartnerships,comeonaslidingscaleuptoamaximumof40percent.Whentradingasacompanyabusiness’sannualtaxableincomeisn’ttaxedataflatrateeither.Inwritingtheincometaxlaw,thegovernmentgavethelittle

either.Inwritingtheincometaxlaw,thegovernmentgavethelittleguyabreak.Asof2011,thecorporateincometaxratestartsat20percentonthefirst£300,000oftaxableincome,thenquicklymovesuptoa26percentrateontaxableincomeintherangeof£300,001to£1,500,000,afterwhichitdropsbackto20percent.Simpleitain’t!Theincometaxonthetaxableincomefortheyeariscalculatedusingthesetaxrates.

Inyearspast,corporateincometaxrateswereconsiderablyhigher,andtheratescouldgoupinthefuture–althoughmostexpertsdon’tpredictanyincrease.TheChancelloroftheExchequerlooksattheincometaxlaweveryyearandmakessomechangesvirtuallyeveryyear.Manychangeshavetodowiththeaccountingmethodsallowedtodetermineannualtaxableincome.Forinstance,themethodsforcomputingannualwritingdownexpense,whichrecognisesthewearandtearonabusiness’slong-livedoperatingassets,havebeenchangedbackandforthbychancellorsovertheyears.YoucancheckwithHMRevenueandCustomsforthelatestrulesatwww.hmrc.gov.ukbysimplyclickingon‘CorporationTax’.

Businessespaytaxonincomeatdifferentratesdependingontheirsize.Butanycapitalgains(made,forexample,whenpartofabusinessissoldorwhenownerscashin)usedtobetaxedat10percent(iftheassetconcernedhadbeenownedfortwoyearsormore)andthenonaslidingscaleupto40percentforsomeassetsandsometimeperiods.However,somefiendishlycomplicated‘taperreliefs’existedthatmadeunderstandingthetruetaxpositionverydifficult.So,from2008,allcapitalgainsarenowtaxedatasinglerateof18

percent.Thesimplificationdoesmeanthatsometaxpayers(inparticular,anyentrepreneurssellingup)faceataxhikeof80percent(from10percentupto18percent).

ProfitaccountingandtaxableincomeaccountingYou’reprobablythinkingthatthissectionofthechapterisabouthowabusiness’sbottom-lineprofit–itsnetincome–drivesitstaxableincomeamount.Actually,wewanttoshowyoutheexactopposite:howincometaxlawdrivesabusiness’sprofitaccounting.That’sright:Taxlawplaysalargeroleinhowabusinessdeterminesitsprofitfigure,ormorepreciselytheaccountingmethodsusedtorecordrevenueandexpenses.

Beforeyouexplorethatparadox,youneedtounderstandsomethingabouttheaccountingmethodsforrecordingprofit.Formeasuringandrecordingmanyexpenses(andsometypesofrevenue),nosingleaccountingmethodemergesastheoneandonlydominantmethod.Accountantshaveacertainamountoflegitimateleewayinmeasuringandreportingtherevenueandexpensesthatdrivetheprofitfigure.(SeeChapter13forfurtherdiscussionofalternativeaccountingmethods.)Therefore,twodifferentaccountants,recordingthesameprofit-makingactivitiesforthesameperiod,wouldmostlikelycomeupwithtwodifferentprofitfigures–thenumberswouldbeoffbyatleastalittle,andperhapsbyalot.

Andthatinconsistencyisfine–aslongasthedifferencesareduetolegitimatereasons.We’dliketobeabletoreporttoyouthatinmeasuringprofit,accountantsalwaysaimrightatthebull’s-eye,thedeadcentreoftheprofittarget.Onecommandmentintheaccountants’bibleisthatannualprofitshouldbeasclosetothetruthascanbemeasured;accountingmethodsshouldbeobjectiveandfair.Butintherealworld,profitaccountingdoesn’tquiteliveuptothisideal.

Beawarethatabusinessmaybetemptedtodeliberatelyoverstateorunderstateitsprofit.Whenabusinessoverstatesitsprofitinitsprofitandlossaccount,someamountofitssalesrevenuehasbeenrecordedtoosoonand/orsomeamountofitsexpenseshasnotyetbeenrecorded(butwillbelater).Overstatingprofitisadangerousgametoplaybecauseitdeceivesinvestorsandotherinterestedpartiesintothinkingthatthebusinessisdoingbetterthanitreallyis.Auditsoffinancialreportsbycharteredaccountants(asdiscussedinChapter15)keepsuchfinancialreportingfraudtoaminimumbutdon’tnecessarilycatcheverycase.

Moretothepointofthischapteristhefactthatmostbusinessesareundersomepressuretounderstatetheprofitreportedintheirannualincomestatements.Businessesgenerallyrecordsalesrevenuecorrectly(withsomenotableexceptions),buttheymayrecordsomeexpensessoonerthanthesecostsshouldbedeductedfromsalesrevenue.Why?Businessesarepreoccupiedwithminimisingincometax,whichmeansminimisingtaxableincome.Tominimisetaxableincome,abusinesschoosesaccountingmethodsthatrecordexpensesassoonaspossible.Keepingtwosetsofbooks(accountingrecords)–onefortaxreturnsandoneforinternalprofitaccountingreportstomanagers–isnotverypractical,sothebusinessusestheaccountingmethodskeptfortaxpurposesforotherpurposesaswell.Andthat’swhytaxconcernscandrivedownabusiness’sprofitfigure.

Inshort,theincometaxlawpermitsfairlyconservativeexpenseaccountingmethods–expenseamountscanbefront-loaded,ordeductedsoonerratherthanlater.Thereasonistogiveabusinesstheoptiontominimiseitscurrenttaxableincome(eventhoughthiscoursehasareverseeffectinlateryears).Manybusinessesselecttheseconservativeexpensemethods–bothfortheirincometaxreturnsandfortheirfinancialstatementsreportedtomanagersand

tooutsideinvestorsandlenders.Thusfinancialstatementsofmanybusinessestilttotheconservative,orunderstated,side.

Ofcourse,abusinessshouldreportanaccuratefigureasitsnetprofit,withnodeliberatefudging.Ifyoucan’ttrustthatfigure,whoknowsforsureexactlyhowthecompanyisdoing?Nottheowners,thevalueofwhoseinvestmentinthebusinessdependsmostlyonprofitperformance,andnoteventhebusiness’smanagers,whosebusinessdecisionsdependonrecordedprofitperformance.Everybusinessneedsareliableprofitcompasstonavigateitswaythroughthecompetitiveenvironmentofthebusinessworld–that’sjustcommonsenseanddoesn’tevenbegintoaddressethicalissues.

OtherreasonsforunderstatingprofitMinimisingtaxableincomeisastrongmotiveforunderstatingprofit,butbusinesseshaveotherreasonsaswell.Imagineforthemomentthatbusinessprofitisn’tsubjecttoincometax(youwish!).Eveninthishypothetical,no-taxworld,manybusinessesprobablywouldselectaccountingmethodsthatmeasuretheirprofitonthelowsideratherthanthehighside.Twopossiblereasonsarebehindthisdecision:

Don’tcountyourchickensbeforetheyhatchphilosophy:Manybusinessmanagersandownerstendtobefinanciallyconservative;theyprefertoerronthelowsideofprofitmeasurementratherthanonthehighside.

Saveforarainydayphilosophy:Abusinessmaywanttokeepsomeprofitinreservesothatduringafuturedownturn,ithasaprofitcushiontosoftentheblow.

Thepeoplewhothinkthiswaytendtoviewoverstatingprofitasaformofdefraudinginvestorsbutviewunderstatingprofitassimplybeingprudent.Frankly,wethinkthatputtingyourthumboneithersideoftheprofitscale

(revenuebeingonesideandexpensestheother)isnotagoodidea.Letthechipsfallwheretheymayisourphilosophy.Adopttheaccountingmethodsthatyouthinkbestreflecthowyouoperatethebusiness.Theincometaxlawhasputtoomuchdownwardpressureonprofitmeasurement,inouropinion.

Weshouldsaythatmanybusinessesdoreporttheirannualprofitcorrectly–salesrevenueandexpensesarerecordedproperlyandwithoutanyattempttomanipulateeithersideoftheprofitequation.

RefertoChapter13formoreabouthowchoosingoneexpenseaccountingmethodoveranothermethodimpactsprofit.(Note:Thefollowingsections,whichdiscussexpensesandincomethatarenotdeductibleorareonlypartiallydeductible,havenothingtodowithchoosingaccountingmethods.)

DeductibleexpensesWhatexpensescanyouclaimwhenyouareself-employed?Expenditurecanbesplitintotwomaincategories,‘Capital’and‘Revenue’.

CapitalExpenditure:Capitalexpenditureisexpenditureonsuchitemsasthepurchaseoralterationofbusinesspremises,purchaseofplant,machineryandvehicles,ortheinitialcostoftools.Youcannotdeduct‘capitalexpenditure’inworkingoutyourtaxableprofits,butsomereliefmaybedueonthistypeofexpenditureintheformofcapitalallowances.YourTaxOfficecangivefurtheradviceontheseallowances.

RevenueExpenditure:Listingalltheexpensesthatcanbedeductedisimpossiblebut,generallyspeaking,allowableexpenditurerelatestoday-to-dayrunningcostsofyourbusiness.Itincludessuchitemsaswages,rent,lightingandheatingofbusinesspremises,runningcostsofvehiclesusedinthebusiness,purchaseofgoodsforresaleandthecostof

replacingtoolsusedinthebusiness.

Non-deductibleexpensesTobedeductible,businessexpensesmustbeordinaryandnecessary–thatis,regular,routinestuffthatyouneedtodotorunyourbusiness.You’reprobablythinkingthatyoucanmakeanargumentthatanyofyourexpensesmeettheordinaryandnecessarytest.Andyou’remostlyright–almostallbusinessexpensesmeetthistwofoldtest.

However,HMRevenueandCustomsconsidercertainbusinessexpensestobeanythingbutordinaryandnecessary;youcanargueaboutthemuntilyou’reblueintheface,anditwon’tmakeanydifference.Examplesofnon-allowableexpenditureareyourownwages,premiumsonpersonalinsurancepolicies,andincometaxandNationalInsurancecontributions.Whereexpenditurerelatestobothbusinessandprivateuse,onlythepartthatrelatestothebusinesswillbeallowed;examplesarelighting,heatingandtelephoneexpenditure.Ifavehicleisusedforbothbusinessandprivatepurposes,thenthecapitalallowancesandthetotalrunningexpenseswillbesplitinproportiontothebusinessandprivatemileage.Youwillneedtokeeprecordsofyourtotalmileageandthenumberofmilestravelledonbusinesstocalculatethecorrectsplit.

Here’salistofexpensesthatarenotdeductibleorareonlypartiallydeductiblewhendeterminingannualtaxableincome:

Customerentertainmentexpenses:Definitelyanogoarea.ForawhileentertainingoverseascustomerswasanallowabletaxexpenseuntiltheRevenuebecamesuspicious

oftheamazingnumberofpeoplebeingentertainedbybusinesseswithnoexportactivitywhatsoever.

Bribes,kickbacks,finesandpenalties:Oh,comeon,didyoureallythinkthatyoucouldgetrewardedfordoingstuffthat’sillegalor,atbest,undesirable?Ifyouwereallowedtodeductthesecosts,thatwouldbetantamounttotheRevenueencouragingsuchbehaviour–apolicythatwouldn’tsittoowellwiththegeneralpublic.

Lobbyingcosts:Youcan’tdeductpaymentsmadetoinfluencelegislation.Sorry,butyoucan’tdeducttheexpensesyouranuptopersuadeMinisterHardnosetogiveyourbicyclebusinessspecialtaxcreditsbecauseridingbicyclesisgoodexerciseforpeople.

Start-upcosts:Youcan’tjustdeductthecostofeverythingneededtostartabusinessinyearone.Someassets,suchascarsandequipmentormachinery,havetobewrittendownoveranumberoffutureyears.Thisareaofthetaxlawcangetalittlehairy.Ifyouhavejuststartedanewbusiness,youmaybewisetoconsultataxprofessionalonthisquestion,especiallyifyourstart-upcostsareratherlarge.

Workingfromhome:Ifyouusepartofyourhomeforwork,youneedtokeepsufficientrecordstobackuptheproportionofheatingandlightingcoststhatrelatetoyourbusinessandyourprivateuse.Sometimesyoumaynotgetevidence,suchasareceipt,forcashexpenses,especiallywheretheamountsaresmall.Ifthishappens,makeabriefnoteassoonasyoucanoftheamountyouspent,whenyouspentit,andwhatitwasfor.HMRevenueandCustomsdon’texpectyoutokeepphotocopiesofbills,althoughyoumayfindthemuseful.

Lifeinsurancepremiums:Abusinessmaybuylifeinsurancecoverageonkeyofficersandexecutives,butifthebusinessisthebeneficiary,thepremiumsarenotdeductible.Theproceedsfromalifeinsurancepolicyarenottaxableincome

tothebusinessiftheinsuredpersondies,becausethecostofthepremiumswasnotdeductible.Inshort,premiumsarenotdeductible,andproceedsupondeathareexcludedfromtaxableincome.

Travelandconventionattendanceexpenses:Somebusinessespayforratherlavishconventionsfortheirmanagersandspendratherfreelyforspecialmeetingsatattractivelocationsthattheircustomersattendforfree.TheRevenuetakesadimviewofsuchextravagantexpendituresandmaynotallowafulldeductionforthesetypesofexpenses.HMRevenueandCustomsholdsthatsuchconventionsandmeetingscouldhavebeenjustaseffectiveforamuchmorereasonablecost.Inshort,abusinessmaynotgeta100percentdeductionforitstravelandconventionexpensesiftheRevenueauditstheseexpenditures.

Transactionswithrelatedparties:Incometaxlawtakesaspecialinterestintransactionswherethetwopartiesarerelatedinsomeway.Forexample,abusinessmayrentspaceinabuildingownedbythesamepeoplewhohavemoneyinvestedinthebusiness;therentmaybeartificiallyhighorlowinanattempttoshiftincomeandexpensesbetweenthetwotaxentitiesorindividuals.Inotherwords,thesetransactionsmaynotbebasedonwhat’sknownasarm’s-lengthbargaining.Abusinessthatdealswitharelatedpartymustbereadytoshowthatthepricepaidorreceivedisconsistentwithwhatthepricewouldbeforanunrelatedparty.

Youcanfindausefulguidetobusinessexpensesonthewww.bytestart.co.uksmallbusinessportal.Justclickon‘TaxandAccounting’and‘BusinessExpensesGuide’.

Equitycapitaldisguisedasdebt

Equitycapitaldisguisedasdebt

Thegeneraltermdebtreferstomoneyborrowedfromlenderswhorequirethatthemoneybepaidbackbyacertaindate,andwhorequirethatinterestbepaidonthedebtuntilitisrepaid.Equityismoneyinvestedbyowners(suchasshareholders)inabusinessinreturnforhoped-for,butnotguaranteed,profitreturns.Interestisdeductible,butcashdividendspaidtoshareholdersarenot–whichgivesdebtcapitalabigedgeoverequitycapitalattaxtime.

Notsurprisingly,somebusinessestrytopassoffequitycapitalasdebtontheirtaxreturnssothattheycandeductthepaymentstotheequitysourcesasinterestexpensetodeterminetaxableincome.Don’tthinkthatHMRevenueandCustomsareignorantofthesetactics:Everythingthatyoudeclareasinterestondebtmaybeexaminedcarefully,andiftheRevenuedeterminesthatwhatyou’recallingdebtisreallyequitycapital,itdisallowstheinterestdeduction.Thebusinesscanmakepaymentstoitssourcesofcapitalthatitcallsandtreatsasinterest–butthisdoesnotmeanthatHMRevenueandCustomswillautomaticallybelievethatthepaymentsareinfactinterest.TheRevenuefollowsthegeneralprincipleofsubstanceoverform.Iftheso-calleddebthastoomanycharacteristicsofequitycapital,HMRevenueandCustomstreatthepaymentsnotasinterestbutratherasdividenddistributionsfromprofittotheequitysourcesofcapital.

Insummary,debtmustreallybedebtandmusthavefewornoneofthecharacteristicsofequity.Drawingaclear-cutlinebetweendebtandequityhasbeenavexingproblemforHMRevenueandCustoms,andtherulesarecomplex.You’llprobablyhavetoconsultataxprofessionalifyouhaveaquestionaboutthisissue.Bewarnedthatifyouattempttodisguiseequitycapitalasdebt,yourcharademaynotwork–andtheRevenuemaydisallowany‘interest’paymentsyouhavemade.

paymentsyouhavemade.

PartII

GettingaGriponFinancialStatements

Inthispart...

Financialstatementsarelikethetipofaniceberg–theyonlyshowthevisiblepart,underneathwhicharealotofrecord-keeping,accountingmethods,andreportingdecisions.Themanagersofabusiness,theinvestorsinabusiness,andthelenderstoabusinessneedafirmgraspontheseaccountingcommunications.Theyneedtoknowwhichhandlestograbholdofandhowtofindboththegoodandbadsignalsinfinancialstatements–and,ugh,thisincludesthesmall-printfootnotesthatgowithfinancialstatements.

Accountantspreparethreeprimaryfinancialstatements.Theprofitandlossaccountreportstheprofit-makingactivitiesofthebusinessandhowmuchprofitorlossthebusinessmade.(Soundsodd,doesn’tit,tosayabusinessmadealoss?Buttomakeprofit,abusinesshastotaketheriskthatitmaysufferaloss.)Thebalancesheetreportsthefinancialsituationandpositionofthebusinessatapointintime–usuallythelastdayoftheprofitperiod.Thecashflowstatementreportshowmuchcashwasactuallyrealisedfromprofitandothersourcesofcash,andwhatthebusinessdidwiththismoney.Inshort,thefinanciallifeofabusinessanditsprospectsforsuccessorpotentialdangeroffailingisallrevealedinitsfinancialstatements,asthispartofthebookexposes.

But,aswithmuchinaccounting,noteverythingisquiteasitappears.Changingasingleletter(FIFOtoLIFO)inthefootnotestotheaccountscanadd(orsubtract)asmallfortunefromthereportedprofit,asyou’llseeinChapter8.

Chapter6

TheBalanceSheetfromtheProfitandLossAccountViewpoint

InThisChapterCouplingtheprofitandlossaccountwiththebalancesheet

Seeinghowsalesrevenueandexpensesdriveassetsandliabilities

Sizingupassetsandliabilities

Drawingthelinebetweendebtandowners’equity

Groupingshort-termassetsandliabilitiestodeterminesolvency

Understandingcostsandotherbalancesheetvalues

Thischapterexploresoneofthethreeprimaryfinancialstatementsreportedbybusinesses–thebalancesheet,or,tobemoreformal,thestatementoffinancialcondition.Thiskeyfinancialstatementmayseemtostandalone–likeanislandtoitself–becauseit’spresentedonaseparatepageinafinancialreport.Infact,theassetsandliabilitiesreportedinabalancesheetaredrivenmainlybythetransactionsthebusinessengagesintomakeprofit.Thesesaleandexpensetransactionsofabusinessaresummarisedforaperiodinitsprofitandlossaccount,whichisexplainedinChapter5.

You’veprobablyheardtheexpressionthatittakesmoneytomakemoney.Forabusinessittakesassetstomakeprofit.Thischapteridentifiestheparticularassetsneededtomakeprofit.Also,thechapterpointsouttheparticularliabilitiesinvolvedinthepursuitofprofit.

Inbrief,abusinessneedsalotofassetstoopenitsdoorsandtocarryonitsprofit-makingactivities–makingsalesandoperatingthebusinessfromdaytoday.Forexample,

companiesthatsellproductsneedtocarryastockofproductsthatareavailablefordeliverytocustomerswhensalesaremade.Abusinesscanpurchaseproductsforitsstockoncredit,anddelaypaymentforthepurchase(assumingithasagoodcreditrating).Inmostcases,however,thebusinesshastopayforthesepurchasesbeforealltheproductshavebeensold–thestock-holdingperiodisconsiderablylongerthanthecreditperiod.Thebusinessneedscashtopayforitsstockpurchases.Wheredoesthecashcomefrom?

Infactabusinessneedsmanymoreassetsthanjuststock.Wheredoesthemoneyfortheseassetscomefrom?Assetsarethefirstactofatwo-actplay.Thesecondactlooksatwherethemoneycomesfrom,orthesourcesofcapitalforbusinesses.AsChapter1explains,thebalancesheetofabusinessisthefinancialstatementthatreportsitsassetsononesideandthesourcesofcapitalontheotherside.

Ofcourse,aswerepeatthroughoutthisbook,youneedtouseallthreeprimaryfinancialstatementstopaintabusiness’scompletefinancialpicture.Theprofitandlossaccountdetailssalesrevenueandexpenses,whichdirectlydeterminetheamountsofassets(andtwoorthreeoftheliabilities)thataresummarisedinthebalancesheet.Thecashflowstatementanswerstheimportantquestionofhowmuchoftheprofithasbeenconvertedtocash,andthecompany’sothersourcesandusesofcashduringtheperiod.

Thischapterconnectssalesrevenueandexpenses,whicharereportedintheprofitandlossaccount,withtheircorrespondingassetsandliabilitiesinthebalancesheet.Thechapteralsoexplainsthesourcesofcapitalthatprovidethemoneyabusinessusestoinvestinitsassets.

CouplingtheProfitandLossAccountwiththeBalanceSheet

Salesrevenuegeneratestheinflowofassetsandexpensescausetheoutflowofassets.Theseincreasesanddecreasesinassetshavetoberecorded.Also,someexpensesspawnshort-termliabilitiesthathavetoberecorded.Inshort,accountingforprofitinvolvesmuchmorethankeepingtrackofcashinflowsandoutflows.Whichspecificassetsandliabilitiesaredirectlyinvolvedinrecordingthesalesrevenueandexpensesofabusiness?Andhowaretheseassetsandliabilitiesreportedinabusiness’sbalancesheetattheendoftheprofitperiod?Thesearethetwomainquestionsthatthischapteranswers.

Thischapterexplainshowtheprofit-makingtransactionsreportedintheprofitandlossaccountconnectwiththeassets(andsomeoperatingliabilities)reportedinthebalancesheet.Westressthedovetailfitbetweenthesetwoprimaryfinancialstatements(theprofitandlossaccountandthebalancesheet).Anddon’tforgetthatbusinessaccountingalsokeepstrackofwherethemoneyfortheassetscomesfrom–toinvestinitsassets,abusinessneedstoraisemoneybyborrowingandpersuadingownerstoputmoneyinthebusiness.Youshouldn’tlookatassetswithoutalsolookingatwherethemoney(thecapital)fortheassetscomesfrom.

Thebalancesheet,orstatementoffinancialcondition,summarisesabusiness’sassets,liabilitiesandowners’equityatapointintimeand,asshowninChapter5,canbesummarisedinthefollowingequation:

Figure6-1showsabalancesheetforafictitiouscompany–notfromlefttorightasshownintheaccountingequationjustabove,butratherfromtoptobottom,whichisaverticalexpressionoftheaccountingequation.Thisbalancesheetisstrippeddowntothebare-boneessentials–pleasenotethatitwouldneedalittletidyingupbeforeyou’dwanttoshowitofftotheworldinanexternalfinancialreport(seeChapter8).

Figure6-1:Abalancesheetexampleshowingabusiness’svariousassets,liabilitiesandowners’equity.

Abalancesheetdoesn’thaveapunchlineliketheprofitandlossaccountdoes–theprofitandlossaccount’spunchlinebeingthenetincomeline(whichisrarelyhumoroustothebusinessitself,butcancausesomesniggersamonganalysts).Youcan’tlookatjustoneitemonthebalancesheet,murmuranappreciative‘ah-hah,’andrushhometowatchthefootygame.Youhavetoreadthewholething(sigh)andmakecomparisonsamongtheitems.SeeChapters8and14formoreinformationoninterpretingfinancialstatements.

Atthemostbasiclevel,thebestwaytounderstandabalancesheet(mostofit,anyway)istofocusontheassetsthataregeneratedbythecompany’sprofit-makingactivities–inotherwords,thecause-and-effectrelationshipbetweenanitemthat’sreportedintheprofitandlossaccountandanitemthat’sreportedinthebalancesheet.

Figure6-2:Connectionsbetweentheassetsandoperatingliabilitiesofabusinessanditssalesrevenueandexpenses.

Figure6-2laysoutthevitallinksbetweensalesrevenueandexpensesandtheassetsandliabilitiesthataredrivenbytheseprofit-seekingactivities.Youcanreferbacktoeachconnectionassalesrevenueandexpensesarediscussedbelow.TheformatoftheprofitandlossaccountisvirtuallythesameastheformatintroducedinChapter5,exceptthatdepreciationexpenseisreportedonaseparateline(inChapter5,depreciationisburiedinthesales,administrativeandgeneralexpensesaccount).

Theamountsreportedintheprofitandlossaccountarethecumulativetotalsforthewholeyear(orothertimeperiod).Incontrast,theamountsreportedinthebalancesheetarethebalancesattheendoftheyear–thenetamount,startingwiththebalanceatthestartoftheyear,adjustedforincreasesanddecreasesthatoccurduringtheyear.Forexample,thetotalcashinflowsandoutflowsoverthecourseoftheentireyearweremuchmorethanthe£2millionendingbalanceforcash.

ThepurposeofFigure6-2istohighlighttheconnectionsbetweentheparticularassetsandoperatingliabilitiesthataretightlyinterwovenwithsalesrevenueandexpenses.Businessmanagersneedagoodgripontheseconnectionstocontrolassetsand

needagoodgripontheseconnectionstocontrolassetsandliabilities.Andoutsideinvestorsneedtounderstandtheseconnectionstointerpretthefinancialstatementsofabusiness(seeChapter14).

Mostpeopleintuitivelyunderstandthatsoonerorlatersalesrevenueincreasescashandexpensesdecreasecash.(Theexceptionisdepreciationexpense,asexplainedinChapters5and7.)It’sthe‘soonerorlater’thatgivesrisetotheassetsandliabilitiesinvolvedinmakingprofit.

Theassetsandliabilitiesdrivenbysalesrevenueandexpensesareasfollows:

Salesrevenuederivesfromsellingproductsandservicestocustomers.

Thecostofgoodssoldexpenseiswhatthebusinesspaidfortheproductsthatitsellstoitscustomers.Youcan’tchargethecostofproductstothisexpenseaccountuntilyouactuallysellthegoods,sothatcostgoesintothestockassetaccountuntilthegoodsaresold.

Thesales,administrativeandgeneralexpenses(SA&G)categorycoversmanydifferentoperatingexpenses(suchasadvertising,travelandtelephonecosts).SA&Gexpensesdrivethefollowingitemsonthebalancesheet:

•Theprepaidexpensesassetaccountholdsthetotalamountofcashpaymentsforfutureexpenses(forexample,youpayinsurancepremiumsbeforethepolicygoesintoeffect,soyouchargethosepremiumstothemonthscoveredbythepolicy).

•Thecreditorliabilityaccountisthetotalamountofexpensesthathaven’tbeenpaidyetbutthataffectthecurrentperiod.Forexample,youreceiveabillforelectricitythatyouusedthemonthbefore,soyouchargethatbilltothemonthbenefitedbytheelectricity–thankstotheaccrualbasisofaccounting.

•Theaccruedexpensespayableaccountistheoppositeoftheprepaidexpensesassetaccount:thisliabilityaccountholdscoststhatarepaidafterthecostisrecordedasanexpense.Anexampleistheaccumulatedholidaypaythatthecompany’semployeeshaveearnedbytheendoftheyear;whentheemployeestaketheirholidaysnextyearthecompanypaysthisliability.

Thepurposeofdepreciationistospreadouttheoriginalcostofafixedassetoverthecourseoftheasset’slife.Ifyoubuyavehiclethat’sgoingtoserveyouforfiveyears,youchargeone-fifthofthecosttodepreciationexpenseeachofthefiveyears.(Insteadofchargingthisstraightline,orlevelamounttoeachyear,abusinesscanchooseanaccelerateddepreciationmethod,asexplainedinChapter13.)Ratherthandecreasingthefixedassetsaccountdirectly(whichwouldmakesomesense),accountantsputdepreciationexpenseinanoffsetaccountcalledaccumulateddepreciation,thebalanceofwhichisdeductedfromtheoriginalcostoffixedassets.Thus,boththeoriginalcostandtheamountbywhichtheoriginalcosthasbeendepreciatedtodateareavailableinseparateaccounts–bothitemsofinformationarereportedinthebalancesheet.

Interestexpensedependsontheamountofmoneythatthebusinessborrowsandtheinterestratethatthelendercharges.Debtisthegenerictermforborrowedmoney;anddebtbearsinterest.Loansandoverdraftsarethemostcommontermsyouseeformostdebtbecausetheborrower(thebusiness)signsalegalinstrumentcalledanote.Normally,thetotalinterestexpenseforaperiodhasn’tbeenpaidbytheendoftheperiodsotheunpaidpartisrecordedinaccruedexpensespayable(orinamorespecificaccountofthistypecalledaccruedinterestpayable).

Asmallpartofthetotalincometaxowedonthecompany’staxableincomefortheyearprobablywillnotbepaidbytheendoftheyear,andtheunpaidpartisrecordedinthe

incometaxpayableaccount.

Afinalnote:Thebottom-lineprofit(netincome)fortheyearincreasesthereservesor,asitisalsoknown,theretainedearningsaccount,whichisoneofthetwoowners’equityaccounts.

SizingUpAssetsandLiabilities

AlthoughthebusinessexampleshowninFigure6–2ishypothetical,wedidn’tmakeupthenumbersatrandom–notatall.Weuseamedium-sizedbusinessthathas£25millioninannualsalesrevenueastheexample.(Yourbusinessmaybealotsmallerorlargerthanonewith£25millionannualsalesrevenue,ofcourse.)Alltheothernumbersinboththeprofitandlossaccountandthebalancesheetofthebusinessarerealisticrelativetoeachother.Weassumethebusinessearns40percentgrossmargin(£10milliongrossmargin÷£25millionsalesrevenue=40percent),whichmeansitscostofgoodssoldexpenseis60percentofsalesrevenue.Thesizesofparticularassetsandliabilitiescomparedwiththeirrelevantprofitandlossaccountnumbersvaryfromindustrytoindustry,andevenfrombusinesstobusinessinthesameindustry.

Basedonitshistoryandpolicies,themanagersofabusinesscanestimatewhatthesizeofeachassetandliabilityshouldbe–andtheseestimatesprovideveryusefulcontrolbenchmarks,oryardsticks,againstwhichtheactualbalancesoftheassetsandliabilitiesarecomparedtospotanyseriousdeviations.Inotherwords,assets(andliabilities,too)canbetoohighortoolowinrelationtothesalesrevenueandexpensesthatdrivethem,andthesedeviationscancauseproblemsthatmanagersshouldtrytocorrectassoonaspossible.

TurningoverassetsAssetsshouldbeturnedover,orputtousebymakingsales.Thehighertheturnover(themoretimestheassetsareusedandthenreplaced),thebetter.Themoresales,thebetter–becauseeverysaleisaprofit-makingopportunity.Theassetturnoverratiocomparesannualsalesrevenuewithtotalassets:

Annualsalesrevenue÷totalassets=assetturnoverratio

Theassetturnoverratioisinterestingasfarasitgoes,butitunfortunatelydoesn’tgoveryfar.Thisratiolooksonlyattotalassetsasanaggregatetotal.Andtheratiolooksonlyatsalesrevenue.Theexpensesofthebusinessfortheyeararenotconsidered–eventhoughexpensesareresponsibleformostoftheassetsofabusiness.

Note:Theassetturnoverratioisaquick-and-dirtytestofhowwellabusinessisusingitsassetstogeneratesales.Theratiodoesnotevaluateprofitability;profitisnotinthecalculation.Basically,theratioindicateshowwellassetsarebeingusedtogeneratesales–nothingmore.

Forexample,basedonthecredittermsextendedtocustomersandthecompany’sactualpoliciesregardinghowaggressivethebusinessisincollectingpast-duereceivables,amanagercandeterminetherangeforhowmuchaproper,orwithin-the-boundaries,balanceofaccountsreceivableshouldbe.Thisfigurewouldbethecontrolbenchmark.Iftheactualbalanceisreasonablyclosetothiscontrolbenchmark,thedebtors’levelisundercontrol.Ifnot,themanagershouldinvestigatewhythedebtors’levelishigherorlowerthanitshouldbe.

Thefollowingsectionsdiscusstherelativesizesoftheassetsandliabilitiesinthebalancesheetthatresultfromsalesandexpenses.Thesalesandexpensesarethedrivers,orcauses,oftheassetsandliabilities.Ifabusinessearnedprofitsimplybyinvestinginstocksandbonds,forexample,itwouldnotneedallthevariousassetsandliabilitiesexplainedinthischapter.Suchabusiness–amutualfund,forexample–wouldhavejustoneincome-producingasset:

investmentsinsecurities.Butthischapterfocusesonbusinessesthatsellproductstomakeprofit.

SalesrevenueanddebtorsInFigure6-2theannualsalesrevenueis£25million.Debtorsrepresentone-tenthofthis,or£2.5million.Inroughterms,theaveragecustomer’screditperiodisabout36days–365daysintheyearmultipliedbythe10percentratioofendingdebtorsbalancetoannualsalesrevenue.Ofcourse,somecustomers’balancesowedtothebusinessmaybepast36daysandsomequitenew.It’stheoverallaveragethatyoushouldfocuson.Thekeyquestioniswhetherornotacustomer-creditperiodaveraging36daysisreasonableornot.

CostofgoodssoldexpenseandstockInFigure6-2theannualcostofgoodssoldexpenseis£15million.Thestockis£3,575,000,orabout24percent.Inroughterms,theaverageproduct’sstock-holdingperiodis87days–365daysintheyearmultipliedbythe24percentratioofendingstocktoannualcostofgoodssold.Ofcourse,someproductsmayremaininstocklongerthanthe87-dayaverageandsomeproductsmaysellinamuchshorterperiodthan87days.It’stheoverallaveragethatyoushouldfocuson.Isan87-dayaveragestock-holdingperiodreasonable?

The‘correct’averagestock-holdingperiodvariesfromindustrytoindustry.Insomeindustries,thestock-holdingperiodisverylong,threemonthsorlonger,especiallyformanufacturersofheavyequipmentandhigh-techproducts.Theoppositeistrueforhigh-volumeretailerssuchasretailsupermarketswhodependongettingproductsofftheshelvesasquicklyaspossible.The87-dayaverageholdingperiodinthe

exampleisreasonableformanybusinesses,butwouldbefartoohighformanyotherbusinesses.

SA&GexpensesandthefourbalancesheetaccountsthatareconnectedwiththeexpensesNotethatinFigure6-2sales,administrativeandgeneral(SA&G)expensesconnectwithfourbalancesheetaccounts–cash,prepaidexpenses,creditorsandaccruedexpensespayable.ThebroadSA&Gexpensecategoryincludesmanydifferenttypesofexpensesthatareinvolvedinmakingsalesandoperatingthebusiness.(Separateexpenseaccountsaremaintainedforspecificexpenses;dependingonthesizeofthebusinessandtheneedsofitsvariousmanagers,hundredsorthousandsofspecificexpenseaccountsareestablished.)

Cashispaidwhenrecordingpayroll,mailingandsomeotherexpenses.Incontrast,insuranceandofficesuppliescostsareprepaid,andthenreleasedtoexpensegraduallyovertime.So,cashispaidbeforetherecordingoftheexpense.Someoftheseexpensesarenotpaiduntilweeksafterbeingrecorded;torecognisethedelayedpaymenttheamountsowedarerecordedinanaccountspayableoranaccruedexpensespayableliabilityaccount.

Onepointwewouldliketorepeatisthatthecompany’smanagersshouldadoptbenchmarksforeachoftheseaccountsthatareconnectedwiththeoperatingexpensesofthebusiness.Forexample,the£1.2millionendingbalanceofaccruedexpensespayableis20percentofthe£6millionSA&Gfortheyear.Isthisratiowithincontrollimits?Isittoohigh?Managersshouldaskandanswerquestionsliketheseforeveryassetand

liabilityconnectedwiththeexpensesofthebusiness.

FixedassetsanddepreciationexpenseAsexplainedinChapter5,depreciationisatrulyuniqueexpense.Depreciationislikeotherexpensesinthat,likeallotherexpenses,itisdeductedfromsalesrevenuetodetermineprofit.Otherthanthis,however,depreciationisverydifferent.Noneofthedepreciationexpenserecordedtotheperiodrequirescashoutlayduringtheperiod.Rather,depreciationexpensefortheperiodisthatportionofthetotalcostofabusiness’sfixedassetsthatisallocatedtotheperiodtorecordanamountofexpenseforusingtheassetsduringtheperiod.Depreciationisanimputedcost,basedonwhatfractionofthetotalcostoffixedassetsisassignedtotheperiod.

Thehigherthetotalcostofitsfixedassets,thehigherabusiness’sdepreciationexpense.However,thereisnostandardratioofdepreciationexpensetothetotalcostoffixedassets.Theamountofdepreciationexpensedependsontheusefullivesofthecompany’sfixedassetsandwhichdepreciationmethodthebusinessselects.(HowtochoosedepreciationmethodsisexplainedinChapter13.)Theannualdepreciationexpenseofabusinessisseldommorethan10–15percentofthetotalcostofitsfixedassets.Thedepreciationexpensefortheyeariseitherreportedasaseparateexpenseintheprofitandlossaccount(asinFigure6–2)ortheamountisdisclosedinafootnote.

Becausedepreciationisbasedonthecostoffixedassets,thebalancesheetreportsnotonebuttwonumbers–theoriginalcostofthefixedassetsandtheaccumulateddepreciationamount(theamountofdepreciationthathasbeenchargedasanexpensefromthetimeofacquiringthefixedassettothecurrentbalancesheetdate).

Thepointisn’ttoconfuseyoubygivingyouevenmorenumberstodealwith.Seeingbothnumbersgivesyouanideaofhowoldthefixedassetsareandalsotellsyouhowmuchthesefixedassetsoriginallycost.

Whataboutcash?Abusiness’scashaccountconsistsofthemoneyithasinitsbankaccountsplusthemoneythatitkeepsonhandtoprovidechangeforitscustomers.Cashistheessentiallubricantofbusinessactivity.Soonerorlater,virtuallyeverythingpassesthroughthecashaccount.

Howmuchofacashbalanceshouldabusinessmaintain?Thisquestionhasnorightanswer.Abusinessneedstodeterminehowlargeacashsafetyreserveit’scomfortablewithtomeetunexpecteddemandsoncashwhilekeepingthefollowingwisdominmind:

Excesscashbalancesarenon-productiveanddon’tearnanyprofitforthebusiness.

Insufficientcashbalancescancausethebusinesstomisstakingadvantageofopportunitiesthatrequirequickactionandlargeamountsofcash–suchassnatchingupaprizedpieceofpropertythatjustcameonthemarketandthatthebusinesshashaditseyeonforsometime,orbuyingoutacompetitorwhenthebusinesscomesupforsale.

ThecashbalanceofthebusinesswhosebalancesheetispresentedinFigure6–2is£2,000,000–whichwouldbetoolargeforsomeotherbusinessesandtoosmallforothers.

Intheexample,thebusinesshas,overseveralyears,invested£11,305,000initsfixedassets(thatitstillownsanduses),andithasalreadychargedoffdepreciationof£4,580,000inpreviousyears.Inthisyear,thebusinessrecords£1,200,000depreciationexpense(youcan’ttellfromthebalancesheethowmuchdepreciationwaschargedthisyear;youhavetolookattheprofitandlossaccountinFigure6–2).Theremainingnon-depreciatedcostofthisbusiness’sfixedassetsattheendoftheyearis£5,525,000.Sothefixedassetspartofthisyear’sbalancesheetlookslikethis:

Youcantellthatthecollectionoffixedassetsincludesbotholdandnewassetsbecausethecompanyhasrecorded£5,780,000totaldepreciationsincetheassetswerebought,whichisafairlysizablepercentageoforiginalcost(morethanhalf).Butmanybusinessesuseaccelerateddepreciationmethods,whichpileupalotofthedepreciationexpenseintheearlyyearsandlessinthebackyears(seeChapter13formoredetails)soit’shardtoestimatetheaverageageoftheassets.

Debtandinterestexpense

ThebusinessexamplewhosebalancesheetandprofitandlossaccountsarepresentedinFigure6–2hasborrowed£5milliononloans,which,atan8percentannualinterestrate,is£400,000ininterestexpensefortheyear.(Thebusinessmayhavehadmoreorlessborrowedatcertaintimesduringtheyear,ofcourse,andtheactualinterestexpensedependsonthedebtlevelsfrommonthtomonth.)

Formostbusinesses,asmallpartoftheirtotalannualinterestisunpaidatyear-end;theunpaidpartisrecordedtobringtheexpenseuptothecorrecttotalamountfortheyear.InFigure6–2,theaccruedamountofinterestisincludedinthemoreinclusiveaccruedexpensespayableliabilityaccount.Youseldomseeaccruedinterestpayablereportedonaseparatelineinabalancesheetunlessithappenstobearatherlargeamountorifthebusinessisseriouslybehindinpayinginterestonitsdebt.

IncometaxexpenseInFigure6-2,earningsbeforeincometax–afterdeductinginterestandallotherexpensesfromsalesrevenue–is£2,400,000.(Theactualtaxableincomeofthebusinessfortheyearprobablywouldbesomewhatmoreorlessthanthisamountbecauseofthemanycomplexitiesintheincometaxlaw,whicharebeyondthescopeofthisbook.)Intheexampleweuseataxrateofone-thirdforconvenience,sotheincometaxexpenseis£800,000ofthepre-taxincomeof£2,400,000.MostoftheincometaxfortheyearmustbepaidovertoHMRevenueandCustomsbeforetheendoftheyear.Butasmallpartisusuallystillowedattheendoftheyear.Theunpaidpartisrecordedintheincometaxpayableliabilityaccount–asyouseeinFigure6–2.Intheexample,theunpaidpartis£80,000ofthetotal£800,000incometaxfortheyear–butwedon’tmeantosuggestthatthisratioistypical.Generally,theunpaidincometaxattheendoftheyearisfairlysmall,butjusthowsmalldependsonseveraltechnicalfactors.Youmaywanttocheckwithyourtaxprofessionaltomakesureyouhavepaidoverenoughoftheannualincometaxbytheendoftheyeartoavoidapenaltyforlatepayment.

Thebottomline:netprofit(netincome)andcashdividends(ifany)Abusinessmayhaveothersourcesofincomeduringtheyear,suchasinterestincomeoninvestments.Inthisexample,however,thebusinesshasonlysalesrevenue,whichisgrossincomefromthesaleofproductsandservices.Allexpenses,startingwithcostofgoodssold,downtoandincludingincometax,aredeductedfromsalesrevenuetoarriveatthelast,orbottomline,oftheprofitandlossaccount.Thepreferredtermforbottom-lineprofitisnetincome,asyouseeinFigure6–2.

The£1,600,000netincomefortheyearincreasesretainedearningsbythesameamount,hencethelineofconnectionfromnetincomeandretainedearningsinFigure6-2.The£1,600,000profit(herewegoagainusingthetermprofitinsteadofnetincome)eitherstaysinthebusiness,orsomeofitispaidoutanddividedamongtheownersofthebusiness.Ifthebusinesspaidoutcashdividendsfromprofitduringtheyear,thesecashpaymentstoitsowners(shareholders)aredeductedfromretainedearnings.Youcan’ttellfromtheprofitandlossaccountorthebalancesheetwhetheranycashdividendswerepaid.Youhavetolookinthecashflowstatementforthisinformation–whichisexplainedinChapter7.

FinancingaBusiness:Owners’EquityandDebt

YoumayhavenoticedinFigure6-2thattherearetwobalancesheetaccountsthathavenolinesofconnectionfromtheprofitandlossaccount–loansandowners’investedcapital.Revenueandexpensesdonotaffectthesetwokeybalancesheetaccounts(northefixedassetsaccountforthatmatter,whichisexplainedinChapter7).However,bothdebtandowners’investedcapitalareextremelyimportantformakingprofit.

Torunabusinessyouneedfinancialbacking,otherwiseknownascapital.Capitalisallincomingfundsthatarenotderivedfromsalesrevenue(orfromsellingoffassets).Abusinessraisescapitalbyborrowingmoney,gettingownerstoinvestmoneyinthebusiness,andmakingprofitthatisretainedinthebusiness.Borrowedmoneyisknownasdebt;investedmoneyandretainedprofitsarethetwosourcesofowners’equity.Thosetwosourcesneedtobekept

separateaccordingtotherulesofaccounting.SeeChapters5and9formoreaboutprofit.

HowmuchcapitaldoesthebusinessshowninFigure6-2have?Itstotalassetsare£14,080,000,butthisisnotquitetheanswer.Thecompany’sprofit-makingactivitiesgeneratedthreeoperatingliabilities–creditors,accruedexpensespayableandincometaxpayable–andintotalthesethreeliabilitiesprovided£2,080,000ofthetotalassetsofthebusiness.So,deductingthisamountfromtotalassetsgivestheanswer:Thebusinesshas£12millionincapital.Wheredidthiscapitalcomefrom?Debtprovided£5millionandthetwosourcesofowners’equityprovidedtheother£7million(seeFigure6-1or6-2tocheckthesenumbers).

Creditors,accruedexpensespayableandincometaxpayableareshort-term,non-interest-bearingliabilitiesthataresometimescalledcurrentliabilitiesbecausetheyarisedirectlyfromabusiness’sexpenseactivities–theyaren’ttheresultofborrowingmoneybutratheraretheresultofbuyingthingsoncreditordelayingpaymentofcertainexpenses.

Thisparticularbusinesshasdecidedtofinanceitselfthroughdebtandequityinthefollowingmix:

Decidinghowtodivideyoursourcesofcapitalcanbetricky.Inaveryrealsense,thedebt-versus-equityquestionneverhasafinalanswer;it’salwaysunderreviewandreconsiderationbymost

answer;it’salwaysunderreviewandreconsiderationbymostbusinesses.Somecompanies,justlikesomeindividuals,arestronglyanti-debt,buteventheymayfindthattheyneedtotakeondebteventuallytokeepupwithchangingtimes.

Debtisbothgoodandbad,andinextremesituationsitcangetveryugly.Theadvantagesofdebtare:

Mostbusinessescan’traiseallthecapitaltheyneedfromowners’equityanddebtoffersanothersourceofcapital(though,ofcourse,manylendersmayprovideonlyhalforlessofthecapitalthatabusinessneeds).

Interestrateschargedbylendersarelowerthanratesofreturnexpectedbyowners.Ownersexpectahigherrateofreturnbecausethey’retakingagreaterriskwiththeirmoney–thebusinessisnotrequiredtopaythembackthesamewaythatit’srequiredtopaybackalender.Forexample,abusinessmaypay8percentinterestonitsdebtandhavetoearna13percentrateofreturnonitsowners’equity.(SeeChapter14formoreonearningprofitforowners.)

Thedisadvantagesofdebtare:

Abusinessmustpaythefixedrateofinterestfortheperiodevenifitsuffersalossfortheperiod.

Abusinessmustbereadytopaybackthedebtonthespecifiedduedate,whichcancausesomepressureonthebusinesstocomeupwiththemoneyontime.(Ofcourse,abusinessmaybeabletorolloveritsdebt,meaningthatitreplacesitsolddebtwithanequivalentamountofnewdebt,butthelenderhastherighttodemandthattheolddebtbepaidandnotrolledover.)

Ifyoudefaultonyourdebtcontract–youdon’tpaytheinterestontime,oryoudon’tpaybackthedebtontheduedate–youfacesomemajorunpleasantries.Inextremecases,alendercanforceyoutoshutdownandliquidateyourassets(thatis,selloffeverythingyouownforcash)topayoffthedebtandunpaidinterest.Justasyoucanloseyourhomeifyoudon’tpayyourhomemortgage,yourbusinesscanbeforcedintoinvoluntarybankruptcyifyoudon’tpayyourbusinessdebts.

Alendermayallowthebusinesstotrytoworkoutitsfinancialcrisisthroughbankruptcyprocedures,butbankruptcyisanastybusinessthatinvariablycausesmanyproblemsandcanreallycrippleabusiness.

ReportingFinancialCondition:TheClassifiedBalanceSheet

Theassets,liabilitiesandowners’equityofabusinessarereportedinitsbalancesheet,whichispreparedattheendoftheprofitandlossaccountperiod.

Thebalancesheetisnotaflowstatementbutapositionstatementwhichreportsthefinancialconditionofacompanyataprecisemomentintime–unliketheincomeandcashflowstatementswhichreportinflowsandoutflows.Thebalancesheetpresentsacompany’sassets,liabilitiesandowners’equitythatexistatthetimethereportisprepared.

Anaccountantcanprepareabalancesheetatanytimethata

Anaccountantcanprepareabalancesheetatanytimethatamanagerwantstoknowhowthingsstandfinancially.However,balancesheetsareusuallypreparedonlyattheendofeachmonth,quarterandyear.Abalancesheetisalwayspreparedatthecloseofbusinessonthelastdayoftheprofitperiodsothatthefinancialeffectsofsalesandexpenses(reportedintheprofitandlossaccount)alsoappearintheassets,liabilitiesandowners’equitysectionsofthebalancesheet.

Tradingontheequity:TakingachanceondebtThelargemajorityofbusinessesborrowmoneytoprovidepartofthetotalcapitalneededfortheirassets.Themainreasonfordebt,byandlarge,istoclosethegapbetweenhowmuchcapitaltheownerscancomeupwithandtheamountthebusinessneeds.Lendersarewillingtoprovidethecapitalbecausetheyhaveaseniorclaimontheassetsofthebusiness.Debthastobepaidbackbeforetheownerscangettheirmoneyoutofthebusiness.Theowners’equityprovidesthepermanentbaseofcapitalandgivesthelendersacushionofprotection.

Theownersusetheircapitalinvestedinthebusinessasthebasistoborrow.Forexample,foreverytwopoundstheownershaveinthebusiness,lendersmaybewillingtoaddanotherpound(orevenmore).Thus,foreverytwopoundsofowners’equitythebusinesscangetthreepoundstotalcapitaltoworkwith.Usingowners’equityasthebasisforborrowingiscalledtradingontheequity.Itisalsoreferredtoasfinancialleverage,becausetheequityistheleverforincreasingthetotalcapitalofthebusiness.

ThesetermsalsorefertothepotentialgainabusinesscanrealisefrommakingmoreEBIT(earningsbeforeinterestandtax)ontheamountborrowedthantheinterestonthedebt.Forasimpleexample,assumethatdebtsuppliesone-thirdofthetotalcapitalofabusiness(andowners’equitytwo-thirds,ofcourse),andthebusiness’sEBITfortheyearjustendedisanice,round£3,000,000.Fairisfair,soyoucouldarguethatthelenderswhoputupone-thirdofthemoneyshouldgetone-thirdor£1,000,000oftheprofit.Thisisnothowitworks.The

shouldgetone-thirdor£1,000,000oftheprofit.Thisisnothowitworks.Thelenders(investors)getonlytheinterestamountontheirloans(theirinvestments).Supposethistotalinterestis£750,000.Thefinancialleveragegain,therefore,is£250,000.Theownerswouldgettheirtwo-thirdsshareofEBITplusthe£250,000pre-taxfinancialleveragegain.

Tradingontheequitymaybackfire.Insteadofagain,thebusinessmayrealiseafinancialleverageloss–one-thirdofitsEBITmaybelessthantheinterestdueonitsdebt.ThatinteresthastobepaidnomatterwhatamountofEBITthebusinessearns.Supposethebusinessjustbreakseven,whichmeansitsEBITequalszerofortheyear.Nevertheless,itmustpaytheinterestonitsdebt.So,thebusinesswouldhaveabottom-linelossfortheyear.

Wehaven’tsaidmuchaboutthesituationinwhichabusinesshasalossfortheyear,insteadofaprofit.Alosshastheeffectofdecreasingtheassetsofabusiness(whereasaprofitincreasesitsassets).Tokeepitsimple,assumecashistheonlyassetdecreasedbytheloss(althoughotherassetscouldalsodecreaseasaresultoftheloss).Basically,cashgoesdownbytheamountoftheloss;and,ontheothersideofthebalancesheet,theretainedearningsaccountgoesdownthesameamount.Theownersdonothavetoinvestadditionalmoneyinthebusinesstocovertheloss.Theimpactontheownersisthattheirtotalequity(therecordedvalueoftheirownershipinthebusiness)takesahitequaltotheamountoftheloss.

ThebalancesheetshowninFigure6-1isabare-bonesstatementoffinancialcondition.Yes,thebasicassets,liabilitiesandowners’equityaccountsarepresentedbutforbothinternalmanagementreportingandforexternalreportingtoinvestorsandlenders,thebalancesheetmustbedresseduprathermorethantheoneshowninFigure6-1.

Forinternalreportingtomanagers,balancesheetsincludemuchmoredetaileitherinthebodyofthefinancial

statementitselfor,morelikely,insupportingschedules.Forexample,onlyonecashaccountisshowninFigure6-1butthechieffinancialofficerofabusinessneedstoseethebalancesineachofthebusiness’sbankaccounts.

Asanotherexample,thebalancesheetshowninFigure6-1includesjustonetotalamountfordebtorsbutmanagersneeddetailsonwhichcustomersowemoneyandwhetheranymajoramountsarepasttheirduedate.Therefore,theassetsandliabilitiesofabusinessarereportedtoitsmanagersingreaterdetail,whichallowsforbettercontrol,analysisanddecision-making.Managementcontrolisverydetail-oriented:Internalbalancesheetsandtheirsupportingschedulesshouldprovideallthedetailthatmanagersneedtomakegoodbusinessdecisions.

Incontrast,balancesheetspresentedinexternalfinancialreports(whichgoouttoinvestorsandlenders)donotincludemuchmoredetailthanthebalancesheetshowninFigure6-1.However,externalbalancesheetsmustclassify(orgrouptogether)short-termassetsandliabilities.Forthisreason,externalbalancesheetsarereferredtoasclassifiedbalancesheets.Thisclassificationisnotmandatoryforinternalreportingtomanagers,althoughseparatingshort-termassetsandliabilitiesisalsousefulformanagers.

Businessbalancesheetsarenotvettedbytheaccountanttomakesurenosecretsarebeingdisclosedthatwouldharmnationalsecurity.Theterm‘classified’appliedtoabalancesheetdoesnotmeanrestrictedortopsecret;rather,thetermmeansthatassetsandliabilitiesaresortedintobasicclasses,orgroups,forexternalreporting.Classifyingcertainassetsandliabilitiesintocurrentcategoriesisdonemainlytohelpreadersofthebalancesheetmoreeasilycomparetotalcurrentassetswithtotalcurrentliabilitiesforthepurposeofjudgingtheshort-termsolvencyofthebusiness.

Solvencyreferstotheabilityofabusinesstopayitsliabilitiesontime.Delaysinpayingliabilitiesontimecancauseveryseriousproblemsforabusiness.Inextremecases,abusinesscouldbethrownintobankruptcy–eventhethreatofbankruptcycancauseseriousdisruptionsinthenormaloperationsofabusiness,andprofitperformanceisboundtosuffer.Ifcurrentliabilitiesbecometoohighrelativetocurrentassets–whicharethefirstlineofdefenceforpayingthosecurrentliabilities–managersshouldmovequicklytoraiseadditionalcashtoreduceoneormoreofthecurrentliabilities.Otherwise,alowcurrentratiowillraisealarmsinthemindsoftheoutsidereadersofthebusiness’sfinancialreport.

Figure6-3presentstheclassifiedbalancesheetforthesamecompany.What’snew?Nottheassets,liabilitiesandowners’equityaccountsandtheirbalances.ThesenumbersarethesameonesshowninFigure6-1.TheclassifiedbalancesheetshowninFigure6-3includesthefollowingnewitemsofinformation:

Thefirstfourassetaccounts(cash,debtors,stockandprepaidexpenses)areaddedtogivethe£8,555,000subtotalforcurrentassets.

The£5,000,000totaldebtofthebusinessisdividedbetween£2,000,000short-termnotespayableand£3,000,000long-termnotespayable.

Thefirstfourliabilityaccounts(accountspayable,accruedexpensespayable,incometaxpayableandshort-termnotespayable)areaddedtogivethe£4,080,000subtotalforcurrentliabilities.

Figure6-3:Exampleofanexternal(classified)balancesheetforabusiness.

Current(short-term)assets

Short-term,orcurrent,assetsare:

Cash

Marketablesecuritiesthatcanbeimmediatelyconvertedintocash

Operatingassetsthatareconvertedintocashwithinoneoperatingcycle

Operatingcyclereferstotheprocessofputtingcashintostock,sellingproductsoncredit(whichgeneratesdebtors)andthen

collectingthereceivablesincash.Inotherwords,theoperatingcycleisthe‘fromcash–throughstockanddebtors–backtocash’sequence.Thetermoperatingreferstothoseassetsthataredirectlypartofmakingsalesanddirectlyinvolvedintheexpensesofthecompany.

Current(short-term)liabilitiesShort-term,orcurrent,liabilitiesarethosenon-interest-bearingliabilitiesthatarisefromtheoperatingactivitiesofthebusiness,aswellasinterest-bearingoverdraftsthathaveamaturitydateoneyearorlessfromthebalancesheetdate.Currentliabilitiesalsoincludeanyotherliabilitiesthatmustbepaidwithintheupcomingfinancialperiod.

Currentliabilitiesaregenerallypaidoutofcurrentassets.Thatis,currentassetsarethefirstsourceofmoneytopaythecurrentliabilitieswhenthoseliabilitiescomedue.Thus,totalcurrentassetsarecomparedagainsttotalcurrentliabilitiesinordertocomputethecurrentratio.Forthebalancesheetshownintheprecedingsection,youcancomputethecurrentratioasfollows:

£8,555,000currentassets÷£4,080,000currentliabilities=2.1currentratio

Thegeneralruleisthatacompany’scurrentratioshouldbe1.5orhigher.However,businessmanagersknowthatthecurrentratiodependsagreatdealonhowthebusiness’sshort-termoperatingassetsarefinancedfromcurrentliabilities.Somebusinessesdoquitewellwithacurrentratiolessthan1.5.Therefore,takethe1.5currentratiorulewithagrainofsalt.Alowercurrentratiodoesnotnecessarilymeanthatthebusinesswon’tbeabletopayitsshort-term(current)liabilitiesontime.Chapters14and17explaincurrent

term(current)liabilitiesontime.Chapters14and17explaincurrentratiosinmoredetail.

CostsandOtherBalanceSheetValues

Thebalancesheetsummarisesthefinancialconditionforabusinessatapointintime.Businessmanagersandinvestorsshouldclearlyunderstandthevaluesreportedinthisprimaryfinancialstatement.Inourexperience,understandingbalancesheetvaluescanbeasourceofconfusionforbothbusinessmanagersandinvestorswhotendtoputallpoundamountsonthesamevaluebasis.Intheirminds,apoundisapound,whetherit’sinthedebtors,stock,fixedassets,oraccountspayable.Assigningthesamevaluetoeveryaccountvaluetendstoglossoversomeimportantdifferencesandcanleadtoseriousmisinterpretationofthebalancesheet.

Abalancesheetmixestogetherseveraldifferenttypesofaccountingvalues:

Cash:Amountsofmoneyonhandincoinandcurrency;moneyondepositinbankaccounts

Debtors:Amountsnotyetcollectedfromcreditsalestocustomers

Stock:Amountsofpurchasecostsorproductioncostsforproductsthathaven’tsoldyet

Fixedassets(orProperty,plant,andequipment):Amountsofcostsinvestedinlong-life,tangible,productiveoperating

assets

Creditorsandaccruedliabilities:Amountsforthecostsofunpaidexpenses

Overdraftsandloans:Amountsborrowedoninterest-bearingliabilities

Capitalstock:Amountsofcapitalinvestedinthebusinessbyowners(shareholders).Thiscanbeeitherbywayoftheinitialcapitalintroducedorprofitsleftinthebusinessaftertradinggetsunderway

Retainedearnings(orreserves):Amountsremainingintheowners’equityaccount

Inshort,abalancesheetrepresentsadiversity,orarainbow,ofvalues–notjustonecolour.Thisisthenatureofthegenerallyacceptedaccountingprinciples–theaccountingmethodsusedtopreparefinancialstatements.

Bookvaluesaretheamountsrecordedintheaccountingprocessandreportedinfinancialstatements.Donotassumethatthebookvaluesreportedinabalancesheetnecessarilyequalthecurrentmarketvalues.Bookvaluesarebasedontheaccountingmethodsusedbyabusiness.Generallyspeaking–andwereallymeangenerallyherebecausewe’resurethatyoucanfindexceptionstothisrule–cash,debtors,andliabilitiesarerecordedatclosetotheirmarketorsettlementvalues.Thesereceivableswillbeturnedintocash(atthesameamountrecordedonthebalancesheet)andliabilitieswillbepaidoffattheamountsreportedinthebalancesheet.It’sthebookvaluesofstockandfixedassetsthatmostlikelyarelowerthancurrentmarketvalues,aswellasanyothernon-operatingassetsinwhichthebusinessinvestedsometimeago.

Abusinesscanusealternativeaccountingmethodstodeterminethecostofstockandthecostofgoodssold,andtodeterminehowmuchofafixedasset’scostisallocatedtodepreciationexpenseeachyear.Abusinessisfreetouseveryconservativeaccountingmethods–withtheresultthatitsstockcostvalueandthenon-depreciatedcostofitsfixedassetsmaybemuchlowerthanthecurrentreplacementcostvaluesoftheseassets.Chapter13explainsmoreaboutchoosingdifferentaccountingmethods.

GrowingUpInthelayoutinFigure6-4westartwiththefixedassetsratherthanliquidassetssuchascashandworkourwaydown.Afterthefixedassetsumhasbeendeterminedtoarriveattheresidualunwrittendown‘value’ofthoseassets,inthiscase£5,525,000,weworkourwaydownthecurrentassetsinthereverseorderoftheirabilitytobeturnedintocash.Thetotalofthecurrentassetscomesto£8,555,000.

Nextwegetthecurrentliabilities,whichcometoatotalof£4,080,000,andsubtractthatfromthecurrentassettotalof£8,555,000toarriveatafigureof£4,475,000.Thisisoftenreferredtoastheworkingcapital,asitrepresentsthemoneycirculatingthroughthebusinessdaytoday.

Byaddingthenetcurrentassets(workingcapital)of£4,475,000tothenetbookvalueofthefixedassets,£5,525,000,bingo!Wecanseewehave£10,000,000tiedupinnettotalassets.Deductthemoneyweowelongterm,thecreditorsdueoveroneyear(afancywayofdescribingbankandotherdebtotherthanoverdraft),andwearriveatthenettotalassets.Net,bytheway,isaccountant-speakfordeductionofonenumberfromanother,oftenaddingafour-figuresumtothebillfordoingso.

Thenettotalassetsfigureof£7,000,000bearsanuncannysimilaritytothetotalofthemoneyputinbytheownersofthebusinesswhentheystartedout,£2,000,000,andthesumtheyhaveleftinbywayofprofitsundistributedovertheyears,£5,000,000.Sothebalancesheetbalances,butwithaverydifferenttotalfromthatofFigure6-3.

Figure6-4:Abalancesheet.

YoucanfindablankbalancesheetandprofitandlossaccountsinExcelformat,aswellasatutoredexerciseandsupportingnotes,atwww.bized.co.uk/learn/sheets/tasker.xls.

Chapter7

CashFlowsandtheCashFlowStatement

InThisChapterSeparatingthethreetypesofcashflows

Figuringouthowmuchactualcashincreasewasgeneratedbyprofit

Lookingatabusiness’sothersourcesandusesofcash

Beingcarefulaboutfreecashflow

Evaluatingmanagers’decisionsbyscrutinisingthecashflowstatement

Thischaptertalksaboutcashflows–whichingeneralreferstocashinflowsandoutflowsoveraperiodoftime.Supposeyoutellusthatlastyearyouhadtotalcashinflowsof£145,000andtotalcashoutflowsof£140,000.Weknowthatyourcashbalanceincreased£5,000.Butwedon’tknowwhereyour£145,000cashinflowscamefrom.Didyouearnthismuchinsalary?Didyoureceiveaninheritancefromyourrichuncle?Likewise,wedon’tknowwhatyouusedyour£140,000cashoutflowfor.Didyoumakelargepaymentsonyourcreditcards?Didyoulosealotofmoneyattheraces?Inshort,cashflowshavetobesortedintodifferentsourcesandusestomakemuchsense.

TheThreeTypesofCashFlow

Accountantscategorisethecashflowsofabusinessintothreetypes:

Cashinflowsfrommakingsalesandcashoutflowsfor

expenses–salesandexpensetransactions–arecalledtheoperatingactivitiesofabusiness(althoughtheycouldbecalledprofitactivitiesjustaswell,becausetheirpurposeistomakeprofit).

Cashoutflowsformakinginvestmentsinnewassets(buildings,machinery,toolsandsoon)andcashinflowsfromliquidatingoldinvestments(assetsnolongerneededthataresoldoff);thesetransactionsarecalledinvestmentactivities.

Cashinflowsfromborrowingmoneyandfromtheadditionalinvestmentofmoneyinthebusinessbyitsowners,andcashoutflowsforpayingoffdebt,returningcapitalthatthebusinessnolongerneedstoownersandmakingcashdistributionsofprofittoitsowners;thesetransactionsarecalledfinancingactivities.

Thecashflowstatement(orstatementofcashflows)summarisesthecashflowsofabusinessforaperiodaccordingtothisthree-wayclassification.Generallyacceptedaccountingprinciplesrequirethatwheneverabusinessreportsitsincomestatement,itmustalsoreportitscashflowstatementforthesameperiod–abusinessshouldn’treportonewithouttheother.Agoodreasonexistsforthisdualfinancialstatementrequirement.

Theincomestatementisbasedontheaccrualbasisofaccountingthatrecordssaleswhenmade,whetherornotcashisreceivedatthattime,andrecordsexpenseswhenincurred,whetherornottheexpensesarepaidatthattime.(Chapter3explainsaccrualbasisaccounting.)Becauseaccrualbasisaccountingisusedtorecordprofit,youcan’tequatebottom-lineprofitwithanincreaseincash.Supposeabusiness’sannualincomestatementreportsthatitearned£1.6millionnetincome

fortheyear.Thisdoesnotmeanthatitscashbalanceincreased£1.6millionduringtheperiod.Youhavetolookinthecashflowstatementtofindouthowmuchitscashbalanceincreased(or,possibly,decreased!)fromitsoperatingactivities(salesrevenueandexpenses)duringtheperiod.

Inthechapter,werefertothenetincrease(ordecrease)inthebusiness’scashbalancethatresultsfromcollectingsalesrevenueandpayingexpensesascashflowfromprofit(thealternativetermforcashflowfromoperatingactivities).Cashflowfromprofitseemsmoreuser-friendlythancashflowfromoperatingactivities,andinfactthetermisusedwidely.Inanycase,donotconfusecashflowfromprofitwiththeothertwotypesofcashflow–fromthebusiness’sinvestingactivitiesandfinancingactivitiesduringtheperiod.

Beforemovingon,here’sashortproblemforyoutosolve.Thissummaryofthebusiness’snetcashflows(inthousands)fortheyearjustended,whichusesthethree-wayclassificationofcashflowsexplainedearlier,hasoneamountmissing:

Notethatthebusiness’scashbalancefromallsourcesandusesdecreased£15,000duringtheyear.Theamountsofnetcashflowsfromthecompany’sinvestingandfinancingactivitiesaregiven.Soyoucandeterminethatthenetcashflowfromprofitwas£1,100,000fortheyear.Understandingcashflowsfrominvestingactivitiesandfinancingactivitiesisfairlystraightforward.Understandingthenetcashflowfromprofit,incontrast,ismorechallenging–butbusiness

Figure7-1:Changesin

cashflowfromprofit,incontrast,ismorechallenging–butbusinessmanagersandinvestorsshouldhaveagoodgriponthisveryimportantnumber.

SettingtheStage:ChangesinBalanceSheetAccounts

Thefirststepinunderstandingtheamountsreportedbyabusinessinitscashflowstatementistofocusonthechangesinthebusiness’sassets,liabilitiesandowners’equityaccountsduringtheperiod–theincreasesordecreasesofeachaccountfromthestartoftheperiodtotheendoftheperiod.Thesechangesarefoundinthecomparativetwo-yearbalancesheetreportedbyabusiness.Figure7-1presentstheincreasesanddecreasesduringtheyearintheassets,liabilitiesandowners’equityaccountsforabusinessexample.Figure7-1isnotabalancesheetbutonlyasummaryofchangesinaccountbalances.Wedonotwanttoburdenyouwithanentirebalancesheet,whichhasmuchmoredetailthanisneededhere.

TakeamomenttoscanFigure7-1.Notethatthebusiness’scashbalancedecreased£15,000duringtheyear.(Anincreaseisnotnecessarilyagoodthing,andadecreaseisnotnecessarilyabadthing;itdependsontheoverallfinancialsituationofthebusiness.)Onepurposeofreportingthecashflowstatementistosummarisethemainreasonsforthechangeincash–accordingtothethree-wayclassificationofcashflowsexplainedearlier.Onequestiononeveryone’smindisthis:Howmuchcashdidtheprofitfortheyeargenerateforthebusiness?Thecashflowstatementbeginsbyansweringthisquestion.

balancesheetassetsandoperatingliabilitiesthataffectcashflowfromprofit.

GettingattheCashIncreasefromProfit

Althoughallamountsreportedonthecashflowstatementareimportant,theonethatusuallygetsthemostattentioniscashflowfromoperatingactivities,orcashflowfromprofitasweprefertocallit.Thisistheincreaseincashgeneratedbyabusiness’sprofit-makingoperationsduringtheyearexclusiveofitsothersourcesofcashduringtheyear(suchasborrowedmoney,sold-offfixedassetsandadditionalowners’investmentsinthebusiness).Cashflowfromprofitindicatesabusiness’sabilitytoturnprofitintoavailablecash–cashinthebankthatcanbeusedfortheneedsofbusiness.Cashflowfrom

profitgetsjustasmuchattentionasnetincome(thebottom-lineprofitnumberintheincomestatement).

Beforepresentingthecashflowstatement–whichisaratherformidable,three-partaccountingreport–inallitsglory,inthefollowingsectionswebuildonthesummaryofchangesinthebusiness’sassets,liabilitiesandowners’equitiesshowninFigure7-1toexplainthecomponentsofthe£1,100,000increaseincashfromthebusiness’sprofitactivitiesduringtheyear.(The£1,100,000amountofcashflowfromprofitwasdeterminedearlierinthechapterbysolvingtheunknownfactor.)

Thebusinessintheexampleexperiencedaratherstronggrowthyear.Itsaccountsreceivableandstockincreasedbyrelativelylargeamounts.Infact,alltherelevantaccountsincreased;theirendingbalancesarelargerthantheirbeginningbalances(whicharetheamountscarriedforwardfromtheendoftheprecedingyear).Atthispoint,weneedtoprovidesomeadditionalinformation.The£1.2millionincreaseinretainedearningsisthenetdifferenceoftwoquitedifferentthings.

The£1.6millionnetincomeearnedbythebusinessincreasedretainedearningsbythisamount.AsyouseeinFigure7-1,theaccountincreasedonly£1.2million.Thustheremusthavebeena£400,000decreaseinretainedearningsduringtheyear.Thebusinesspaid£400,000cashdividendsfromprofittoitsowners(theshareholders)duringtheyear,whichisrecordedasadecreaseinretainedearnings.Theamountofcashdividendsisreportedinthefinancingactivitiessectionofthecashflowstatement.Theentireamountofnetincomeisreportedintheoperatingactivitiessectionofthecashflowstatement.

Cashflowfromprofit(£3,020positiveincreasesminus£1,920negativeincreases)£1,100

Notethatnetincome(profit)fortheyear–whichisthecorrectamountofprofitbasedontheaccrualbasisofaccounting–islistedinthepositivecashflowcolumn.Thisisonlythestartingpoint.Thinkofthisthefollowingway:Ifthebusinesshadcollectedallitssalesrevenuefortheyearincash,andifithadmadecashpaymentsforitsexpensesexactlyequaltotheamountsrecordedfortheexpenses,thenthenetincomeamountwouldequaltheincreaseincash.Thesetwoconditionsarevirtuallynevertrue,andtheyarenottrueinthisexample.Sothenetincomefigureisjustthejumping-offpointfordeterminingtheamountofcashgeneratedbythebusiness’sprofitactivitiesduringtheyear.

We’llletyouinonalittlesecrethere.Theanalysisofcashflowfromprofitaskswhatamountofprofitwouldhavebeenrecordedifthebusinesshadbeenonthecashbasisofaccountinginsteadoftheaccrualbasis.Thiscanbeconfusingandexasperating,becauseitseemsthattwodifferentprofitmeasuresareprovidedinabusiness’sfinancialreport–thetrueeconomicprofitnumber,whichisthebottomlineintheincomestatement(usuallycallednetincome),andasecondprofitnumbercalledcashflowfromoperatingactivitiesinthecashflowstatement.

Whenthecashflowstatementwasmademandatory,manyaccountantsworriedaboutthisproblem,butthemajorityopinionwasthattheamountofcashincrease(ordecrease)generatedfromtheprofitactivitiesofabusinessisveryimportanttodiscloseinfinancialreports.Forreadingtheincomestatementyouhavetowearyouraccrualbasisaccountinglenses,andforthecashflowstatementyouhavetoputonyourcashbasislenses.Whosaysaccountantscan’tseetwosidesofsomething?

Thefollowingsectionsexplaintheeffectsoncashflowthateachbalancesheetaccountchangecauses(refertoFigure7-1).

Gettingspecificaboutchangesinassetsandliabilities

Asabusinessmanager,youshouldkeepaclosewatchoneachofyourassetsandliabilitiesandunderstandthecashfloweffectsofincreases(ordecreases)causedbythese

changes.Investorsshouldfocusonthebusiness’sabilitytogenerateahealthycashflowfromprofit,soinvestorsshouldbeequallyconcernedaboutthesechanges.

Debtorsincrease

Rememberthatthedebtorsassetshowshowmuchmoneycustomerswhoboughtproductsoncreditstillowethebusiness;thisassetisapromiseofcashthatthebusinesswillreceive.Basically,debtorsistheamountofuncollectedsalesrevenueattheendoftheperiod.Cashdoesnotincreaseuntilthebusinesscollectsmoneyfromitscustomers.

Buttheamountindebtorsisincludedinthetotalsalesrevenueoftheperiod–afterall,youdidmakethesales,evenifyouhaven’tbeenpaidyet.Obviously,then,youcan’tlookatsalesrevenueasbeingequaltotheamountofcashthatthebusinessreceivedduringtheperiod.

Tocalculatetheactualcashflowfromsales,youneedtosubtractfromsalesrevenuetheamountofcreditsalesthatyoudidnotcollectincashovertheperiod–butyouaddintheamountofcashthatyoucollectedduringtheperiodjustendedforcreditsalesthatyoumadeintheprecedingperiod.Takealookatthefollowingequationforthebusinessexample,whichisfirstintroducedinChapter6–theincomestatementfiguresusedherearegiveninFigure6–2andtheassetandliabilitychangesareshowninFigure7–1.(NoneedtolookbacktoFigure6–2unlessyouwanttoreviewtheincomestatement.)

£25millionsalesrevenue–£0.8millionincreaseindebtors=£24.2millioncashcollectedfromcustomersduringtheyear

Thebusinessstartedtheyearwith£1.7millionindebtorsandendedtheyearwith£2.5millionindebtors.Thebeginningbalancewascollectedduringtheyearbutattheendoftheyeartheendingbalancehadnotbeencollected.Thustheneteffectisashortfallincashinflowof£800,000,whichiswhyit’scalledanegativecashflowfactor.Thekeypointisthatyouneedtokeepaneyeontheincreaseordecreaseindebtorsfromthebeginningoftheperiodtotheend

oftheperiod.

Iftheamountofcreditsalesyoumadeduringtheperiodisgreaterthantheamountcollectedfromcustomersduringthesameperiod,yourdebtorsincreasedovertheperiod.Thereforeyouneedtosubtractfromsalesrevenuethatdifferencebetweenstart-of-perioddebtorsandend-of-perioddebtors.Inshort,anincreaseindebtorshurtscashflowbytheamountoftheincrease.

Iftheamountyoucollectedfromcustomersduringtheperiodisgreaterthanthecreditsalesyoumadeduringtheperiod,yourdebtorsdecreasedovertheperiod.Inthiscaseyouneedtoaddtosalesrevenuethatdifferencebetweenstart-of-perioddebtorsandend-of-perioddebtors.Inshort,adecreaseindebtorshelpscashflowbytheamountofthedecrease.

Intheexamplewe’vebeenusing,debtorsincreased£800,000.Cashcollectionsfromsaleswere£800,000lessthansalesrevenue.Ouch!Thebusinessincreaseditssalessubstantiallyoverlastperiod,soyoushouldn’tbesurprisedthatitsdebtorsincreased.Thehighersalesrevenuewasgoodforprofitbutbadforcashflowfromprofit.

Anoccasionalhiccupincashflowisthepriceofgrowth–managersandinvestorsneedtounderstandthispoint.Increasingsaleswithoutincreasingdebtorsisahappysituationforcashflow,butintherealworldyoucan’thaveoneincreasewithouttheother(exceptinveryunusualcircumstances).

Stockincrease

StockisthenextassetinFigure7-1–andusuallythelargestshort-term,orcurrent,assetforbusinessesthatsellproducts.Ifthestockaccountisgreaterattheendoftheperiodthanatthestartoftheperiod–becauseeitherunitcostsincreasedorthequantityofproductsincreased–whatthebusinessactuallypaidoutincashforstockpurchases(ormanufacturingproducts)ismorethanthebusinessrecordedasitscost-of-goods-soldexpenseintheperiod.Therefore,youneedtodeductthestockincreasefromnetincomewhendeterminingcashflowfromprofit.

Intheexample,stockincreased£975,000fromstart-of-periodtoend-of-period.Inotherwords,thisbusinessreplacedtheproductsthatitsoldduringtheperiodandincreaseditsstockby£975,000.Theeasiestwaytounderstandtheeffectofthisincreaseoncashflowistopretendthatthebusinesspaidforallitsstockpurchasesincashimmediatelyuponreceivingthem.Thestockonhandatthestartoftheperiodhadalreadybeenpaidforlastperiod,sothatcostdoesnotaffectthisperiod’scashflow.Thoseproductsweresoldduringtheperiodandinvolvednofurthercashpaymentbythebusiness.Butthebusinessdidpaycashthisperiodfortheproductsthatwereinstockattheendoftheperiod.

Inotherwords,ifthebusinesshadboughtjustenoughnewstock(atthesamecostthatitpaidoutlastperiod)toreplacethestockthatitsoldduringtheperiod,theactualcashoutlayforitspurchaseswouldequalthecost-of-goods-soldexpensereportedinitsincomestatement.Endingstockwouldequalthebeginningstock;thetwostockcostswouldcanceleachotheroutandthuswouldhavenoeffectoncashflow.Butthishypotheticalscenariodoesn’tfittheexamplebecausethecompanyincreaseditssalessubstantiallyoverthelastperiod.

thelastperiod.

Tosupportthehighersaleslevel,thebusinessneededtoincreaseitsstocklevel.Sothebusinessbought£975,000moreinproductsthanitsoldduringtheperiod–andithadtocomeupwiththecashtopayforthisstockincrease.Basically,thebusinesswrotechequesamountingto£975,000morethanitscost-of-goods-soldexpensefortheperiod.Thisstep-upinitsstocklevelwasnecessarytosupportthehighersaleslevel,whichincreasedprofit–eventhoughcashflowtookahit.

It’sthataccrualbasisaccountingthingagain:Thecostthatabusinesspaysthisperiodfornextperiod’sstockisreflectedinthisperiod’scashflowbutisn’trecordeduntilnextperiod’sincomestatement(whentheproductsareactuallysold).Soifabusinesspaidmorethisperiodfornextperiod’sstockthanitpaidlastperiodforthisperiod’sstock,youcanseehowtheadditionalexpensewouldadverselyaffectcashflowbutwouldnotbereflectedinthebottom-linenetincomefigure.Thiscashflowanalysisstuffgetsalittlecomplicated,weknow,buthanginthere.Thecashflowstatement,presentedlaterinthechapter,makesalotmoresenseafteryougothroughthisbackgroundbriefing.

Prepaidexpensesincrease

Thenextasset,afterstock,isprepaidexpenses(refertoFigure7-1).Achangeinthisaccountworksthesamewayasachangeinstockanddebtors,althoughchangesinprepaidexpensesareusuallymuchsmallerthanchangesinthoseothertwoassetaccounts.

Again,thebeginningbalanceofprepaidexpensesisrecordedasanexpensethisperiodbutthecashwasactuallypaidoutlastperiod,notthisperiod.Thisperiod,abusinesspayscashfornextperiod’sprepaidexpenses–whichaffectsthisperiod’scashflowbutdoesn’taffectnetincomeuntilnextperiod.Sothe£145,000increaseinprepaidexpensesfromstart-of-periodtoend-of-periodinthisexamplehasanegativecashfloweffect.

Asitgrows,abusinessneedstoincreaseitsprepaidexpensesforsuchthingsasfireinsurance(premiumshavetobepaidinadvanceoftheinsurancecoverage)anditsstocksofofficeanddataprocessingsupplies.Increasesindebtors,stockandprepaidexpensesarethepriceabusinesshastopayforgrowth.Rarelydoyoufindabusinessthatcanincreaseitssalesrevenuewithoutincreasingtheseassets.

Thesimplebuttroublesomedepreciationfactor

Depreciationexpenserecordedintheperiodisboththesimplestcashfloweffecttounderstandand,atthesametime,oneofthemostmisunderstoodelementsincalculatingcashflowfromprofit.(RefertoChapters5and6formoreaboutdepreciation.)Tostartwith,depreciationisnotacashoutlayduringtheperiod.Theamountofdepreciationexpenserecordedintheperiodissimplyafractionoftheoriginalcostofthebusiness’sfixedassetsthatwereboughtandpaidforyearsago.(Well,ifyouwanttonit-pickhere,

boughtandpaidforyearsago.(Well,ifyouwanttonit-pickhere,someofthefixedassetsmayhavebeenboughtduringthisperiod,andtheircostisreportedintheinvestingactivitiessectionofthecashflowstatement.)Becausethedepreciationexpenseisnotacashoutlaythisperiod,theamountisaddedbacktonetincomeinthecalculationofcashflowfromprofit–sofarsogood.

Whenmeasuringprofitontheaccrualbasisofaccountingyoucountdepreciationasanexpense.Thefixedassetsofabusinessareonanirreversiblejourneytothejunkheap.Fixedassetshavealimitedlifeofusefulnesstoabusiness(exceptforland);depreciationistheaccountingmethodthatallocatesthetotalcostoffixedassetstoeachyearoftheiruseinhelpingthebusinessgeneratesalesrevenue.Partofthetotalsalesrevenueofabusinessconstitutesrecoveryofcostinvestedinitsfixedassets.Inarealsense,abusiness‘sells’someofitsfixedassetseachperiodtoitscustomers–itfactorsthecostoffixedassetsintothesalespricesthatitchargesitscustomers.Forexample,whenyougotoasupermarket,averysmallsliceofthepriceyoupayforthatboxofcerealgoestowardthecostofthebuilding,theshelves,therefrigerationequipmentandsoon.(Nowondertheychargesomuchforaboxofcornflakes!)

Eachperiod,abusinessrecoupspartofthecostinvestedinitsfixedassets.Inotherwords,£1.2millionofsalesrevenue(intheexample)wenttowardreimbursingthebusinessfortheuseofitsfixedassetsduringtheyear.Theproblemregardingdepreciationincashflowanalysisisthatmanypeoplesimplyaddbackdepreciationfortheyeartobottom-lineprofitandthenstop,asifthisisthepropernumberforcashflowfromprofit.Itain’tso.Thechangesinotherassetsaswellasthechangesinliabilitiesalsoaffectcashflowfromprofit.Youshouldfactorinallthechangesthatdeterminecashflowfromprofit,asexplainedinthefollowingsection.

Addingnetincomeanddepreciationtodeterminecashflowfromprofitismixingapplesandoranges.Thebusinessdidnotrealise£1,600,000cashincreasefromits£1,600,000netincome.Thetotaloftheincreasesofitsdebtors,stockandprepaidexpensesis£1,920,000(refertoFigure7-1),whichwipesoutthenetincomeamountandleavesthebusinesswithacashbalanceholeof£320,000.Thiscashdeficitisoffsetbythe£220,000increaseinliabilities(explainedlater),leavinga£100,000netincomedeficitasfarascashflowisconcerned.Depreciationrecoveryincreasedcashflow£1.2million.Sothefinalcashflowfromprofitequals£1.1million.Butyou’dneverknowthisifyousimplyaddeddepreciationexpensetonetincomefortheperiod.

Themanagersdidnothavetogooutsidethebusinessforthe£1.1millioncashincreasegeneratedfromitsprofitfortheyear.Cashflowfromprofitisaninternalsourceofmoneygeneratedbythebusinessitself,incontrasttoexternalmoneythatthebusinessraisesfromlendersandowners.Abusinessdoesnothavetofindsourcesofexternalmoneyifitsinternalcashflowfromprofitissufficienttoprovideforitsgrowth.

Netincome+depreciationexpensedoesn’tequalcashflowfromprofit!

Thebusinessinourexampleearned£1.6millioninnetincomefortheyear,plusitreceived£1.2millioncashflowbecauseofthedepreciationexpensebuiltintoitssalesrevenuefortheyear.Thesumofthesefiguresis£2.8million.Is£2.8milliontheamountofcashflowfromprofitfortheperiod?Theknee-jerkanswerofmanyinvestorsandmanagersis‘yes’.Butifnetincome+

depreciationtrulyequalscashflow,thenbothfactorsinthebrackets–bothnetincomeanddepreciation–mustbefullyrealisedincash.Depreciationis,butthenetincomeamountisnotfullyrealisedincashbecausethecompany’sdebtors,stockandprepaidexpensesincreasedduringtheyear,andtheseincreaseshavenegativeimpactsoncashflow.

Inpassing,weshouldmentionthatabusinesscouldhaveanegativecashflowfromprofitforayear–meaningthatdespitepostinganetincomefortheperiod,thechangesinthecompany’sassetsandliabilitiescauseditscashbalancetodecrease.Inreverse,abusinesscouldreportabottomlinelossinitsincomestatementyethaveapositivecashflowfromitsoperatingactivities:Thepositivecontributionfromdepreciationexpenseplusdecreasesinitsdebtorsandstockcouldamounttomorethantheamountofloss.Morecommonly,alossleadstonegativecashfloworverylittlepositivecashflow.

Operatingliabilitiesincreases

Thebusinessintheexample,likealmostallbusinesses,hasthreebasicliabilitiesthatareinextricablyintertwinedwithitsexpenses:creditors,accruedexpensespayableandincometaxpayable.Whenthebeginningbalanceofoneoftheseliabilityaccountsisthesameastheendingbalanceofthesameaccount(nottoolikely,ofcourse),thebusinessbreaksevenoncashflowforthataccount.Whentheend-of-periodbalanceishigherthanthestart-of-periodbalance,thebusinessdidnotpayoutasmuchmoneyaswasactuallyrecordedasanexpenseontheperiod’sincomestatement.

Intheexamplewe’vebeenusing,thebusinessdisbursed£720,000topayofflastperiod’screditorsbalance.(This£720,000wasreportedasthecreditorsbalanceonlastperiod’sendingbalancesheet.)Itscashflowthisperioddecreasedby£720,000becauseofthesepayments.Butthisperiod’sendingbalancesheetshowstheamountofcreditorsthatthebusinesswillneedtopaynextperiod–£800,000.Thebusinessactuallypaidoff£720,000andrecorded£800,000ofexpensestotheyear,sothistimecashflowisricherthanwhat’sreflectedinthebusiness’snetincomefigureby£80,000–inotherwords,theincreaseincreditorshasapositivecashfloweffect.Theincreasesinaccruedexpensespayableandincometaxpayableworkthesameway.

Therefore,liabilityincreasesarefavourabletocashflow–inasensethebusinessborrowedmorethanitpaidoff.Suchanincreasemeansthatthebusinessdelayedpayingcashforcertainthingsuntilnextyear.Soyouneedtoaddtheincreasesinthethreeliabilitiestonetincometodeterminecashflowfromprofit,followingthesamelogicasaddingbackdepreciationtonetincome.Thebusinessdidnothavecashoutlaystotheextentofincreasesinthesethreeliabilities.

liabilities.

Theanalysisofthechangesinassetsandliabilitiesofthebusinessthataffectcashflowfromprofitiscompleteforthebusinessexample.Thefinalresultisthatthecompany’scashbalanceincreased£1.1millionfromprofit.Youcouldarguethatcashshouldhaveincreased£2.8million–£1.6millionnetincomeplus£1.2milliondepreciationthatwasrecoveredduringtheyear–sothebusinessis£1.7millionbehindinturningitsprofitintocashflow(£2.8millionlessthe£1.1millioncashflowfromprofit).This£1.7millionlaginconvertingprofitintocashflowiscausedbythe£1,920,000increaseinassetslessthe£220,000increaseinliabilities,asshowninFigure7–1.

PresentingtheCashFlowStatementThecashflowstatementisoneofthethreeprimaryfinancialstatementsthatabusinessmustreporttotheoutsideworld,accordingtogenerallyacceptedaccountingprinciples(GAAP).Tobetechnical,therulesaysthatwheneverabusinessreportsaprofitandlossaccount,itshouldalsoreportacashflowstatement.Theprofitandlossaccountsummarisessalesrevenueandexpensesandendswiththebottom-lineprofitfortheperiod.Thebalancesheetsummarisesabusiness’sfinancialconditionbyreportingitsassets,liabilitiesandowners’equity.(RefertoChapters5and6formoreaboutthesereports.)

Youcanprobablyguesswhatthecashflowstatementdoesbyitsnamealone:Thisstatementtellsyouwhereabusinessgotitscashandwhatthebusinessdidwithitscashduringtheperiod.WepreferthenamegiventothisstatementintheolddaysintheUS–theWhereGot,WhereGonestatement.Thisnicknamegoesstraighttothepurposeofthecashflowstatement:askingwherethebusinessgotitsmoneyandwhatitdidwiththemoney.

Togiveyouaroughideaofwhatacashflowstatementreports,werepeatsomeofthequestionsweaskedatthestartofthechapter:Howmuchmoneydidyouearnlastyear?Didyougetallyourincomeincash(ordidsomeofyourwagesgostraightintoapensionplanordidyoucollectacoupleofIOUs)?Wheredidyougetothermoney(didyoutakeoutaloan,winthelotteryorreceiveagiftfromarichuncle)?Whatdidyoudowithyourmoney(didyoubuyahouse,supportyourout-of-controlInternetaddictionorloseitplayingbingo)?

Gettingalittletoopersonalforyou?That’sexactlywhythecashflowstatementissoimportant:Itbaresabusiness’sfinancialsoultoitslendersandowners.Sometimesthecashflowstatementrevealsquestionablejudgmentcallsthatthebusiness’smanagersmade.Attheveryleast,thecashflowstatementrevealshowwellabusinesshandlesthecashincreasefromitsprofit.

Asexplainedatthestartofthechapter,thecashflowstatementisdividedintothreesectionsaccordingtothethree-foldclassificationofcashflowsforabusiness:operatingactivities(whichwealsocallcashflowfromprofitinthechapter),investingactivitiesandfinancingactivities.

Thecashflowstatementreportsabusiness’snetcashincreaseordecreasebasedonthesethreegroupingsofthecashflowstatement.Figure7-2showswhatacashflowstatementtypicallylookslike–inthisexample,foragrowingbusiness(whichmeansthatitsassets,liabilitiesandowners’equityincreaseduringtheperiod).

ThehistoryofthecashflowstatementThecashflowstatementwasnotrequiredforexternalfinancialreportinguntilthelate1980s.Untilthen,theaccountingprofessionhadturnedadeafeartocallsfromtheinvestmentcommunityforcashflowstatementsinannualfinancialreports.(Accountantshadpresentedafundsflowstatementpriorto

Figure7-2:Cashflowstatementforthebusinessintheexample.

then,butthatreportprovedtobeadisaster–thetermfundsincludedmoreassetsthanjustcashandrepresentedanetamountafterdeductingshort-termliabilitiesfromshort-term,orcurrent,assets.)

Inouropinion,thereluctancetorequirecashflowstatementscamefromfearsthatthecashflowfromprofitfigurewouldusurpnetincome–peoplewouldloseconfidenceinthenetincomeline.

Thosefearshavesomejustification–consideringtheattentiongiventocashflowfromprofitandwhatiscalled‘freecashflow’(discussedlaterinthechapter).Althoughtheprofitandlossaccountcontinuestogetmostofthefanfare(becauseitshowsthemagicbottom-linenumberofnetincome),cashflowgetsalotofemphasisthesedays.

Thetricktounderstandingcashflowfromprofitistolinkthesalesrevenueandexpensesofthebusinesswiththechangesinthebusiness’sassetsandliabilitiesthataredirectlyconnectedwithitsprofit-makingactivities.Usingthisapproachearlierinthechapter,wedeterminethatthecashflowfromprofitis£1.1millionfortheyearforthesamplebusiness.ThisisthenumberyouseeinFigure7-2forcashflowfromoperatingactivities.Inourexperience,manybusinessmanagers,lendersandinvestorsdon’tfullyunderstandtheselinks,butthesavvyonesknowtokeepacloseeyeontherelevantbalancesheetchanges.

Whatdothefiguresinthefirstsectionofthecashflowstatement(SeeFigure7-2)revealaboutthisbusinessoverthepastperiod?Recallthatthebusinessexperiencedrapidsalesgrowthoverthelastperiod.However,thedownsideofsalesgrowthisthatoperatingassetsandliabilitiesalsogrow–thebusinessneedsmorestockatthehighersaleslevelandalsohashigherdebtors.

Thebusiness’sprepaidexpensesandliabilitiesalsoincreased,althoughnotnearlyasmuchasdebtorsandstock.Therapidgrowthofthebusinessyieldedhigherprofitbutalsocausedquiteasurgeinitsoperatingassetsandliabilities–theresultbeingthatcashflowfromprofitisonly£1.1millioncomparedwith£1.6millioninnetincome–a£500,000shortfall.Still,thebusinesshad£1.1millionatitsdisposalafterallowingfortheincreasesinassetsandliabilities.Whatdidthebusinessdowiththis£1.1millionofavailablecash?Youhavetolooktotheremainderofthecashflowstatementtoanswerthiskeyquestion.

Averyquickreadthroughtherestofthecashflowstatement(refertoFigure7-2)goessomethinglikethis:Thecompanyused£1,275,000tobuynewfixedassets,borrowed£500,000anddistributed£400,000oftheprofittoitsowners.Theresultisthatcashdecreased£15,000duringtheyear.Shouldn’tthebusinesshave

cashdecreased£15,000duringtheyear.Shouldn’tthebusinesshaveincreaseditscashbalance,givenitsfairlyrapidgrowthduringtheperiod?That’sagoodquestion!Higherlevelsofsalesgenerallyrequirehigherlevelsofoperatingcashbalances.However,youcanseeinitsbalancesheetattheendoftheyear(referbacktoFigure6-2)thatthecompanyhas£2millionincash,which,comparedwithits£25millionannualsalesrevenue,isprobablyenough.

Abetteralternativeforreportingcashflowfromprofit?

Wecallyourattention,again,tothefirstsectionofthecashflowstatementinFigure7-2.Youstartwithnetincomefortheperiod.Next,changesinassetsandliabilitiesaredeductedoraddedtonetincometoarriveatcashflowfromoperatingactivities(thecashflowfromprofit)fortheyear.Thisformatiscalledtheindirectmethod.Thealternativeformatforthissectionofthecashflowstatementiscalledthedirectmethodandispresentedlikethis(usingthesamebusinessexample,withpoundamountsinmillions):

Youmayrememberfromtheearlierdiscussionthatsalesrevenuefortheyearis£25million,butthatthecompany’sdebtorsincreased£800,000duringtheyear,socashflowfromsalesis£24.2million.Likewise,theexpensesfortheyearcanbeputonacashflowbasis.Butwe‘cheated’here–wehavealreadydeterminedthatcashflowfromprofitis£1.1millionfortheyear,sowepluggedthefigureforcashoutflowforexpenses.Wewouldtakemoretimetoexplainthe

cashoutflowforexpenses.Wewouldtakemoretimetoexplainthedirectapproach,exceptforonemajorreason.

Wheretoputdepreciation?Wherethedepreciationlinegoeswithinthefirstsection(operatingactivities)ofthecashflowstatementisamatterofpersonalpreference–nostandardlocationisrequired.Manybusinessesreportitinthemiddleortowardthebottomofthechangesinassetsandliabilities–perhapstoavoidgivingpeopletheideathatcashflowfromprofitsimplyrequiresaddingbackdepreciationtonetincome.

AlthoughtheAccountingStandardsBoard(ASB)expressesadefinitepreferenceforthedirectmethod,thisaugustrule-makingbodydoespermittheindirectmethodtobeusedinexternalfinancialreports–and,infact,theoverwhelmingmajorityofbusinessesusetheindirectmethod.Unlessyou’reanaccountant,wedon’tthinkyouneedtoknowmuchmoreaboutthedirectmethod.

SailingthroughtheRestoftheCashFlowStatement

Afteryougetpastthefirstsection,therestofthecashflowstatementisabreeze.Thelasttwosectionsofthestatementexplainwhatthebusinessdidwithitscashandwherecashthatdidn’tcomefromprofitcamefrom.

InvestingactivitiesThesecondsectionofthecashflowstatementreportstheinvestmentactionsthatabusiness’smanagerstookduringtheyear.Investmentsareliketealeaves,servingasindicatorsregardingwhatthefuturemayholdforthecompany.Majornewinvestmentsarethesuresignsofexpandingormodernisingtheproductionanddistributionfacilitiesandcapacityofthebusiness.Majordisposalsoflong-termassetsandthesheddingofamajorpartofthebusinesscouldbegoodnewsorbadnewsforthebusiness,dependingonmanyfactors.Differentinvestorsmayinterpretthisinformationdifferently,butallwouldagreethattheinformationinthissectionofthecashflowstatementisveryimportant.

Certainlong-livedoperatingassetsarerequiredfordoingbusiness–forexample,FederalExpresswouldn’tbeterriblysuccessfulifitdidn’thaveaeroplanesandvansfordeliveringpackagesandcomputersfortrackingdeliveries.Whenthoseassetswearout,thebusinessneedstoreplacethem.Also,toremaincompetitive,abusinessmayneedtoupgradeitsequipmenttotakeadvantageofthelatesttechnologyorprovideforgrowth.Theseinvestmentsinlong-lived,tangible,productiveassets,whichwecallfixedassetsinthisbook,arecriticaltothefutureofthebusinessandarecalledcapitalexpenditurestostressthatcapitalisbeinginvestedforthelongterm.

Oneofthefirstclaimsoncashflowfromprofitiscapitalexpenditure.NoticeinFigure7–2thatthebusinessspent£1,275,000fornewfixedassets,whicharereferredtoasproperty,plantandequipmentinthecashflowstatement(tokeeptheterminologyconsistentwithaccounttitlesusedinthebalancesheet,because

thetermfixedassetsisratherinformal).

Cashflowstatementsgenerallydon’tgointomuchdetailregardingexactlywhatspecifictypesoffixedassetsabusinesspurchased–howmanyadditionalsquarefeetofspacethebusinessacquired,howmanynewdrillpressesitboughtandsoon.(Somebusinessesdoleaveaclearertrailoftheirinvestments,though.Forexample,airlinesdescribehowmanynewaircraftofeachkindwerepurchasedtoreplaceoldequipmentorexpandtheirfleets.)

Note:Typically,everyyearabusinessdisposesofsomeofitsfixedassetsthathavereachedtheendoftheirusefullivesandwillnolongerbeused.Thesefixedassetsaresenttothejunkyard,tradedinonnewfixedassets,orsoldforrelativelysmallamountsofmoney.Thevalueofafixedassetattheendofitsusefullifeiscalleditssalvagevalue.Thedisposalproceedsfromsellingfixedassetsarereportedasasourceofcashintheinvestmentssectionofthecashflowstatement.Usually,theseamountsarefairlysmall.Incontrast,abusinessmaysellofffixedassetsbecauseit’sdownsizingorabandoningamajorsegmentofitsbusiness.Thesecashproceedscanbefairlylarge.

Financingactivities

Notethatintheannualcashflowstatement(refertoFigure7-2)ofthebusinessexamplewe’vebeenusing,thepositivecashflowfromprofitis£1,100,000andthenegativecashflowfrominvestingactivitiesis£1,275,000.Theresulttothispoint,therefore,isanetcashoutflowof£175,000–whichwouldhavedecreasedthecompany’scashbalancethismuchifthebusinessdidnotgotooutsidesourcesofcapitalforadditionalmoneyduringtheyear.Infact,thebusinessincreaseditsshort-termandlong-termdebtduringtheyear,anditsownersinvestedadditionalmoneyinthebusiness.Thethirdsectionofthecashflowstatementsummarisesthesefinancingactivitiesofthebusinessovertheperiod.

Thetermfinancinggenerallyreferstoabusinessraisingcapitalfromdebtandequitysources–fromborrowingmoneyfrombanksandothersourceswillingtoloanmoneytothebusinessandfromitsownersputtingadditionalmoneyinthebusiness.Inaddition,thetermincludesmakingpaymentsondebtandreturningcapitaltoowners.Financingalsoreferstocashdistributions(ifany)fromprofitbythebusinesstoitsowners.

Mostbusinessesborrowmoneyforashortterm(generallydefinedaslessthanoneyear),aswellasforlongerterms(generallydefinedasmorethanoneyear).Inotherwords,atypicalbusinesshasbothshort-termandlong-termdebt.(Chapter6explainsthatshort-termdebtispresentedinthecurrentliabilitiessectionofthebalancesheet.)Thebusinessinourexamplehasbothshort-termandlong-termdebt.Althoughnotahard-and-fastrule,mostcashflowstatementsreportjustthenetincreaseordecreaseinshort-termdebt,notthetotalamountborrowedandthetotalpaymentson

short-termdebtduringtheperiod.Incontrast,boththetotalamountborrowedandthetotalamountpaidonlong-termdebtduringtheyeararereportedinthecashflowstatement.

Forthebusinesswe’vebeenusingasanexample,nolong-termdebtwaspaiddownduringtheyearbutshort-termdebtwaspaidoffduringtheyearandreplacedwithnewshort-termnotespayable.However,onlythenetincrease(£200,000)isreportedinthecashflowstatement.Thebusinessalsoincreaseditslong-termdebtby£300,000(refertoFigure7-2).

Thefinancingsectionofthecashflowstatementalsoreportsontheflowofcashbetweenthebusinessanditsowners(whoarethestockholdersofacorporation).Ownerscanbebothasourceofabusiness’scash(capitalinvestedbyowners)andauseofabusiness’scash(profitdistributedtoowners).Thissectionofthecashflowstatementreportscapitalraisedfromitsowners,ifany,aswellasanycapitalreturnedtotheowners.Inthecashflowstatement(Figure7–2),notethatthebusinessdidissueadditionalstocksharesfor£60,000duringtheyear,anditpaidatotalof£400,000cashdividends(distributions)fromprofittoitsowners.

FreeCashFlow:WhatonEarthDoesThatMean?

Anewtermhasemergedinthelexiconofaccountingandfinance–freecashflow.Thispieceoflanguageisnot–werepeat,not–anofficiallydefinedtermbyanyauthoritativeaccountingrule-makingbody.Furthermore,thetermdoesnotappearinthecashflowstatementsreportedbybusinesses.Rather,freecashflowisstreetlanguage,orslang,eventhoughthetermappearsofteninTheFinancialTimesandTheEconomist.Securitiesbrokersandinvestmentanalystsusethetermfreely(punintended).Likemostnewwordsbeingtossedaroundforthefirsttime,thisonehasn’tsettleddownintooneuniversalmeaningalthoughthemost

commonusageofthetermpivotsoncashflowfromprofit.

Thetermfreecashflowisusedtomeananyofthefollowing:

Netincomeplusdepreciation(plusanyotherexpenserecordedduringtheperiodthatdoesnotinvolvetheoutlayofcashbutrathertheallocationofthecostofalong-termassetotherthanproperty,plantandequipment–suchastheintangibleassetsofabusiness).

Cashflowfromoperatingactivities(asreportedinthecashflowstatement).

Cashflowfromoperatingactivitiesminussomeorallofthecapitalexpendituresmadeduringtheyear(suchaspurchasesorconstructionofnew,long-livedoperatingassetssuchasproperty,plantandequipment).

Cashflowfromoperatingactivitiesplusinterest,anddepreciation,andincometaxexpenses,or,inotherwords,cashflowbeforetheseexpensesarededucted.

Inthestrongestpossibleterms,weadviseyoutobeveryclearonwhichdefinitionoffreecashflowthespeakerorwriterisusing.Unfortunately,youcan’talwaysdeterminewhatthetermmeansinanygivencontext.Thereporterorinvestmentprofessionalshoulddefinetheterm.

Onedefinitionoffreecashflow,inourview,isquiteuseful:cashflowfromprofitminuscapitalexpendituresfortheyear.Theideaisthatabusinessneedstomakecapitalexpendituresinordertostayinbusinessandthrive.Andtomakecapitalexpenditures,thebusinessneedscash.Onlyafterpayingforitscapitalexpendituresdoesabusinesshave‘free’cashflowthatitcanuseasitlikes.Inourexample,thefreecashflowis,infact,negative–£1,100,000cash

flowfromprofitminus£1,275,000capitalexpendituresfornewfixedassetsequalsanegative£175,000.

Thisisakeypoint.Inmanycases,cashflowfromprofitfallsshortofthemoneyneededforcapitalexpenditures.Sothebusinesshastoborrowmoremoney,persuadeitsownerstoinvestmoremoneyinthebusiness,ordipintoitscashreserve.Shouldabusinessinthissituationdistributesomeofitsprofittoowners?Afterall,ithasacashdeficitafterpayingforcapitalexpenditures.Butmanycompanieslikethebusinessinourexampledo,infact,makecashdistributionsfromprofittotheirowners.

ScrutinisingtheCashFlowStatementAnalysingabusiness’scashflowstatementinevitablyraisescertainquestions:WhatwouldIhavedonedifferentlyifIwererunningthisbusiness?WouldIhaveborrowedmoremoney?WouldIhaveraisedmoremoneyfromtheowners?WouldIhavedistributedsomuchoftheprofittotheowners?WouldIhaveletmycashbalancedropbyevensuchasmallamount?

Onepurposeofthecashflowstatementistoshowreaderswhatjudgmentcallsandfinancialdecisionsthebusiness’smanagersmadeduringtheperiod.Ofcourse,managementdecisionsarealwayssubjecttosecond-guessingandcriticising,andpassingjudgmentbasedonafinancialstatementisn’ttotallyfairbecauseitdoesn’trevealthepressuresthemanagersfacedduringtheperiod.Maybetheymadethebestpossibledecisionsgiventhecircumstances.Maybenot.

Thebusinessinourexample(refertoFigure7-2)distributed£400,000cashfromprofittoitsowners–a25percentpay-outratio(whichisthe£400,000distributiondividedby£1.6millionnetincome).Inanalysingwhetherthepay-outratioistoohigh,tooloworjustaboutright,youneedtolookatthebroadercontextofthebusiness’ssourcesof,andneedsfor,cash.

Firstlookatcashflowfromprofit:£1.1million,whichisnotenoughtocoverthebusiness’s£1,275,000capitalexpendituresduringtheyear.Thebusinessincreaseditstotaldebt£500,000.Giventhesecircumstances,maybethebusinessshouldhavehoardeditscashandnotpaidsomuchincashdistributionstoitsowners.

Sodoesthisbusinesshaveenoughcashtooperatewith?Youcan’tanswerthatquestionjustbyexaminingthecashflowstatement–oranyfinancialstatementforthatmatter.Everybusinessneedsabufferofcashtoprotectagainstunexpecteddevelopmentsandtotakeadvantageofunexpectedopportunities,asweexplaininChapter10onbudgeting.Thisparticularbusinesshasa£2millioncashbalancecomparedwith£25millionannualsalesrevenuefortheperiodjustended,whichprobablyisenough.Ifyouwerethebossofthisbusinesshowmuchworkingcashbalancewouldyouwant?Notaneasyquestiontoanswer!Don’tforgetthatyouneedtolookatallthreeprimaryfinancialstatements–theprofitandlossaccountandthebalancesheetaswellasthecashflowstatement–togetthebigpictureofabusiness’sfinancialhealth.

Youprobablydidn’tcountthenumberoflinesofinformationinFigure7-2,thecashflowstatementforthebusinessexample.Anyway,thefinancialstatementhas17linesofinformation.Wouldyouliketohazardaguessregardingtheaveragenumberoflinesincashflowstatementsofpubliclyownedcompanies?Typically,theircashflowstatementshave30to40linesofinformationbyourreckoning.Soittakesquiteawhiletoreadthecashflowstatement–moretimethantheaverageinvestorprobablyhas.(Professionalstockanalystsandinvestmentmanagersarepaidtotakethetimetoreadthisfinancialstatementmeticulously.)Quitefrankly,wefindthatmanycashflowstatementsarenotonlyratherlongbutalsodifficulttounderstand–evenforanaccountant.Wewon’tgetonasoapboxherebutwedefinitelythinkbusinessescoulddoabetterjobofreportingtheircashflowstatementsbyreducingthenumberoflinesintheirfinancialstatementsandmakingeachlineclearer.

Thewebsitewww.score.orgoffersadownloadableExcelspreadsheetthatenablesyoutotailoracashflowstatementtoyourrequirements.YoucanfindthespreadsheetbygoingtotheSCOREhomepageandclickingon‘Templates&Tools’whereyoucanfindanextensiveselectionoftemplatesandcalculators.Microsoftalsohasacomprehensiverangeoftemplatesathttp://office.microsoft.com/en-gb/Templatesfollowedbyasearchterm,inthiscase‘cashflow’.

Chapter8

GettingaFinancialReportReadyforPrimeTime

InThisChapterMakingsurethatallthepiecesfittogether

Lookingatthevariouschangesinowners’equity

Makingsurethatdisclosureisadequate

Touchingupthenumbers

FinancialreportingontheInternet

Dealingwithfinancialreports’informationoverload

Theprimaryfinancialstatementsofabusiness(asexplainedinChapters5,6and7)are:

Profitandlossaccount:Summarisessalesrevenueinflowsandexpenseoutflowsfortheperiodandendswiththebottom-lineprofit,whichisthenetinflowfortheperiod(alossisanetoutflow).

Balancesheet:Summarisesfinancialconditionattheendoftheperiod,consistingofamountsforassets,liabilitiesandowners’equityatthatinstantintime.

Cashflowstatement:Summarisesthenetcashinflow(oroutflow)fromprofitfortheperiodplustheothersourcesandusesofcashduringtheperiod.

Anannualfinancialreportofabusinesscontainsmorethanjustthesethreefinancialstatements.Inthe‘more’,thebusinessmanagerplaysanimportantrole–whichoutsideinvestorsandlendersshouldunderstand.Themanagershoulddocertaincriticalthingsbeforethefinancialreportisreleasedtotheoutsideworld.

1.Themanagershouldreviewwithacriticaleyethevitalconnectionsbetweentheitemsreportedinallthreefinancialstatements–allamountshavetofittogetherlikethepiecesofa

jigsaw.Thenetcashincrease(ordecrease)reportedattheendofthecashflowstatement,forinstance,hastotieinwiththechangeincashreportedinthebalancesheet.Abnormallyhighorlowratiosbetweenconnectedaccountsshouldbescrutinisedcarefully.2.Themanagershouldcarefullyreviewthedisclosuresinthefinancialreport(allinformationinadditiontothefinancialstatements)tomakesurethatdisclosureisadequateaccordingtofinancialreportingstandards,andthatallthedisclosureelementsaretruthfulbutnotdamagingtotheinterestsofthebusiness.

Thisdisclosurereviewcanbecomparedwiththenotionofduediligence,whichisdonetomakecertainthatallrelevantinformationiscollected,thattheinformationisaccurateandreliable,andthatallrelevantrequirementsandregulationsarebeingcompliedwith.Thisstepisespeciallyimportantforpubliccorporationswhosesecurities(sharesanddebtinstruments)aretradedonnationalsecuritiesexchanges.

3.Themanagershouldconsiderwhetherthefinancialstatementnumbersneedtouchinguptosmooththejaggededgesoffthecompany’syear-to-yearprofitgyrationsortoimprovethebusiness’sshort-termsolvencypicture.Althoughthiscanbedescribedasputtingyourthumbonthescale,youcanalsoarguethatsometimesthescaleisalittleoutofbalancetobeginwithandthemanagerisadjustingthefinancialstatementstojibebetterwiththenormalcircumstancesofthebusiness.

Indiscussingthethirdsteplaterinthechapter,wewalkonthinice.Sometopicsare,shallwesay,ratherdelicate.Themanagerhastostrikeabalancebetweentheinterestsofthe

businessontheonehandandtheinterestsoftheowners(investors)andcreditorsofthebusinessontheother.Thebestanalogywecanthinkofistheadvertisingdonebyabusiness.Advertisingshouldbetruthfulbut,aswe’resureyouknow,businesseshavealotofleewayinhowtoadvertisetheirproductsandtheyhavebeenknowntoengageinhyperbole.Managersexercisethesamefreedomsinputtingtogethertheirfinancialreports.

ReviewingVitalConnections

Businessmanagersandinvestorsreadfinancialreportsbecausethesereportsprovideinformationregardinghowthebusinessisdoing.Thetopmanagersofabusiness,inreviewingtheannualfinancialreportbeforereleasingitoutsidethebusiness,shouldkeepinmindthatafinancialreportisdesignedtoanswercertainbasicfinancialquestions:

Isthebusinessmakingaprofitorsufferingaloss,andhowmuch?

Howdoassetsstackupagainstliabilities?

Wheredidthebusinessgetitscapitalandisitmakinggooduseofthemoney?

Isprofitgeneratingcashflow?

Didthebusinessreinvestallitsprofitordistributesomeoftheprofittoowners?

Doesthebusinesshaveenoughcapitalforfuturegrowth?

Asahypotheticalbutrealisticbusinessexample,Figure8-1highlightssomeofthevitalconnections–thelinesconnectoneormorebalancesheetaccountswithsalesrevenueoranexpenseintheprofitandlossaccount.Thesavvymanagerorinvestorcheckstheselinkstoseewhethereverythingisin

Figure8-1:Vitalconnectionsbetweentheprofitandlossaccountandthebalancesheet.

orderorwhethersomedangersignalspointtoproblems.(Weshouldmakeclearthattheselinesofconnectiondonotappearinactualfinancialreports.)

Inthefollowinglist,webrieflyexplainthesefiveconnections,mainlyfromthemanager’spointofview.Chapters14and17explainhowinvestorsandlendersreadafinancialreportandcomputecertainratios.(Investorsandlendersareontheoutsidelookingin;managersareontheinsidelookingout.)

Note:Wecutrighttothechaseinthefollowingbriefcommentsandwedonotillustratethecalculationsbehindthecomments.Thepurposehereistoemphasisewhymanagersshouldpayattentiontotheseimportantratios.(Chapters5and6providefullerexplanationsoftheseandotherconnectionsofoperatingassetsandliabilitieswithsalesrevenueandexpenses.)

1.SalesRevenueandDebtors:Thisbusiness’sendingbalanceofdebtorsisfiveweeksofitsannualsalesrevenue.Themanagershouldcomparethisratiotothenormalcredittermsofferedtothebusiness’scustomers.Iftheendingbalanceistoohigh,themanagershouldidentifywhichcustomers’accountsarepastdueandtakeactionstocollecttheseamounts,orperhapsshutoff

futurecredittothesecustomers.Anabnormallyhighbalanceofdebtorsmaysignalthatsomeofthesecustomers’amountsowedtothebusinessshouldbewrittenoffasuncollectablebaddebts.2.CostofGoodsSoldExpenseandStock:Thisbusiness’sendingstockis13weeksofitsannualcostofgoodssoldexpense.Themanagershouldcomparethisratiotothecompany’sstockpoliciesandobjectivesregardinghowlongstockshouldbeheldawaitingsale.Ifstockistoolargethemanagershouldidentifywhichproductshavebeeninstocktoolong;furtherpurchases(ormanufacturing)shouldbecurtailed.Also,themanagermaywanttoconsidersalespromotionsorcuttingsalespricestomovetheseproductsoutofstockfaster.3.Sales,AdministrationandGeneral(SA&G)ExpensesandPrepaidExpenses:Thisbusiness’sendingbalanceofprepaidexpensesisthreeweeksofthetotaloftheseannualoperatingexpenses.ThemanagershouldknowwhatthenormalratioofprepaidexpensesshouldberelativetotheannualSA&Goperatingexpenses(excludingdepreciationexpense).Iftheendingbalanceistoohigh,themanagershouldinvestigatewhichcostshavebeenpaidtoofarinadvanceandtakeactiontobringtheseprepaidsbackdowntonormal.4.Sales,AdministrationandGeneral(SA&G)ExpensesandCreditors:Thisbusiness’sendingbalanceofcreditorsisfiveweeksofitsannualoperatingexpenses.Delayingpaymentoftheseliabilitiesisgoodfromthecashflowpointofview(refertoChapter7)butdelayingtoolongmayjeopardisethecompany’sgoodcreditratingwithitskeysuppliersandvendors.Ifthisratioistoohigh,themanagershouldpinpointwhichspecificliabilitieshavenotbeenpaidandwhetheranyoftheseareoverdueandshouldbepaidimmediately.Or,thehighbalancemayindicatethatthecompanyisinadifficultshort-termsolvencysituationandneedstoraisemoremoneytopaytheamountsowedtosuppliersandvendors.5.Sales,AdministrationandGeneral(SA&G)ExpensesandAccruedExpensesPayable:Thisbusiness’sendingbalanceofthisoperatingliabilityiseightweeksofthebusiness’sannualoperating

expenses.Thisratiomaybeconsistentwithpastexperienceandthenormallagbeforepayingthesecosts.Ontheotherhand,theendingbalancemaybeabnormallyhigh.Themanagershouldidentifywhichoftheseunpaidcostsarehigherthantheyshouldbe.Aswithcreditors,inflatedamountsofaccruedliabilitiesmaysignalseriousshort-termsolvencyproblems.

Thesefivekeyconnectionsareveryimportantones,butthemanagershouldscanallbasicconnectionstoseewhethertheratiospassthecommonsensetest.Forexample,themanagershouldmakeaquickeyeballtestofinterestexpensecomparedwithinterest-bearingdebt.InFigure8-1,interestexpenseis£750,000comparedwith£10milliontotaldebt,whichindicatesa7.5percentinterestrate.ThisseemsOK.Butiftheinterestexpenseweremorethan£1million,themanagershouldinvestigateanddeterminewhyit’ssohigh.

There’salwaysthechanceoferrorsintheaccountsofabusiness.Reviewingthevitalconnectionsbetweentheprofitandlossaccountitemsandthebalancesheetitemsisaveryvaluablefinalcheckbeforethefinancialstatementsareapprovedforinclusioninthebusiness’sfinancialreport.Afterthefinancialreportisreleasedtotheoutsideworld,itbecomesthelatestchapterintheofficialfinancialhistoryofthebusiness.Ifthefinancialstatementsarewrong,thebusinessanditstopmanagersareresponsible.

StatementofChangesinOwners’EquityandComprehensiveIncome

Inmanysituationsabusinessneedstoprepareoneadditionalfinancialstatement–thestatementofchangesinowners’equity.Owners’equityconsistsoftwofundamentallydifferentsources–capitalinvestedinthebusinessbytheowners,andprofitearnedbyandretainedinthebusiness.Thespecificaccountsmaintainedbythebusinessforitstotalowners’equitydependonthelegalorganisationofthebusinessentity.Oneofthemaintypesoflegalorganisationofbusinessisthecompany,anditsownersareshareholdersbecausethecompanyissuesownershipsharesrepresentingportionsofthebusiness.So,thetitlestatementofchangesinshareholders’equityisusedforcompanies.(Chapter11explainsthecorporationandotherlegaltypesofbusinessentities.)

First,considerthesituationinwhichabusinessdoesnotneedtoreportthisstatement–tomakeclearerwhythestatementisneeded.Supposeacompanyhasonlyoneclassofshareanditdidnotbuyanyofitsownsharesduringtheyearanditdidnotrecordanygainsorlossesinowners’equityduringtheyearduetoothercomprehensiveincome(explainedbelow).Thisbusinessdoesnotneedastatementofchangesinshareholders’equity.Inreadingthefinancialreportofthisbusinessyouwouldseeinitscashflowstatement(Figure7–2showsanexample)whetherthebusinessraisedadditionalcapitalfromitsownersduringtheyearandhowmuchincashdividends(distributionsfromprofit)waspaidtotheownersduringtheyear.Thecashflowstatementcontainsallthechangesintheowners’equityaccountsduringtheyear.

Insharpcontrast,largerbusinesses–especiallypubliclytradedcorporations–generallyhavecomplexownershipstructuresconsistingoftwoormoreclassesofshares;theyusuallybuysomeoftheirownsharesandtheyhaveoneormoretechnicaltypesofgainsorlossesduringtheyear.So,theyprepareastatementofchangesinstockholders’equitytocollecttogetherinoneplaceall

thechangesaffectingtheowners’equityaccountsduringtheyear.Thisparticular‘mini’statement(thatfocusesnarrowlyonchangesinowners’equityaccounts)iswhereyoufindcertaingainsandlossesthatincreaseordecreaseowners’equitybutwhicharenotreportedintheprofitandlossaccount.Basically,abusinesshastheoptiontobypasstheprofitandlossaccountand,instead,reportthesegainsandlossesinthestatementofchangesinowners’equity.Inthiswaythegainsorlossesdonotaffectthebottom-lineprofitofthebusinessreportedinitsprofitandlossaccount.Youhavetoreadthisfinancialsummaryofthechangesintheowners’equityaccountstofindoutwhetherthebusinesshadanyofthesegainsorlossesandtheamountsofthegainsorlosses.

Thespecialtypesofgainsandlossesthatcanbereportedinthestatementofowners’equity(insteadoftheprofitandlossaccount)havetodowithforeigncurrencytranslations,unrealisedgainsandlossesfromcertaintypesofsecuritiesinvestmentsbythebusinessandchangesinliabilitiesforunfundedpensionfundobligationsofthebusiness.Comprehensiveincomeisthetermusedtodescribethenormalcontentoftheprofitandlossaccountplustheadditionallayerofthesespecialtypesofgainsandlosses.Beingsotechnicalinnature,thesegainsandlossesfallina‘twilightzone’asitwere,infinancialreporting.Thegainsandlossescanbetackedonatthebottomoftheprofitandlossaccountortheycanbeputinthestatementofchangesinowners’equity–it’suptothebusinesstomakethechoice.Ifyouencounterthesegainsandlossesinreadingafinancialreport,you’llhavetostudythefootnotestothefinancialstatementstolearnmoreinformationabouteachgainandloss.

Keeponthelookoutforthespecialtypesofgainsandlossesthatarereportedinthestatementofchangesinowners’equity.Abusinesshastheoptiontotacksuchgainsandlossesontothebottomofitsprofitandlossaccount–belowthenetincomeline.But,mostbusinessesputtheseincomegainsandlossesintheirstatementofchangesinshareholders’equity,orinanoteornotestotheiraccounts.So,watchoutforanylargeamountsofgainsorlossesthatarereportedinthestatementofchangesinowners’equity.

Thegeneralformatofthestatementofchangesinshareholders’equityincludesacolumnforeachclassofstock(ordinaryshares,preferencesharesandsoon);acolumnforanysharesofitsownthatthebusinesshaspurchasedandnotcancelled;acolumnforretainedearnings;andoneormorecolumnsforanyotherseparatecomponentsofthebusiness’sowners’equity.Eachcolumnstartswiththebeginningbalanceandthenshowstheincreasesordecreasesintheaccountduringtheyear.Forexample,acomprehensivegainisshownasanincreaseinretainedearningsandacomprehensivelossasadecrease.Thepurchaseofitsownsharesisshownasanincreaseintherelevantcolumnandifthebusinessreissuedsomeoftheseshares(suchasforstockoptionsexercisedbyexecutives),thecostofthesesharesreissuedisshownasadecreaseinthecolumn.

Wehavetoadmitthatreadingthestatementofchanges,ornotestotheaccountsinshareholders’equitycanbeheavygoing.Theprofessionals–stockanalysts,moneyandinvestmentmanagersandsoon–carefullyreadthroughanddissectthisstatement,oratleasttheyshould.Theaveragenon-professionalinvestorshouldfocusonwhetherthebusinesshadamajorincreaseordecreaseinthenumberofsharesduringtheyear,whetherthebusinesschangeditsownershipstructurebycreatingoreliminatingaclassofstock,andtheimpactofstockoptionsawardedtomanagersofthebusiness.

MakingSurethatDisclosureIsAdequate

Theprimaryfinancialstatements(includingthestatementofchangesinowners’equity,ifreported)arethebackboneofafinancialreport.Infact,afinancialreportisnotdeservingofthenameiftheprimaryfinancialstatementsarenotincluded.But,asmentionedearlier,there’smuchmoretoafinancialreportthanthefinancialstatements.Afinancialreportneedsdisclosures.Ofcourse,thefinancialstatementsprovidedisclosureofthemostimportantfinancialinformationaboutthebusiness.Thetermdisclosures,however,usuallyreferstoadditionalinformationprovidedinafinancialreport.Inanutshell,afinancialreporthastwobasicparts:(1)theprimaryfinancialstatementsand(2)disclosures.

Thechiefofficerofthebusiness(usuallytheCEOofapubliclyownedcompany,thepresidentofaprivatecorporationorthemanagingpartnerofapartnership)hastheprimaryresponsibilitytomakesurethatthefinancialstatementshavebeenpreparedaccordingtoprevailingaccountingstandardsandthatthefinancialreportprovidesadequatedisclosure.Heorsheworkswiththechieffinancialofficerofthebusinesstomakesurethatthefinancialreportmeetsthestandardofadequatedisclosure.(Manysmallerbusinesseshireanindependentqualifiedaccountanttoadvisethemontheirfinancialstatementsandotherdisclosuresintheirfinancialreports.)

TypesofdisclosuresinfinancialreportsForaquicksurveyofdisclosuresinfinancialreports–thatistosay,thedisclosuresinadditiontothefinancialstatements–thefollowingdistinctionsarehelpful:

Footnotesthatprovideadditionalinformationaboutthe

basicfiguresincludedinthefinancialstatements;virtuallyallfinancialstatementsneedfootnotestoprovideadditionalinformationfortheaccountbalancesinthefinancialstatements.

Supplementaryfinancialschedulesandtablesthatprovidemoredetailsthancanbeincludedinthebodyoffinancialstatements.

Awidevarietyofotherinformation,someofwhichisrequiredifthebusinessisacompanyquotedonastockmarketsubjecttogovernmentregulationsregardingfinancialreportingtoitsshareholdersandotherinformationthatisvoluntaryandnotstrictlyrequiredlegallyoraccordingtoGAAP.

Footnotes:NettlesomebutneededFootnotesappearattheendoftheprimaryfinancialstatements.Withinthefinancialstatementsyouseereferencestoparticularfootnotes.Andatthebottomofeachfinancialstatement,youfindthefollowingsentence(orwordstothiseffect):‘Thefootnotesareintegraltothefinancialstatements.’Youshouldreadallfootnotesforafullunderstandingofthefinancialstatements.

Footnotescomeintwotypes:

Oneormorefootnotesmustbeincludedtoidentifythemajoraccountingpoliciesandmethodsthatthebusinessuses.(Chapter13explainsthatabusinessmustchooseamongalternativeaccountingmethodsforcertainexpenses,andfortheircorrespondingoperatingassetsandliabilities.)Thebusinessmustrevealwhichaccountingmethodsitusesforitsmajorexpenses.Inparticular,thebusinessmustidentifyitscostofgoodssoldexpense(andstock)methodanditsdepreciationmethods.

Otherfootnotesprovideadditionalinformationanddetailsformanyassetsandliabilities.Detailsaboutshareoptionplansforkeyexecutivesarethemaintypeoffootnotetothecapitalstockaccountintheowners’equitysectionofthebalancesheet.

Oneproblemthatmostinvestorsfacewhenreadingfootnotes–and,forthatmatter,manymanagerswhoshouldunderstandtheirownfootnotesbutfindthemalittledense–isthatfootnotesoftendealwithcomplexissues(suchaslawsuits)andrathertechnicalaccountingmatters.Letusofferyouonefootnotethatbringsoutthislatterpoint.Thisfootnoteistakenfromtherecentfinancialreportofawell-knownmanufacturerthatusesaveryconservativeaccountingmethodfordeterminingitscostofgoodssoldexpenseandstockcostvalue.Weknowthatwehavenotyettalkedabouttheseaccountingmethods;thisisdeliberateonourpart.(Chapter13explainsaccountingmethods.)Wewantyoutoreadthefollowingfootnotefromthe2011AnnualReportofthismanufacturerandtrytomakesenseofit(amountsareinthousands).

D.Inventories:InventoriesarevaluedprincipallybytheLIFO(last-in,first-out)method.IftheFIFO(first-in,first-out)methodhadbeeninuse,inventorieswouldhavebeen£2,000millionand£1,978millionhigherthanreportedatDecember31,2010and2011,respectively.

Yes,theseamountsareinmillionsofpounds.Thecompany’sstockcostvalueattheendof2010wouldhavebeen£2billionhigheriftheFIFOmethodhadbeenused.Ofcourse,youhavetohavesomeideaofthedifferencebetweenthetwomethods,whichweexplaininChapter13.

Youmaywonderhowdifferentthecompany’sannualprofitswouldhavebeenifthealternativemethodhadbeeninuse.Amanagercanasktheaccountingdepartmenttodothisanalysis.But,asanoutsideinvestor,youwouldhavetocomputetheseamounts.Businessesdisclosewhichaccountingmethodstheyusebuttheydonothavetodisclosehowdifferentannualprofitswouldhavebeenifthealternativemethodhadbeenused–andveryfewdo.

OtherdisclosuresinfinancialreportsThefollowingdiscussionincludesafairlycomprehensivelistofthevarioustypesofdisclosuresfoundinannualfinancialreportsoflarger,publiclyownedbusinesses–inadditiontofootnotes.Afewcaveatsareinorder.First,noteverypubliccompanyincludeseveryoneofthefollowingitemsalthoughthedisclosuresarefairlycommon.Second,thelevelofdisclosurebyprivatebusinesses–afteryougetbeyondthefinancialstatementsandfootnotes–ismuchlessthaninpubliccompanies.Third,trackingtheactualdisclosurepracticesofprivatebusinessesisdifficultbecausetheirannualfinancialreportsarecirculatedonlytotheirownersandlenders.Aprivatebusinessmayincludeanyorallofthefollowingdisclosuresbut,byandlarge,itisnotlegallyrequiredtodoso.Thenextsectionfurtherexplainsthedifferencesbetweenprivateandpublicbusinessesregardingdisclosurepracticesintheirannualfinancialreports.

WarrenBuffett’sannuallettertoshareholdersWehavetocallyourattentiontoonenotableexceptiontothegenerallyself-servingandslantedwritingfoundinthelettertoshareholdersbythechiefexecutiveofficerofthebusinessinannualfinancialreports.TheannuallettertostockholdersofBerkshireHathaway,Inc.iswrittenbyWarrenBuffett,theChairmanandCEO.MrBuffetthasbecomeverywellknown–he’scalledthe‘OracleofOmaha’.Intheannualrankingoftheworld’srichestpeoplebyForbesmagazineheisnearthetopofthelist–rightbehindpeoplelikeBillGates,theco-founderofMicrosoft.Ifyouhadinvested£1,000withhimin1960,yourinvestmentwouldbeworthwellover£1,000,000today.EvenintherecentfinancialmeltdownBerkshireHathawaystockdeliveredareturnofnearly80%overtheperiod2000–2011comparedtoanegative12%returnfortheS&P500.MrBuffett’slettersaretheepitomeoftellingitlikeitis;theyareveryfrankandquitehumorous.

Youcangotothewebsiteofthecompany(www.berkshirehathaway.com)anddownloadhismostrecentletter.You’lllearnalotabouthisinvesting

philosophyandthelettersareadelighttoread.

Publiccorporationstypicallyincludemostofthefollowingdisclosuresintheirannualfinancialreportstotheirshareholders:

Cover(ortransmittal)letter):Aletterfromthechiefexecutiveofthebusinesstotheshareholders.

Highlightstable:Ashorttablethatpresentstheshareholderwithafinancialthumbnailsketchofthebusiness.

Managementdiscussionandanalysis(MD&A):Dealswiththemajordevelopmentsandchangesduringtheyearthataffectedthefinancialperformanceandsituationofthebusiness.

Segmentinformation:Thesalesrevenueandoperatingprofitsarereportedforthemajordivisionsoftheorganisationorforitsdifferentmarkets(internationalversusdomestic,forexample).

Historicalsummaries:Financialhistorythatextendsbackbeyondtheyears(usuallythreebutcanbeuptofiveorsix)includedintheprimaryfinancialstatements.

Graphics:Barcharts,trendchartsandpiechartsrepresentingfinancialconditions;photosofkeypeopleandproducts.

Promotionalmaterial:informationaboutthecompany,itsproducts,itsemployeesanditsmanagers,oftenstressinganover-archingthemefortheyear.

Profiles:Informationaboutmembersoftopmanagementandtheboardofdirectors.

Quarterlysummariesofprofitperformanceandsharepricesanddividends:Showsfinancialperformanceforall

fourquartersintheyearandsharepricerangesforeachquarter.

Management’sresponsibilitystatement:Ashortstatementthatmanagementhasprimaryresponsibilityfortheaccountingmethodsusedtopreparethefinancialstatementsandforprovidingtheotherdisclosuresinthefinancialreport.

Independentauditor’sreport:Thereportfromtheaccountingfirmthatperformedtheaudit,expressinganopiniononthefairnessofthefinancialstatementsandaccompanyingdisclosures.(Chapter15discussesthenatureofaudits.)Publiccompaniesarerequiredtohaveaudits;privatebusinessesmayormaynothavetheirannualfinancialreportsauditeddependingontheirsize.

Companycontactinformation:Informationonhowtocontactthecompany,thewebsiteaddressofthecompany,howtogetcopiesofthereportsfiledwiththeLondonStockExchange,SEC,thestocktransferagentandregistrarofthecompany,andotherinformation.

Managersofpubliccorporationsrelyonlawyers,auditorsandtheirfinancialandaccountingofficerstomakesurethateverythingthatshouldbedisclosedinthebusiness’sannualfinancialreportsisincludedandthattheexactwordingofthedisclosuresisnotmisleading,inaccurateorincomplete.Thisisatallorder.Thefieldoffinancialreportingdisclosurechangesconstantly.Laws,aswellasauthoritativeaccountingstandards,havetobeobserved.Inadequatedisclosureinanannualfinancialreportisjustasseriousasusingwrongaccountingmethodsformeasuringprofitandfordeterminingvaluesforassets,liabilitiesandowners’equity.Afinancialreportcanbemisleadingbecauseofimproperaccounting

methodsorbecauseofinadequateormisleadingdisclosure.Bothtypesofdeficienciescanleadtonastylawsuitsagainstthebusinessanditsmanagers.

CompaniesHouseprovidesformsshowinghowtheCompaniesActrequiresbalancesheetsandprofitandlossaccountstobelaidout.Toaccesstheirguidance,gotowww.companieshouse.gov.uk/forms/introduction.shtml.Alltheirstatutoryformsareavailableonrequestandfreeofcharge.

KeepingItPrivateversusGoingPublic

Comparedwiththeirbigbrothersandsisters,privatelyownedbusinessesprovideverylittleadditionaldisclosuresintheirannualfinancialreports.Theprimaryfinancialstatementsandfootnotesareprettymuchallyouget.

Theannualfinancialreportsofpubliclyownedcorporationsincludeall,ornearlyall,ofthedisclosureitemslistedearlier.Somewhereintherangeof3,000companiesarepubliclyowned,andtheirsharesaretradedontheLondonStockExchange,NASDAQorotherstockexchanges.PubliclyownedcompaniesmustfileannualfinancialreportswiththeStockExchange,whichistheagencythatmakesandenforcestherulesfortradinginsecuritiesandforthefinancialreportingrequirementsofpubliclyownedcorporations.ThesefilingsareavailabletothepublicontheLondonStockExchange’swebsite(www.londonstockexchange.com)orforUScompaniesontheSecuritiesExchangeCommission’s(SEC’s)EDGARdatabaseattheSEC’swebsite–www.sec.gov/edgar/searchedgar/cik.htm.

Bothprivatelyheldandpubliclyownedbusinessesareboundbythesameaccountingrulesformeasuringprofit,assets,liabilitiesandowners’equityinannualfinancialreportstotheownersofthebusinessandinreportsthataremadeavailabletoothers(suchasthelenderstothebusiness).Therearen’ttwodifferentsetsofaccountingrules–oneforprivatecompaniesandanotheroneforpublicbusinesses.Theaccountingmeasurementandvaluationrulesarethesameforallbusinesses.However,disclosurerequirementsandpracticesdiffergreatlybetweenprivateandpubliccompanies.

Publiclyownedbusinessesliveinafishbowl.WhenacompanygoespublicwithanIPO(initialpublicofferingofshares),itgivesupalotoftheprivacythatacloselyheldbusinessenjoys.Publiclyownedcompanieswhosesharesaretradedonnationalstockexchangesliveinglasshouses.Incontrast,privatelyownedbusinesseslocktheirdoorsregardingdisclosure.Wheneveraprivatelyownedbusinessreleasesafinancialreporttoitsbankinseekingaloan,ortotheoutsidenon-managementinvestorsinthebusiness,itshouldincludeitsthreeprimaryfinancialstatementsandfootnotes.Butbeyondthis,theyhavemuchmoreleewayanddonothavetoincludetheadditionaldisclosureitemslistedintheprecedingsection.

Aprivatebusinessmayhaveitsfinancialstatementsauditedbyaprofessionalaccountingfirm.Ifso,theauditreportisincludedinthebusiness’sannualfinancialreport.Theverypurposeofhavinganauditistoreassureshareholdersandpotentialinvestorsinthebusinessthatthefinancialstatementscanbetrusted.Butaswelookupanddowntheprecedinglistofdisclosureitemswedon’tseeanyotherabsolutelyrequireddisclosureitemforaprivatelyheldbusiness.ThelargemajorityofcloselyheldbusinessesguardtheirfinancialinformationlikeFortKnox.

Thelessinformationdivulgedintheannualfinancialreport,thebetter–that’stheirthinking.Andwedon’tentirelydisagree.The

better–that’stheirthinking.Andwedon’tentirelydisagree.Theshareholdersdon’thavetheliquidityfortheirsharesthatshareholdersofpubliclyheldcorporationsenjoy.Themarketpricesofpubliccompaniesareeverything,soinformationismadepubliclyavailablesothatmarketpricesarefairlydetermined.Thesharesofprivatelyownedbusinessesarerarelytraded,sothereisnotsuchanurgentneedforacompletepackageofinformation.

Aprivatecompanycouldprovideallthedisclosuresgivenintheprecedinglist–there’scertainlynolawagainstthis.Butusuallytheydon’t.Investorsinprivatebusinessescanrequestconfidentialreportsfrommanagersattheannualshareholders’meetings,butdoingsoisnotpracticalforashareholderinalargepubliccorporation.

NudgingtheNumbersThissectiondiscussestwoaccountingtricksthatbusinessmanagersandinvestorsshouldknowabout.Wedon’tendorseeithertechnique,butyoushouldbeawareofbothofthem.Insomesituations,thefinancialstatementnumbersdon’tcomeoutexactlythewaythebusinesswants.Accountantsusecertaintricksofthetrade–somewouldsaysleight-of-hand–tomovethenumbersclosertowhatthebusinessprefers.Onetrickimprovestheappearanceoftheshort-termsolvencyofthebusiness,inparticularthecashbalancereportedinthebalancesheetattheendoftheyear.Theotherdeviceshiftsprofitfromoneyeartothenexttomakeforasmoothertrendofnetincomefromyeartoyear.

Notallbusinessesusethesetechniques,buttheextentoftheiruseishardtopindownbecausenobusinesswouldopenlyadmittousingthesemanipulationmethods.Theevidenceisfairlyconvincing,however,thatmanybusinessesusethesetechniques.We’resureyou’veheardthetermloopholesappliedtoincometaxaccounting.Well,someloopholesexistinfinancialstatementaccountingaswell.

Fluffingupthecashbalanceby‘windowdressing’Supposeyoumanageabusinessandyouraccountanthasjustsubmittedtoyouapreliminary,orfirstdraft,oftheyear-endbalancesheetforyourreview.(Chapter6explainsthebalancesheet,andFigure6-1showsacompletebalancesheetforabusiness.)Yourpreliminarybalancesheetincludesthefollowing:

Youstartreadingthenumberswhensomethingstrikesyou:azerocashbalance?Howcanthatbe?Maybeyourbusinesshasbeenhavingsomecashflowproblemsandyou’veintendedtoincreaseyourshort-termborrowingandspeedupcollectionofdebtorstohelpthecashbalance.Butthatplandoesn’thelpyourightnow,withthisparticularfinancialreportthatyoumustsendouttoyourbusiness’sinvestorsandyourbanker.Folksgenerallydon’tliketoseeazerocashbalance–itmakesthemkindofnervous,toputitmildly,nomatterhowyoutrytocushionit.Sowhatdoyoudotoavoidalarmingthem?

Youraccountantisprobablyawareofatechniqueknownaswindowdressing,averysimplemethodformakingthecashbalancelookbetter.Supposeyourfinancialyear-endisOctober31.YouraccountanttakesthecashreceiptsfromcustomerspayingtheirbillsthatareactuallyreceivedonNovember1,2and3,andrecordsthemasifthesecashcollectionshadbeenreceivedonOctober31.Afterall,theargumentcanbemadethatthecustomers’chequeswereinthemail–thatmoneyisyours,asfarasthecustomersareconcerned,soyourreportsshouldreflectthatcashinflow.

Whatimpactdoeswindowdressinghave?Itreducestheamountindebtorsandincreasestheamountincashbythesameamount–ithasabsolutelynoeffectontheprofitfigure.Itjustmakesyourcashbalancelookatouchbetter.Windowdressingcanalsobeusedtoimproveotheraccounts’balances,whichwedon’tgointohere.Allofthesetechniquesinvolveholdingthebooksopentorecordcertaineventsthattakeplaceaftertheendofthefinancialyear(the

certaineventsthattakeplaceaftertheendofthefinancialyear(theendingbalancesheetdate)tomakethingslookbetterthantheyactuallywereatthecloseofbusinessonthelastdayoftheyear.

Soundslikeeverybodywins,doesn’tit?Yourinvestorsdon’tpanicandyourjobissafe.Wehavetowarnyou,though,thatwindowdressingmaybethefirststeponaslipperyslope.Alittlewindowdressingtodayandtomorrow,whoknows?–Maybegivingthenumbersanudgewillleadtoseriousfinancialfraud.Anywayyoulookatit,windowdressingisdeceptivetoyourinvestorswhohaveeveryrighttoexpectthattheendofyourfiscalyearasstatedonyourfinancialreportsistrulytheendofyourfiscalyear.Thinkaboutitthisway:Ifyou’veinvestedinabusinessthathasfudgedthisdata,howdoyouknowwhatothernumbersonthereportaresuspect?

SmoothingtheroughedgesoffprofitManagersstrivetomaketheirnumbersandtohitthemilestonemarkerssetforthebusiness.Reportingalossfortheyear,orevenadipbelowtheprofittrendline,isaredflagthatinvestorsviewwithalarm.

Managerscandocertainthingstodeflateorinflateprofit(thenetincome)recordedintheyear,whicharereferredtoasprofit-smoothingtechniques.Profitsmoothingisalsocalledincomesmoothing.Profitsmoothingisnotnearlyasseriousascookingthebooks,orjugglingthebooks,whichreferstodeliberate,fraudulentaccountingpracticessuchasrecordingsalesrevenuethathasnothappenedornotrecordingexpenses

thathavehappened.Cookingthebooksisveryserious;managerscangotojailforfraudulentfinancialstatements.Profitsmoothingismorelikeawhiteliethatistoldforthegoodofthebusiness,andperhapsforthegoodofmanagersaswell.Managersknowthatthereisalwayssomenoiseintheaccountingsystem.Profitsmoothingmufflesthenoise.

Managersofpubliclyownedcompanieswhosesharesareactivelytradedareunderintensepressuretokeepprofitssteadilyrising.Securityanalystswhofollowaparticularcompanymakeprofitforecastsforthebusiness,andtheirbuy-hold-sellrecommendationsarebasedlargelyontheseearningsforecasts.Ifabusinessfailstomeetitsownprofitforecastorfallsshortofanalysts’forecasts,themarketpriceofitssharessuffers.Shareoptionandbonusincentivecompensationplansarealsostrongmotivationsforachievingtheprofitgoalssetforthebusiness.

Theevidenceisfairlystrongthatpubliclyownedbusinessesengageinsomedegreeofprofitsmoothing.Frankly,it’smuchhardertoknowwhetherprivatebusinessesdoso.Privatebusinessesdon’tfacethepublicscrutinyandexpectationsthatpubliccorporationsdo.Ontheotherhand,keymanagersinaprivatebusinessmayhaveincentivebonusarrangementsthatdependonrecordedprofit.Inanycase,businessinvestorsandmanagersshouldknowaboutprofitsmoothingandhowit’sdone.

Mostprofitsmoothinginvolvespushingrevenueandexpensesintootheryearsthantheywouldnormallyberecorded.Forexample,ifthepresidentofabusinesswantstoreportmoreprofitfortheyear,heorshecaninstructthechiefaccountanttoacceleratetherecordingofsomesalesrevenuethatnormallywouldn’tberecordeduntilnextyear,ortodelaytherecordingofsomeexpensesuntilnextyearthatnormallywouldberecordedthisyear.Themainreasonforsmoothingprofitistokeepitclosertoaprojectedtrend

reasonforsmoothingprofitistokeepitclosertoaprojectedtrendlineandmakethelinelessjagged.

Chapter13explainsthatmanagerschooseamongalternativeaccountingmethodsforseveralimportantexpenses.Aftermakingthesekeychoicesthemanagersshouldlettheaccountantsdotheirjobsandletthechipsfallwheretheymay.Ifbottom-lineprofitfortheyearturnsouttobealittleshortoftheforecastortargetfortheperiod,sobeit.Thishands-offapproachtoprofitaccountingistheidealway.However,managersoftenuseahands-onapproach–theyintercede(onecouldsayinterfere)andoverridethenormalaccountingforsalesrevenueorexpenses.

Bothmanagerswhodoitandinvestorswhorelyonfinancialstatementsinwhichprofitsmoothinghasbeendoneshoulddefinitelyunderstandonething–thesetechniqueshaverobbing-Peter-to-pay-Pauleffects.Accountantsrefertotheseascompensatoryeffects.Theeffectsonnextyear’sstatementsimplyoffsetandcancelouttheeffectsonthisyear.Lessexpensethisyeariscounterbalancedbymoreexpensenextyear.Salesrevenuerecordedthisyearmeanslesssalesrevenuerecordednextyear.

Twoprofithistories

Figure8-2shows,sidebyside,theannualprofithistoriesoftwodifferentcompaniesoversixyears.BusinessXshowsanicesteadyupwardtrendofprofit.BusinessY,incontrast,showssomewhatofarollercoasterrideoverthesixyears.Bothbusinessesearnedthesametotalprofitforthesixyears–inthiscase,£1,050,449.Theirtotalsix-yearprofitperformanceisthesame,downtothelastpound.Whichcompanywouldyoubemorewillingtoriskyourmoneyin?Wesuspectthatyou’dpreferBusinessXbecauseofthesteadyupwardslopeofitsprofithistory.

Question:DoesFigure8-2reallyshowtwodifferentcompanies–orarethetwoprofithistoriesactuallyalternativesforthesamecompany?Theyear-by-yearprofitsforBusinessXcouldbethecompany’ssmoothedprofit,andtheannualprofitsforBusinessYcouldbetheactualprofitofthesamebusiness–theprofitthatwouldhavebeenrecordedifsmoothingtechniqueshadnotbeenapplied.

Forthefirstyearintheseries,2006,noprofitsmoothingoccurred.Actualprofitisontarget.Foreachofthenextfiveyears,thetwoprofitnumbersdiffer.Theunder-gaporover-gapofactualprofitcomparedwithsmoothedprofitfortheyearistheamountofrevenueorexpensesmanipulationthatwasdoneintheyear.Forexample,in2007,actualprofitwouldhavebeentoohigh,sothecompanymovedsomeexpensesthatnormallywouldberecordedthefollowingyearinto2007.Incontrast,in2008,actualprofitwasrunningtoolow,sothebusinesstookactiontoputoffrecordingsomeexpensesuntil2011.

Ifabusinesshasaparticularlybadyear,alltheprofit-smoothingtricksintheworldwon’tclosethegap.Butseveralsmoothingtechniquesareavailableforfillingthepotholesandstraightening

Figure8-2:Comparisonoftwoannualprofithistories.

techniquesareavailableforfillingthepotholesandstraighteningthecurvesontheprofithighway.

Profit-smoothingtechniques

Onecommontechniqueforprofitsmoothingisdeferredmaintenance.Manyroutineandrecurringmaintenancecostsrequiredforvehicles,machines,equipmentandbuildingscanbeputoff,ordeferreduntillater.Thesecostsarenotrecordedtoexpenseuntiltheactualmaintenanceisdone,soputtingofftheworkmeansthatnoexpenseisrecorded.Oracompanycancutbackonitscurrentyear’soutlaysformarketresearchandproductdevelopment.Keepinmindthatmostofthesecostswillbeincurrednextyear,sotheeffectistorobPeter(makenextyearabsorbthecost)topayPaul(letthisyearescapethecost).

Abusinesscaneaseuponitsrulesregardingwhenslow-payingcustomersaredecidedtobebaddebts(uncollectabledebtors).A

businesscanputoffrecordingsomeofitsbaddebtsexpenseuntilnextyear.Afixedassetoutofactiveusemayhaveverylittleornofuturevaluetoabusiness.Insteadofwritingoffthenon-depreciatedcostoftheimpairedassetasalossthisyear,thebusinessmaydelaythewrite-offuntilnextyear.

So,managershavecontroloverthetimingofmanyexpenses,andtheycanusethisdiscretionforprofitsmoothing.Someamountofexpensescanbeacceleratedintothisyearordeferredtonextyearinordertomakeforasmootherprofittrend.Ofcourse,initsexternalfinancialreportabusinessdoesnotdivulgetheextenttowhichithasengagedinprofitsmoothing.Nordoestheindependentauditorcommentontheuseofprofit-smoothingtechniquesbythebusiness–unlesstheauditorthinksthatthecompanyhasgonetoofarinmassagingthenumbersandthatitsfinancialstatementsaremisleading.

StickingtotheaccountingconventionsOvertime,agenerallyacceptedapproachtotheboundariesofacceptablenumbernudginghasbeenarrivedat.Thishingesontheuseofthreeconventions:conservatism,materialityandconsistency.

Conservatism

Accountantsareoftenviewedasmerchantsofgloom,alwayspronetotakingapessimisticpointofview.Thefactthatapointofviewhastobetakenatallistherootoftheproblem.Theconventionofconservatismmeansthat,givenachoice,theaccountanttakesthefigurethatwillresultinalowerendprofit.Thismightmean,forexample,takingthehigheroftwopossibleexpensefigures.Fewpeopleareupsetiftheprofitfigureattheendofthedayishigherthanearlierestimates.Theconverseisnevertrue.

Materiality

Astrictinterpretationofdepreciationcouldleadtoallsortsoftrivialpaperwork.Forexample,pencilsharpeners,staplersandpaperclips,alltheoreticallyitemsoffixedassets,shouldbedepreciatedovertheirworkinglives.Thisisobviouslyauselessexerciseandinpracticetheseitemsarewritten-offwhentheyarebought.

Clearly,thelevelofmaterialityisnotthesameforallbusinesses.Amultinationalmaynotkeepmeticulousrecordsofeveryitemofmachineryunder£1,000.Forasmallbusinessthismayrepresentallthemachineryithas.

Consistency

Evenwiththehelpofthoseconceptsandconventions,there’safairdegreeoflatitudeinhowyoucanrecordandinterpretfinancialinformation.Youneedtochoosethemethodsthatgivethefairestpictureofhowthefirmisperformingandstickwiththem.Keepingtrackofeventsinabusinessthat’salwayschangingitsaccountingmethodsisverydifficult.Thisdoesn’tmeanthatyou’restuckwithonemethodforever.Anychange,however,isanimportantstep.

BrowsingversusReadingFinancialReports

Veryfewpeoplehavethetimetocarefullyreadalltheinformationinanannualfinancialreport–evenifthereportisrelativelyshort.

Annualfinancialreportsarelonganddensedocuments–likelengthylegalcontractsinmanyways.Pickupatypicalannualfinancialreportofapubliccorporation:Youwouldneedmanyhours(perhapsthewholeday)tothoroughlyreadeverythinginthereport.Youwouldneedatleastanhourortwojusttoreadandabsorbthemainpointsinthereport.Howdoinvestorsinabusinessdealwiththeinformationoverloadofannualfinancialreportsputoutbybusinesses?

AnannualfinancialreportisliketheSundayeditionofTheTimesorTheTelegraph.HardlyanyonereadseverysentenceoneverypageoftheseSundaypapers–mostpeoplepickandchoosewhattheywanttoread.InvestorsreadannualfinancialreportsliketheyreadSundaynewspapers.Theinformationisthereifyoureallywanttoreadit,butmostreaderspickandchoosewhichinformationtheyhavetimetoread.

Annualfinancialreportsaredesignedforarchivalpurposes,notforaquickread.Insteadofaddressingtheneedsofinvestorsandotherswhowanttoknowabouttheprofitperformanceandfinancialconditionofthebusiness–buthaveonlyaverylimitedamountof

conditionofthebusiness–buthaveonlyaverylimitedamountoftimetodoso–accountantsproduceanannualfinancialreportthatisavoluminousfinancialhistoryofthebusiness.Accountantsleaveittotheusersofannualreportstoextractthemainpointsfromanannualreport.So,financialstatementreadersuserelativelyfewratiosandotherteststogetafeelforthefinancialperformanceandpositionofthebusiness.(Chapters14and17explainhowreadersoffinancialreportsgetafixonthefinancialperformanceandpositionofabusiness.)

Somebusinesses(andnon-profitorganisationsinreportingtotheirmembersandotherconstituencies)don’tfurnishanannualfinancialreport.Theyknowthatfewpeoplehavethetimeorthetechnicalbackgroundtoreadthroughtheirannualfinancialreports.Instead,theyproviderelativelybriefsummariesthatareboiled-downversionsoftheirofficialfinancialstatements.Typicallythesesummariesdonotprovidefootnotesortheotherdisclosuresthatareincludedinannualfinancialreports.Thesecondensedfinancialstatements,withoutfootnotes,areprovidedbyseveralnon-profitorganisations–creditunions,forinstance.Ifyoureallywanttoseethecompletefinancialreportoftheorganisationyoucanaskitsheadquarterstosendyouacopy.

Youshouldkeepinmindthatannualfinancialreportsdonotreporteverythingofinteresttoowners,creditorsandotherswhohaveafinancialinterestinthebusiness.Annualreports,ofcourse,comeoutonlyonceayear–usuallytwomonthsorsoaftertheendofthecompany’sfiscal(accounting)year.Youhavetokeepabreastofdevelopmentsduringtheyearbyreadingfinancialnewspapersorthroughothermeans.Also,annualfinancialreportspresentthe‘sanitised’versionofevents;theydon’tdivulgescandalsorothernegativenewsaboutthebusiness.

Finally,noteverythingyoumayliketoknowasan

investorisincludedintheannualfinancialreport.Forexample,forUScompanies,informationaboutsalariesandincentivecompensationarrangementswiththetop-levelmanagersofthebusinessaredisclosedintheproxystatement,notintheannualfinancialreportofthebusiness.Aproxystatementisthemeansbywhichthecorporationsolicitsthevotesofshareholdersonissuesthatrequiretheirapproval–oneofwhichiscompensationpackagesoftop-levelmanagers.IntheUS,proxystatementsarefiledwiththeSECandareavailableonitsEDGARdatabase,www.sec.gov/edgar/searchedgar/cik.htm.IntheUKthisinformationwouldusuallyappearinthebodyofthemainreportundertheheading‘ReportoftheDirectorsonRemuneration’.

Thequalityoffinancialreportsvariesfromcompanytocompany.TheInvestorRelationsSociety(gotowww.irs.org.ukandclickon‘IRBestPractice’)makesanawardeachyeartothecompanyproducingthebest(inotherwords,‘complete’and‘clear’)setofreportsandaccounts.

PartIV

FinancialReportsintheOutsideWorld

Inthispart...Thispartlooksataccountingandfinancialreportingfromtheoutsideinvestor’s,ornon-manager’spointofview.Outsideinvestorsinabusiness–theownerswhoarenotontheinside

managingthebusiness–dependonthefinancialreportsfromthebusinessastheirmainsourceofinformationaboutthebusiness.Investorsshouldknowhowtoreadandinterpretthefinancialstatementsandwhattolookforinthefootnotestothestatements.Theirmainconcernsarethebusiness’sprofitandcashflowperformanceanditsfinancialhealth.Lenderstothebusinesshavesimilarinterestsinhowthebusinessisdoing.Keyratiosarecalculatedtotestthesuccessofthebusinessinmakingprofitandkeepingitsfinancialaffairsinorder.Youcanusethesameratiosontheaccountsofyourcompetitors,customers,suppliersorpotentialacquisitiontargetstoseehowthey’reperforming.

Investorsshouldalsoreadtheindependentauditor’sreport,whichprovidessome,thoughfarfromconclusive,assurancethatthefinancialstatementshavebeenpreparedproperly.Theauditor’sreportmayrevealseriousshortcomingsinthestatements(iftheyfindany),andwarnsinvestorsintheeventthatthebusinessisstandingonthinfinancialiceandmaynotbeabletocontinueasagoingconcern.Investorsshouldalsolookandseefromafinancialperspectivehowcomparablebusinessesareperforming.

Chapter14

HowInvestorsReadaFinancialReport

InThisChapterLookingafteryourinvestments

Keepingfinancialreportsprivateversusmakingthempublic

Usingratiostounderstandprofitperformance

Usingratiostointerpretfinancialconditionandcashflow

Scanningfootnotesandidentifyingtheimportantones

Payingattentiontowhattheauditorhastosay

Inreadingfinancialreports,directors,managers,businessownersandinvestorsneedtoknowhowtonavigatethroughthefinancialstatementstofindthevitalsignsofprogressandproblems.Thefinancialstatementratiosexplainedinthischapterpointtheway–theseratiosaresignpostsonthefinancialinformationhighway.Youcanalsokeepabreastofbusinessaffairsbyreadingfinancialnewspapersandinvestmentmagazines,andinvestmentnewslettersareverypopular.Thesesourcesoffinancialinformationrefertotheratiosdiscussedinthischapteronthepremisethatyouknowwhattheratiosmean.Mostmanagersorindividualinvestorsinpubliccompaniesdon’thavethetimeorexpertisetostudyafinancialreportthoroughlyenoughtomakedecisionsbasedonthereport,sotheyrelyonstockbrokers,investmentadvisersandpublishersofcreditratings(likeStandard&Poor’s)forinterpretationsoffinancialreports.Thefactisthatthefolkswhopreparefinancialreportshavethiskindofexpertaudienceinmind;theydon’tincludeexplanationsormarkpassageswithiconstohelpyouunderstandthereport.

Sureyoumayhaveyourownaccountantorinvestmentadviseron

Sureyoumayhaveyourownaccountantorinvestmentadviserontapsowhyshouldyoubotherreadingthischapterifyourelyonotherstointerpretfinancialreportsanyway?Well,themoreyouunderstandthefactorsthatgointointerpretingafinancialreport,thebetterpreparedyouaretoevaluatethecommentaryandadviceofstockanalystsandotherinvestmentexperts.Ifyoucanatleastnodintelligentlywhileyourstockbrokertalksaboutabusiness’sP/EandEPS,you’lllooklikeasavvyinvestor–andmaygetmorefavourabletreatment.(P/EandEPS,bytheway,aretwoofthekeyratiosexplainedlaterinthechapter.)

Thischaptergivesyouthebasicsforcomparingcompanies’financialreports,includingthepointsofdifferencebetweenprivateandpubliccompanies,theimportantratiosthatyoushouldknowaboutandthewarningsignstolookoutforonauditreports.PartIIofthisbookexplainsthethreeprimaryfinancialstatementsthatarethecoreofeveryfinancialreport:theprofitandlossaccount,thebalancesheetandthecashflowstatement.Inthischapter,wealsosuggesthowtosortthroughthefootnotesthatareanintegralpartofeveryfinancialreporttoidentifythosethathavethemostimportancetoyou.Believeus,theprosreadthefootnoteswithakeeneye.

FinancialReportingbyPrivateversusPublicBusinesses

Themainimpetusbehindthecontinueddevelopmentofgenerallyacceptedaccountingprinciples(GAAP)hasbeenthewidespreadpublicownershipandtradinginthesecurities(stocksandbonds)issuedbythousandsofcompanies.The1929stockmarketcrashanditsaftermathplainlyexposedthelackofaccountingstandards,aswellasmanyfinancial

reportingabusesandfrauds.LandmarkfederalsecuritieslawswerepassedintheUSin1933and1934,andafederalregulatoryagencywithbroadpowers–theSecuritiesandExchangeCommission(SEC)–wascreatedandgivenjurisdictionovertradingincorporatesecurities.IntheUK,theGovernmenthasenactedaseriesofCompaniesActs,culminatinginoneconsolidatedactin2006,thathavestrengthenedtheprotectionforshareholders.FinancialreportsandotherinformationmustbefiledwithTheLondonStockExchangeortherelevantauthoritieselsewhere,suchastheSECintheUS,andmadeavailabletotheinvestingpublic.

Accountingstandardsarenotlimitedtopubliccompanieswhosesecuritiesaretradedonpublicexchanges,suchastheLondonandNewYorkStockExchangesandNASDAQ.Thesefinancialaccountingandreportingstandardsapplywithequalforceandauthoritytoprivatebusinesseswhoseownershipsharesarenottradedinanyopenmarket.Whentheshareholdersofaprivatebusinessreceiveitsperiodicfinancialreports,theyareentitledtoassumethatthecompany’sfinancialstatementsandfootnotesarepreparedinaccordancewiththeaccountingrulesinforceatthetime.Evenfollowingtherulesleavesafairamountofwriggleroom–lookbacktoChapter13ifyouneedarefresheronthissubject.Soitalwayspaystocheckoverthefiguresyourselftobesureofwhatisreallygoingon.Thebare-bonescontentofaprivatebusiness’sannualfinancialreportincludesthethreeprimaryfinancialstatements(balancesheet,profitandlossaccount,andcashflowstatement)plusseveralfootnotes.We’veseenmanyprivatecompanyfinancialreportsthatdon’tevenhavealetterfromthechairman–justthethreefinancialstatementsplusafewfootnotesandnothingmore.Infact,we’veseenfinancialreportsofprivatebusinesses(mostlysmallcompanies)thatdon’tevenincludeacashflowstatement;only

thebalancesheetandprofitandlossaccountarepresented.Omittingacashflowstatementviolatestherules–butthecompany’sshareholdersanditslendersmaynotdemandtoseethecashflowstatement,sothecompanycangetawaywithit.

Publiclyownedbusinessesmustcomplywithanadditionallayerofrulesandrequirementsthatdon’tapplytoprivatelyownedbusinesses.TheserulesareissuedbytheStockExchange,theagencythatregulatesfinancialreportingandtradinginstocksandbondsofpubliclyownedbusinesses.TheStockExchangehasnojurisdictionoverprivatebusinesses;thosebusinessesneedonlyworryaboutGAAP,whichdon’thavemanyhard-and-fastrulesaboutfinancialreportformats.PublicbusinesseshavetofilefinancialreportsandotherformswiththeStockExchangethataremadeavailabletothepublic.ThesefilingsareavailabletothepublicontheLondonStockExchange’swebsitewww.londonstockexchange.com/orforUScompaniesontheSecuritiesExchangeCommission’s(SEC’s)EDGARdatabaseattheSEC’swebsite–www.sec.gov/edgar/quickedgar.htm.

Thebestknownoftheseformsistheannual10-K,whichincludesthebusiness’sannualfinancialstatementsinprescribedformatswithallthesupportingschedulesanddetaileddisclosuresthattheSECrequires.

Herearesome(butnotall)ofthemainfinancialreportingrequirementsthatpubliclyownedbusinessesmustadhereto.(Privatebusinessesmayincludetheseitemsaswelliftheywant,buttheygenerallydon’t.)

Managementdiscussionandanalysis(MD&A)section:Presentsthetopmanagers’interpretationandanalysisofabusiness’sprofitperformanceandotherimportantfinancialdevelopmentsovertheyear.

Earningspershare(EPS):Theonlyratiothatapublicbusinessisrequiredtoreport,althoughmostpublicbusinessesdoreportafewotherratiosaswell.See‘Earningspershare,basicanddiluted’laterinthischapter.Notethatprivatebusinesses’reportsgenerallydon’tincludeanyratios(butyoucan,ofcourse,computetheratiosyourself).

Three-yearcomparativeprofitandlossaccount:SeeChapter5formoreinformationaboutprofitandlossaccounts.

Note:Apublicly-ownedbusinesscanmaketherequiredfilingswiththeStockExchangeorSECandthenprepareadifferentannualfinancialreportforitsshareholders,thuspreparingtwosetsoffinancialreports.Thisiscommonpractice.However,thefinancialinformationinthetwodocumentscan’tdifferinanymaterialway.Atypicalannualfinancialreporttoshareholdersisaglossybookletwithexcellentartandgraphicdesignincludinghigh-qualityphotographs.Thecompany’sproductsarepromotedanditspeoplearefeaturedinglowingtermsthatdescribeteamwork,creativityandinnovation–we’resureyougetthepicture.Incontrast,thereportstotheLondonStockExchangeorSEClooklikelegalbriefs–nothingfancyinthesefilings.Thecoreoffinancialstatementsandfootnotes(pluscertainotherinformation)isthesameinboththeStockExchangefilingsandtheannualreportstoshareholders.TheStockExchangefilingscontainmoreinformationaboutcertainexpensesandrequiremuchmoredisclosureaboutthehistoryofthebusiness,itsmainmarketsandcompetitors,itsprincipalofficers,anymajorchangesonthehorizonandsoon.ProfessionalinvestorsandinvestmentmanagersreadtheStockExchangefilings.

Mostpubliccompaniessolicittheirshareholders’votesintheannualelectionofpersonstotheboardofdirectors(whomthebusinesshasnominated)andonothermattersthatmustbeputtoavoteattheannualshareholders’meeting.Themethodofcommunicationfordoingsoiscalledaproxystatement–thereasonbeingthattheshareholdersgivetheirvotestoaproxy,ordesignatedperson,whoactuallycaststhevotesattheannualmeeting.TheStockExchangerequiresmanydisclosuresinproxystatementsthatarenotfoundinannualfinancialreportsissuedtoshareholdersorinthebusiness’sannualaccountsfiledatCompaniesHouse.Forexample,compensationpaidtothetop-levelofficersofthebusinessmustbedisclosed,aswellastheirshareholdings.Ifyouownsharesinapubliccompany,takethetimetoreadthroughallthefinancialstatementsyoureceivethroughthepostandanyothersyoucangetyourhandson.

AnalysingFinancialReportswithRatios

Financialreportshavelotsofnumbersinthem.(Duh!)Thesignificanceofmanyofthesenumbersisnotclearunlesstheyarecomparedwithothernumbersinthefinancialstatementstodeterminetherelativesizeofonenumbertoanothernumber.Oneveryusefulwayofinterpretingfinancialreportsistocomputeratios–thatis,todivideaparticularnumberinthefinancialreportbyanother.Financialreportratiosarealsousefulbecausetheyenableyoutocompareabusiness’scurrentperformancewithitspastperformanceorwithanotherbusiness’sperformance,regardlessofwhethersalesrevenueornetincomewasbiggerorsmallerfortheotheryearsortheotherbusiness.Inotherwords,usingratios

cancelsoutsizedifferences.

Thefollowingsectionsexplainthetenfinancialstatementratiosthatyou’remostlikelytoruninto.Here’sageneraloverviewofwhytheseratiosareimportant:

Grossmarginratioandprofitratio:Youusetheseratiostomeasureabusiness’sprofitperformancewithrespecttoitssalesrevenue.Salesrevenueisthestartingpointformakingprofit;theseratiosmeasurethepercentageoftotalsalesrevenuethatisleftoverasprofit.

Earningspershare(EPS),price/earnings(P/E)ratioanddividendyield:Thesethreeratiosrevolvearoundthemarketpriceofshares,andanyonewhoinvestsinpubliclyownedbusinessesshouldbeintimatelyfamiliarwiththem.Asaninvestor,yourmainconcernisthereturnyoureceiveonyourinvestedcapital.Returnoncapitalconsistsoftwoelements:

•Periodiccashdividendsdistributedbythebusiness.

•Increase(ordecrease)inthemarketpriceoftheshares.

Dividendsandmarketpricesdependonearnings–andthereyouhavetherelationshipamongthesethreeratiosandwhythey’resoimportanttoyou,theinvestor.MajornewspapersreportP/Eratiosanddividendyieldsintheirstockmarketactivitytables;stockbrokers’investmentreportsfocusmainlyonforecastsofEPSanddividendyield.

Bookvaluepershareandreturnonequity(ROE):Sharesforprivatebusinesseshavenoreadymarketprice,soinvestorsinthesebusinessesusetheROEratio,whichisbasedonthevalueoftheirownershipequityreportedinthebalancesheet,tomeasureinvestmentperformance.Withoutamarketpriceforthesharesofaprivatebusiness,theP/Eratiocannotbedetermined.EPScaneasilybedeterminedfor

Figure14-1:Asampleprofitandlossaccount.

aprivatebusinessbutdoesnothavetobereportedinitsprofitandlossaccount.

Currentratioandacid-testratio:Theseratiosindicatewhetherabusinessshouldhaveenoughcashtopayitsliabilities.

Returnonassets(ROA):Thisratioisthefirststepindetermininghowwellabusinessisusingitscapitalandwhetherit’searningmorethantheinterestrateonitsdebt,whichcausesfinancialleveragegain(orloss).

TheprofitandlossaccountandbalancesheetofthebusinessexamplethatwefirstuseinChapter8arerepeatedheresothatyouhaveafinancialstatementforreference–seeFigures14-1(profitandlossaccount)and14-2(balancesheet).Noticethatacashflowstatementisnotpresentedhere–mainlybecausenoratiosarecalculatedfromdatainthecashflowstatement.(Refertothesidebar‘Thetemptationtocomputecashflowpershare:Don’tgivein!’)Thefootnotestothecompany’sfinancialstatementsarenotpresentedhere,buttheuseoffootnotesisdiscussedinthefollowingsections.

Figure14-2:Asamplebalancesheet.

Grossmarginratio

Makingbottom-lineprofitbeginswithmakingsalesandearningenoughgrossmarginfromthosesales,asexplainedinChapters5and9.Inotherwords,abusinessmustsetitssalespriceshighenoughoverproductcoststoyieldsatisfactorygrossmarginsonitsproducts,becausethebusinesshastoworryaboutmanymoreexpensesofmakingsalesandrunningthebusiness,plusinterestexpenseandincometaxexpense.Youcalculatethegrossmarginratioasfollows:

Grossmargin÷salesrevenue=grossmarginratio

Soabusinesswitha£20.8milliongrossmarginand£52millioninsalesrevenue(refertoFigure14-1)endsupwitha40percentgrossmarginratio.Now,ifthebusinesshadonlybeenabletoearna41percentgrossmargin,thatoneadditionalpoint(onepointis1percent)wouldhavecausedajumpinitsgrossmarginof£520,000(1percent´£52millionsalesrevenue)–whichwouldhavetrickleddowntoearningsbeforeincometax.Earningsbeforeincometaxwouldhavebeen19percenthigher(a£520,000bumpingrossmargin÷£2.8millionincomebeforeincometax).Neverunderestimatetheimpactofevenasmallimprovementinthegrossmarginratio!

Outsideinvestorsknowonlytheinformationdisclosedintheexternalfinancialreportthatthebusinessreleases.Theycan’tdomuchmorethancomparethegrossmarginforthetwo-orthree-yearlyprofitandlossaccountsincludedintheannualfinancialreport.Althoughpubliclyownedbusinessesarerequiredtoincludeamanagementdiscussionandanalysis(MD&A)sectionthatshouldcommentonanysignificantchange

inthegrossmarginratio,corporatemanagershavewidelatitudeindecidingwhatexactlytodiscussandhowmuchdetailtogointo.YoudefinitelyshouldreadtheMD&Asection,butitmaynotprovidealltheanswersyou’relookingfor.Youhavetosearchfurtherinstockbrokerreleases,inarticlesinthefinancialpress,oratthenextprofessionalbusinessmeetingyouattend.

AsexplainedinChapter9,managersfocusoncontributionmarginperunitandtotalcontributionmargintocontrolandimproveprofitperformancebusiness.Contributionmarginequalssalesrevenueminusproductcostandothervariableoperatingexpensesofthebusiness.Contributionmarginisprofitbeforethecompany’stotalfixedcostsfortheperiodarededucted.Changesinthecontributionmarginsperunitoftheproductssoldbyabusinessandchangesinitstotalfixedcostsareextremelyimportantinformationinmanagingprofit.

However,businessesdonotdisclosecontributionmargininformationintheirexternalfinancialreports–theywouldn’teventhinkofdoingso.Thisinformationisconsideredtobeproprietaryinnature;itshouldbekeptconfidentialandoutofthehandsofitscompetitors.Inshort,investorsdonothaveaccesstoinformationaboutthebusiness’scontributionmargin.NeitheraccountingstandardsnortheStockExchangerequiresthatsuchinformationbedisclosed.Theexternalprofitandlossaccountdisclosesgrossmarginandoperatingprofit,orearningsbeforeinterestandincometaxexpenses.However,theexpensesbetweenthesetwoprofitlinesintheprofitandlossaccountarenotseparatedbetweenvariableandfixed(refertoFigure14-1).

ProfitratioBusinessismotivatedbyprofit,sotheprofitratioisveryimportanttosaytheleast.Theprofitratioindicateshowmuchnetincomewasearnedoneach£100ofsalesrevenue:

Netincome÷salesrevenue=profitratio

Netincome÷salesrevenue=profitratio

Forexample,thebusinessinFigure14-1earned£1.9millionnetincomefromits£52millionsalesrevenue,soitsprofitratiois3.65percent,meaningthatthebusinessearned£3.65netincomeforeach£100ofsalesrevenue.

Aseeminglysmallchangeintheprofitratiocanhaveabigimpactonthebottomline.Supposethatthisbusinesshadearnedaprofitratioof5percentinsteadof3.65percent.Thatincreaseintheprofitratiotranslatesintoa£700,000increaseinbottom-lineprofit(netincome)onthesamesalesrevenue.

Profitratiosvarywidelyfromindustrytoindustry.A5–10percentprofitratioiscommoninmostindustries,althoughsomehigh-volumeretailers,suchassupermarkets,aresatisfiedwithprofitratiosaround1percentor2percent.

Youcanturnanyratioupsidedownandcomeupwithanewwayoflookingatthesameinformation.Ifyoufliptheprofitratioovertobesalesrevenuedividedbynetincome,theresultistheamountofsalesrevenueneededtomake£1profit.Usingthesameexample,£52millionsalesrevenue÷£1.9millionnetincome=27.37to1upside-downprofitratio,whichmeansthatthisbusinessneeds£27.37insalestomake£1profit.Soyoucansaythatnetincomeis3.65percentofsalesrevenue,oryoucansaythatsalesrevenueis27.37timesnetincome–butthestandardprofitratioisexpressedasnetincomedividedbysalesrevenue.

Earningspershare,basicanddiluted

Earningspershare,basicanddilutedPubliclyownedbusinesses,accordingtogenerallyacceptedaccountingprinciples(GAAP),mustreportearningspershare(EPS)belowthenetincomelineintheirprofitandlossaccounts–givingEPSacertaindistinctionamongtheratios.WhyisEPSconsideredsoimportant?Becauseitgivesinvestorsameansofdeterminingtheamountthebusinessearnedontheirshareinvestments:EPStellsyouhowmuchnetincomethebusinessearnedforeachshareyouown.TheessentialequationforEPSisasfollows:

Netincome÷totalnumberofcapitalstockshares=EPS

FortheexampleinFigures14-1and14-2,thecompany’s£1.9millionnetincomeisdividedbythe795,000sharesofstockthebusinesshasissuedtocomputeits£2.39EPS.

Note:PrivatebusinessesdonothavetoreportEPSiftheydon’twantto.ConsideringthewiderangeofissuescoveredbyGAAP,youfindsurprisinglyfewdistinctionsbetweenprivateandpublicbusinesses–theseauthoritativeaccountingrulesapplytoallbusinesses.ButEPSisoneareawhereGAAPmakesanexceptionforprivatelyownedbusinesses.EPSisextraordinarilyimportanttotheshareholdersofbusinesseswhosesharesarepubliclytraded.Theseshareholdersfocusonmarketpricepershare.Theywantthetotalnetincomeofthebusinesstobecommunicatedtothemonapersharebasissothattheycaneasilycompareitwiththemarketpriceoftheirshares.Thesharesofprivatelyownedcompaniesarenotactivelytraded,sothereisnoreadilyavailablemarketvaluefortheirshares.ThethinkingbehindtherulethatprivatelyownedbusinessesshouldnothavetoreportEPSisthattheirshareholdersdonotfocusonpersharevaluesandaremoreinterestedinthebusiness’stotalnetincomeperformance.

Thebusinessintheexampleistoosmalltobepubliclyowned.Soweturnheretoalargerpubliccompanyexample.Thispubliclyownedcompanyreportsthatitearned£1.32billionnetincomefortheyearjustended.Attheendoftheyear,thiscompanyhas400millionsharesoutstanding,whichreferstothenumberofsharesthathavebeenissuedandareownedbyitsshareholders.Thus,itsEPSis£3.30(£1.32billionnetincome÷400millionstockshares).Buthere’sacomplication:Thebusinessiscommittedtoissuingadditionalcapitalsharesinthefutureforshareoptionsthatthecompanyhasgrantedtoitsmanagers,andithasborrowedmoneyonthebasisofdebtinstrumentsthatgivethelenderstherighttoconvertthedebtintoitscapitalstock.Undertermsofitsmanagementshareoptionsanditsconvertibledebt,thebusinesscouldhavetoissue40millionadditionalcapitalsharesinthefuture.DividingnetincomebythenumberofsharesoutstandingplusthenumberofsharesthatcouldbeissuedinthefuturegivesthefollowingcomputationofEPS:

£1.32billionnetincome÷440millioncapitalstockshares=£3.00EPS

Thissecondcomputation,basedonthehighernumberofshares,iscalledthedilutedearningspershare.(Dilutedmeansthinnedoutorspreadoveralargernumberofshares.)Thefirstcomputation,basedonthenumberofsharesactuallyoutstanding,iscalledbasicearningspershare.PubliclyownedbusinesseshavetoreporttwoEPSfigures–unlesstheyhaveasimplecapitalstructurethatdoesnotrequirethebusinesstoissueadditionalsharesinthefuture.Generally,publiclyowned

companieshavecomplexcapitalstructuresandhavetoreporttwoEPSfigures.Botharereportedatthebottomoftheprofitandlossaccount.Sothecompanyinthisexamplereports£3.30basicEPSand£3.00dilutedEPS.Sometimesit’snotclearwhichofthetwoEPSfiguresisbeingusedinpressreleasesandinarticlesgivinginvestmentadvice.Fortunately,TheFinancialTimesandmostothermajorfinancialpublicationsleaveacleartrailofbothEPSfigures.

CalculatingbasicanddilutedEPSisn’talwaysassimpleasourexamplesmaysuggest.AnaccountantwouldhavetoadjusttheEPSequationforthefollowingcomplicatingthingsthatabusinessmaydo:

Issueadditionalsharesduringtheyearandbuybacksomeofitsshares(sharesofitsstockownedbythebusinessitselfthatarenotformallycancelledarecalledtreasurystock).

Issuemorethanoneclassofshare,causingnetincometobedividedintotwoormorepools–onepoolforeachclassofshare.

Gothroughamerger(businesscombination)inwhichalargenumberofsharesareissuedtoacquiretheotherbusiness.

TheshareholdersshoulddrawcomfortfromthefactthatthetopmanagementofmanybusinessesinwhichtheyinvestareprobablyjustasanxiouslyreviewingEPSperformanceastheyare.ThisextractfromTesco’sannualaccountsrevealsmuch:

AnnualbonusesbasedonachievingstretchingEPSgrowthtargetsandspecificcorporateobjectives.

Annualbonusesarepaidinshares.Onaward,theExecutive

canelecttodeferreceiptofthesharesforafurthertwoyears,whichisencouraged,withadditionalmatchingshareawards.

Longer-termbonusbasedonacombinationofrelativetotalshareholderreturn,andtheachievementofstretchingEPSgrowthtargetsandspecificcorporateobjectives.Longer-termbonusesarepaidinshares,whichmustbeheldforafurtherfouryears.ExecutiveDirectorsareencouragedtoholdsharesforlongerthanfouryearswithadditionalmatchingshareawards.Furtherdetailsareprovidedbelow.

ShareoptionsaregrantedtoExecutiveDirectorsatmarketvalueandcanonlybeexercisedifEPSgrowthexceedsRetailPriceIndex(RPI)plus9percentoveranythreeyearsfromgrant.

ExecutiveDirectorsarerequiredtobuildandholdashareholdingwithavalueatleastequaltotheirbasicsalary;fullparticipationintheExecutiveIncentiveschemeisconditionaluponmeetingthistarget.

Price/earnings(P/E)ratioTheprice/earnings(P/E)ratioisanotherratiothat’sofparticularinteresttoinvestorsinpublicbusinesses.TheP/Eratiogivesyouanideaofhowmuchyou’repayinginthecurrentpriceforthesharesforeachpoundofearnings,ornetincome,beingearnedbythebusiness.Rememberthatearningspropupthemarketvalueofshares,notthebookvalueofthesharesthat’sreportedinthebalancesheet.(Readonforthebookvaluepersharediscussion.)

TheP/Eratiois,inonesense,arealitycheckonjusthowhighthecurrentmarketpriceisinrelationtotheunderlyingprofitthatthebusinessisearning.ExtraordinarilyhighP/Eratiosarejustifiedonlywheninvestorsthinkthatthecompany’sEPShasalotofupsidepotentialinthefuture.

TheP/Eratioiscalculatedasfollows:

Currentmarketpriceofstock÷mostrecenttrailing12monthsdilutedEPS=P/Eratio

IfthebusinesshasasimplecapitalstructureanddoesnotreportadilutedEPS,itsbasicEPSisusedforcalculatingitsP/Eratio.(Seetheearliersection‘Earningspershare,basicanddiluted’.)

Assumethatthestocksharesofapublicbusinesswitha£3.65dilutedEPSaresellingat£54.75inthestockmarket.Note:Fromhereforward,wewillusethebriefertermEPSinreferencetoP/Eratios;weassumeyouunderstandthatitreferstodilutedEPSforbusinesseswithcomplexcapitalstructuresandtobasicEPSforbusinesseswithsimplecapitalstructures.

Theactualsharepricebouncesarounddaytodayandissubjecttochangeonshortnotice.ToillustratetheP/Eratio,weusethisprice,whichistheclosingpriceonthelatesttradingdayinthestockmarket.Thismarketpricemeansthatinvestorstradinginthestockthinkthatthesharesareworth15timesdilutedEPS(£54.75marketprice÷£3.65dilutedEPS=15).Thisvaluemaybebelowthebroadmarketaveragethatvaluessharesat,say,20timesEPS.TheoutlookforfuturegrowthinitsEPSisprobablynottoogood.

DividendyieldThedividendyieldtellsinvestorshowmuchcashflowincomethey’rereceivingontheirinvestment.(Thedividendisthecashflowincomepartofinvestmentreturn;theotherpartisthegainorlossinthemarketvalueoftheinvestmentovertheyear.)

Marketcap–notacaponmarketvalueOneinvestmentnumberyouseealotinthefinancialpressisthemarketcap.No,thisdoesnotrefertoacap,orlimit,onthemarketvalueofacompany’scapitalshares.Thetermisshorthandformarketcapitalisation,whichrefersto

thetotalmarketvalueofthebusinessthatisdeterminedbymultiplyingthestock’scurrentmarketpricebythetotalnumberofsharesissuedbythecompany.Supposeacompany’sstockissellingat£50pershareinthestockmarketandithas200millionsharesoutstanding.Itsmarketcapis£10billion.Anotherbusinessmaybewillingtopayhigherthan£50pershareforthecompany.Indeed,manyacquisitionsandmergersinvolvetheacquiringcompanypayingaheftypremiumoverthegoingmarketpriceofthesharesofthecompanybeingacquired.

Supposethatastockofapubliccompanythatissellingfor£60paid£1.20cashdividendspershareoverthelastyear.Youcalculatedividendyieldasfollows:

£1.20annualcashdividendpershare÷£60currentmarketpriceofstock=2%dividendyield

Youusedividendyieldtocomparehowyourstockinvestmentisdoingtohowitwouldbedoingifyou’dputthatmoneyincorporateorTreasurybonds,giltedgedstock(UKgovernmentborrowings)orotherdebtsecuritiesthatpayinterest.Theaverageinterestrateofhigh-gradedebtsecuritieshasrecentlybeenthreetofourtimesthedividendyieldsonmostpubliccompanies;intheory,marketpriceappreciationofthesharesovertimemakesupforthatgap.Ofcourse,shareholderstaketheriskthatthemarketvaluewillnotincreaseenoughtomaketheirtotalreturnoninvestmentratehigherthanabenchmarkinterestrate.(Atthetimeofwriting,thisyieldgaphasshrunktonothingandiscausinganagonizingreappraisalofthevalueofequities,inrelationtodebt,asaninvestmentmedium.)

Assumethatlong-termgovernmentgiltedgedstockarecurrentlypaying6percentannualinterest,whichis4percenthigherthanthebusiness’s2percentdividendyieldinthe

examplejustdiscussed.Ifthisbusiness’ssharesdon’tincreaseinvaluebyatleast4percentovertheyear,itsinvestorswouldhavebeenbetteroffinvestinginthedebtsecuritiesinstead.(Ofcourse,theywouldn’thavehadalltheperksofashareinvestment,likethoseheartfeltlettersfromthechairmanandthoseglossyfinancialreports.)Themarketpriceofpubliclytradeddebtsecuritiescanfallorrise,sothingsgetalittletrickyinthissortofinvestmentanalysis.

BookvaluepershareBookvaluepershareisonemeasure,butit’scertainlynottheonlyamount,usedfordeterminingthevalueofaprivatelyownedbusiness’sshares.AsdiscussedinChapter6,bookvalueisnotthesamethingasmarketvalue.Theassetvaluesthatabusinessrecordsinitsbooks(alsoknownasitsaccounts)arenottheamountsthatabusinesscouldgetifitputitsassetsupforsale.Bookvaluesofsomeassetsaregenerallylowerthanwhatthecostwouldbeforreplacingtheassetsifadisaster(suchasafloodorafire)wipedoutthebusiness’sstockorequipment.Recordingcurrentmarketvaluesinthebooksisreallynotapracticaloption.Untilasellerandabuyermeetandhaggleoverprice,tryingtodeterminethemarketpriceforaprivatelyownedbusiness’ssharesisawfullyhard.

Youcancalculatebookvaluepershareforpubliclyownedbusinessestoo.However,marketvalueisreadilyavailable,soshareholders(andinvestmentadvisersandmanagers)donotputmuchweightonbookvaluepershare.EPSisthemainfactorthataffectsthemarketpricesofstocksharesofpubliccompanies–notthebookvaluepershare.Weshouldaddthatsomeinvestingstrategies,knownasvalueinvesting,searchoutcompaniesthathaveahighbookvaluepersharecomparedtotheirgoingmarketprices.Butbyandlarge,bookvaluepershareplaysasecondaryroleinthemarketvaluesofstocksharesissuedbypubliccompanies.

Althoughbookvaluepershareisgenerallynotagoodindicatorofthemarketvalueofaprivatebusiness’sshares,youdorunintothisratio,atleastasastartingpointforhagglingoverasellingprice.Here’showtocalculatebookvaluepershare:

Totalowners’equity÷totalnumberofstockshares=bookvaluepershare

ThebusinessshowninFigure14-2hasissued795,000shares:Its£15.9milliontotalowners’equitydividedbyits795,000sharesgivesabookvaluepershareof£20.Ifthebusinesssoldoffitsassetsexactlyfortheirbookvaluesandpaidallitsliabilities,itwouldendupwith£15.9millionleftfortheshareholders,anditcouldthereforedistribute£20pershare.Butthecompanywillnotgooutofbusinessandliquidateitsassetsandpayoffitsliabilities.Sobookvaluepershareisatheoreticalvalue.It’snottotallyirrelevant,butit’snotallthatdefinitive,either.

Returnonequity(ROE)ratioThereturnonequity(ROE)ratiotellsyouhowmuchprofitabusinessearnedincomparisontothebookvalueofshareholders’equity.Thisratioisusefulforprivatelyownedbusinesses,whichhavenowayofdeterminingthecurrentvalueofowners’equity(atleastnotuntilthebusinessisactuallysold).ROEisalsocalculatedforpubliccompanies,but,justlikebookvaluepershare,itplaysasecondaryroleandisnotthedominantfactordrivingmarketprices.(Earningsare.)Here’showyoucalculatethiskeyratio:

Netincome÷owners’equity=ROE

Theowners’equityfigureisatbookvalue,whichisreportedinthecompany’sbalancesheet.Chapter6explainsowners’equityandthedifferencebetweensharecapitalandretainedearnings,whicharethetwocomponentsofowners’equity.

ThebusinesswhoseprofitandlossaccountandbalancesheetareshowninFigures14-1and14-2earned£1.9millionnetincomefortheyearjustendedandhas£15.9millionowners’equity.Therefore,itsROEis11.95percent(£1.9millionnetincome÷£15.9millionowners’equity=11.95percent).ROEisnetincomeexpressedasapercentageoftheamountoftotalowners’equityofthebusiness,whichisoneofthetwosourcesofcapitaltothebusiness,theotherbeingborrowedmoney,orinterest-bearingdebt.(Abusinessalsohasnon-interest-bearingoperatingliabilities,suchascreditors.)Thecostofdebtcapital(interest)isdeductedasanexpensetodeterminenetincome.Sonetincome‘belongs’totheowners;itincreasestheirequityinthebusiness,soitmakessensetoexpressnetincomeasthepercentageofimprovementintheowners’equity.

GearingorleverageYourcompany’sliquiditykeepsyousolventfromdaytodayandmonthtomonthandwecometothatnextwhenwelookatthecurrentratioandacidtest.Butwhataboutyourabilitytopaybacklong-termdebtyearafteryear?Twofinancialratiosindicatewhatkindofshapeyou’reinoverthelongterm.

Ifyou’vereadthischapterfromthebeginning,youmaybegettingreallyboredwithfinancialratiosbynow,butyourlenders–bankersandbondholders,ifyouhavethem–findtheselong-termratiostobeincrediblyfascinating,forobviousreasons.

Thefirstratiogaugeshoweasyitisforyourcompanytocontinuemakinginterestpaymentsonthedebt:

Timesinterestearned=earningsbeforeinterestandtaxes÷interestexpense

Don’tgetconfused–earningsbeforeanyinterestexpenseandtaxesarepaid(EBIT)isreallyjusttheprofitthatyouhaveavailabletomakethoseinterestpaymentsinthefirstplace.Figure14-1,forexample,showsanEBITof£3,550(thousand)andaninterestexpenseof£750(thousand)thisyearforatimes-interest-earnedratioof4.73.Inotherwords,thisbusinesscanmeetitsinterestexpense4.73timesover.

Youmayalsohearthesamenumbercalledaninterestcoverage.Lendersgetmightynervousifthisratioevergetsanywherecloseto1.0,becauseatthatpoint,everylastpennyofprofitsgoesforinterestpaymentsonthelong-termdebt.

Thesecondratiotriestodeterminewhethertheprincipalamountofyourdebtisinanydanger:

Debt-to-equityratio=long-termliabilities÷owners’equity

Thedebt-to-equityratiosaysagreatdealaboutthegeneralfinancialstructureofyourcompany.Afterall,youcanraisemoneytosupportyourcompanyinonlytwoways:borrowitandpromisetopayitbackwithinterest,orsellpiecesofthecompanyandpromisetosharealltherewardsofownership.Thefirstmethodisdebt;thesecond,equity.

Figure14-2,forexample,showsadebt-to-equityratioof£6,000÷£15,900,or.38.Thisratiomeansthatthecompanyhasaroundthreetimesmoreequityfinancingthanitdoeslong-termdebt.

Lenderslovetoseelotsofequitysupportingacompany’sdebtbecausethentheyknowthatthemoneytheyloanoutissafer.Ifsomethinggoeswrongwiththecompany,theycangoafterthe

somethinggoeswrongwiththecompany,theycangoaftertheowners’money.Equityinvestors,ontheotherhand,actuallywanttotakeonsomerisk.Theyliketoseerelativelyhighdebt-to-equityratiosbecausethatsituationincreasestheirleverageand(asthefollowingsectionpointsout)cansubstantiallyboosttheirprofits.Sothedebt-to-equityratiothat’sjustrightforyourcompanydependsnotonlyonyourindustryandhowstableitis,butalsoonwhoyouask.

CurrentratioThecurrentratioisatestofabusiness’sshort-termsolvency–itscapabilitytopayoffitsliabilitiesthatcomedueinthenearfuture(uptooneyear).Theratioisaroughindicatorofwhethercash-on-handplusthecashflowfromcollectingdebtorsandsellingstockwillbeenoughtopayofftheliabilitiesthatwillcomedueinthenextperiod.

Asyoucanimagine,lendersareparticularlykeenonpunchinginthenumberstocalculatethecurrentratio.Here’showtheydoit:

Currentassets÷currentliabilities=currentratio

Note:Unlikewithmostoftheotherratios,youdon’tmultiplytheresultofthisequationby100andrepresentitasapercentage.

Businessesareexpectedbytheircreditorstomaintainaminimumcurrentratio(2.0,meaninga2-to-1ratio,isthegeneralrule)andmaybelegallyrequiredtostayaboveaminimumcurrentratioasstipulatedintheircontractswithlenders.ThebusinessinFigure14-2has£17.2millionincurrentassetsand£7,975,000incurrentliabilities,soitscurrentratiois2.16anditshouldn’thavetoworryaboutlenderscomingbyinthemiddleofthenighttobreakitslegs.Chapter6discusses

currentassetsandcurrentliabilitiesandhowtheyarereportedinthebalancesheet.

Howmuchworkingcapital,readyornearlyreadymoneydoyouneedtoensuresurvival?Havingtheliquidassetsavailablewhenyouabsolutelyneedthemtomeetshort-termobligationsiscalledliquidity.Youdon’thavetohavecashinthetilltobeliquid.Debtors(thatis,peoplewhooweyoumoneyandcanbereasonablyexpectedtocoughupsoon)andstockreadytobesoldarebothpartofyourliquidassets.Youcanuseseveralfinancialratiostotestabusiness’sliquidity,includingthecurrentratioandtheacidtest.Youcanmonitortheseratiosyearbyyearandmeasurethemagainstyourcompetitors’ratiosandtheindustryaverages.

Acid-testratio

Mostseriousinvestorsandlendersdon’tstopwiththecurrentratioforanindicationofthebusiness’sshort-termsolvency–itscapabilitytopaytheliabilitiesthatwillcomedueintheshortterm.Investorsalsocalculatetheacid-testratio(alsoknownasthequickratioorthepounceratio),whichisamoreseveretestofabusiness’ssolvencythanthecurrentratio.Theacid-testratioexcludesstockandprepaidexpenses,whichthecurrentratioincludes,andlimitsassetstocashanditemsthatthebusinesscanquicklyconverttocash.Thislimitedcategoryofassetsisknownasquickorliquidassets.

Youcalculatetheacid-testratioasfollows:

Liquidassets÷totalcurrentliabilities=acid-testratio

Note:Unlikemostotherfinancialratios,youdon’tmultiplytheresultofthisequationby100andrepresentitasapercentage.

ForthebusinessexampleshowninFigure14-2,theacid-testratioisasfollows:

A1.07acid-testratiomeansthatthebusinesswouldbeabletopayoffitsshort-termliabilitiesandstillhavealittlebitofliquidassetsleftover.Thegeneralruleisthattheacid-testratioshouldbeatleast1.0,whichmeansthatliquidassetsequalcurrentliabilities.Ofcourse,fallingbelow1.0doesn’tmeanthatthebusinessisonthevergeofbankruptcy,butiftheratiofallsaslowas0.5,thatmaybecauseforalarm.

Thisratioisalsoknownasthepounceratiotoemphasisethatyou’recalculatingforaworst-casescenario,whereapackofwolves(morepolitelyknownascreditors)haspouncedonthebusinessandisdemandingquickpaymentofthebusiness’sliabilities.Butdon’tpanic.Short-termcreditorsdonothavetherighttodemandimmediatepayment,exceptunderunusualcircumstances.Thisisaveryconservativewaytolookatabusiness’scapabilitytopayitsshort-termliabilities–tooconservativeinmostcases.

KeepingtrackofstockanddebtorlevelsTwootherareasthateffectliquidityneedtobemonitoredcarefully:howfastyourstockissellingout(ifyourbusinessrequiresholdinggoodsforsale),andhowfastyourcustomersarepayingup.

Here’stheratioforstocklevels:

Stockturnover=costofgoodssold÷stock

Stockturnovertellsyousomethingabouthowliquidyourstocksreallyare.Thisratiodividesthecostofgoodssold,asshowninyouryearlyprofitandlossaccount,bytheaveragevalueofyourstock.Ifyoudon’tknowtheaverage,youcanestimateitbyusingthestockfigurelistedinthebalancesheetattheendoftheyear.

ForthebusinessrepresentedinFigures14-1and14-2,thestockturnoveris£31,200÷£7,800,or4.0.Thisratiomeansthatthisbusinessturnsoveritsstocksfourtimeseachyear.Expressedindays,thebusinesscarriesa91.25-day(365÷4.0)supplyofstock.

Isa90-dayplusinventorygoodorbad?Itdependsontheindustryandevenonthetimeofyear.Acardealerwhohasa90-daysupplyofcarsattheheightoftheseasonmaybeinastrongstockposition,butthesamestockpositionattheendoftheseasoncouldbearealweakness.AsJustInTime(JIT)supplychainsandimprovedinformationsystemsmakebusinessoperationsmoreefficientacrossallindustries,stockturnoverisontherise,andtheaveragenumberofdaysthatstockofanykindhangsaroundcontinuestoshrink.

Whataboutdebtorlevels?

Debtorturnover=salesoncredit÷debtors

Debtorturnovertellsyousomethingaboutliquiditybydividingthesalesthatyoumakeoncreditbytheaveragedebtors.Ifanaverageisn’tavailable,youcanusethedebtorsfromabalancesheet.

IfthebusinessrepresentedinFigures14-1and14-2makes80percentofitssalesoncredit,itsdebtorturnoveris(£52,000´0.8)÷£5,000,or8.3.Inotherwords,thecompanyturnsoveritsdebtors8.3timesperyear,oronceevery44days,onaverage.That’snottoobad:paymenttermsare30days.Butremember,unlikefinewine,debtorsdon’timprovewithage.

Returnonassets(ROA)ratioAsdiscussedinChapter6(refertothesidebar‘Tradingontheequity:Takingachanceondebt’),onefactoraffectingthebottom-lineprofitofabusinessiswhetherituseddebttoitsadvantage.Fortheyear,abusinessmayhaverealisedafinancialleveragegain–itearnedmoreprofitonthemoneyitborrowedthantheinterestpaidfortheuseofthatborrowedmoney.Soagoodpartofitsnetincomefortheyearmaybeduetofinancialleverage.Thefirststepindeterminingfinancialleveragegainistocalculateabusiness’sreturnonassets(ROA)ratio,whichistheratioofEBIT(earningsbeforeinterestandtax)tothetotalcapitalinvestedinoperatingassets.

Here’showtocalculateROA:

EBIT÷netoperatingassets=ROA

Note:Thisequationcallsfornetoperatingassets,whichequalstotalassetslessthenon-interest-bearingoperatingliabilitiesofthebusiness.Actually,manystockanalystsandinvestorsusethetotalassetsfigurebecausedeductingallthenon-interest-bearingoperatingliabilitiesfromtotalassetstodeterminenetoperatingassetsis,quitefrankly,anuisance.Butwestronglyrecommendusingnetoperatingassetsbecausethat’sthetotalamountofcapitalraisedfromdebtandequity.

CompareROAwiththeinterestrate:Ifabusiness’sROAis14per

CompareROAwiththeinterestrate:Ifabusiness’sROAis14percentandtheinterestrateonitsdebtis8percent,forexample,thebusiness’snetgainonitsdebtcapitalis6percentmorethanwhatit’spayingininterest.There’safavourablespreadof6points(onepoint=1percent),whichcanbemultipliedbythetotaldebtofthebusinesstodeterminehowmuchitstotalearningsbeforeincometaxistraceabletofinancialleveragegain.

InFigure14-2,noticethatthecompanyhas£10milliontotalinterest-bearingdebt(£4millionshort-termplus£6millionlong-term).Itstotalowners’equityis£15.9million.Soitsnetoperatingassetstotalis£25.9million(whichexcludesthethreeshort-termnon-interest-bearingoperatingliabilities).Thecompany’sROA,therefore,is

£3.55millionearningsbeforeinterestandtax÷£25.9millionnetoperatingassets=13.71%ROA

Thebusinessearned£1,371,000(rounded)onitstotaldebt–13.71percentROAtimes£10milliontotaldebt.Thebusinesspaidonly£750,000interestonitsdebt.Sothebusinesshad£621,000financialleveragegainbeforeincometax(£1,371,000less£750,000).Putanotherway,thebusinesspaid7.5percentinterestonitsdebtbutearned13.71percentonthismoneyforafavourablespreadof6.21points–which,whenmultipliedbythe£10milliondebt,yieldsthe£621,000pre-taxfinancialgainfortheyear.

ROAisausefulearningsratio,asidefromdeterminingfinancialleveragegain(orloss)fortheperiod.ROAisacapitalutilisationtest–howmuchprofitbeforeinterestandtaxwasearnedonthetotalcapitalemployedbythebusiness.Thebasicideaisthatittakesmoney(assets)tomakemoney(profit);thefinaltestishowmuchprofitwasmadeontheassets.If,forexample,abusinessearns£1millionEBITon£20millionassets,itsROAisonly5percent.Sucha

lowROAsignalsthatthebusinessismakingpooruseofitsassetsandwillhavetoimproveitsROAorfaceseriousproblemsinthefuture.

UsingcombinedratiosYouwouldn’tuseasingleratiotodecidewhetheronevehiclewasabetterorworsebuythananother.MPG,MPH,annualdepreciationpercentageandresidualvalueproportionarejustahandfuloftheratiosthatyou’dwanttoreview.Soitiswithabusiness.Youcanuseacombinationofratiostoformanopiniononthefinancialstateofaffairsatanyonetime.

ThebestknownofthesecombinationratiosistheAltmanZ-Score(www.creditguru.com/CalcAltZ.shtml)thatusesacombinedsetoffivefinancialratiosderivedfromeightvariablesfromacompany’sfinancialstatementslinkedtosomestatisticaltechniquestopredictacompany’sprobabilityoffailure.Enteringthefiguresintotheonscreentemplateatthiswebsiteproducesascoreandanexplanatorynarrativegivingaviewonthebusinessesfinancialstrengthsandweaknesses.

AppreciatingthelimitsofratiosAdangerwithratiosistobelievethatbecauseyouhaveaprecisenumber,youhavearightfiguretoaimfor.Forexample,anaturalfeelingwithfinancialratiosistothinkthathighfiguresaregoodones,andanupwardtrendrepresentstherightdirection.Thistheoryis,tosomeextent,encouragedbythepersonalfeelingofwealththathavingalotofcashengenders.

Unfortunately,nogeneralruleexistsonwhichwayisrightforfinancialratios.Insomecasesahighfigureisgood;inothers,alowfigureisbest.Indeed,insomecircumstances,ratiosofthesamevaluearen’tasgoodaseachother.LookatthetwoworkingcapitalstatementsinTable14-1.

Theamountofworkingcapitalinexamples1and2isthesame,£16,410,asarethecurrentassetsandcurrentliabilities,at£23,100and£6,690respectively.Itfollowsthatanyratiousingthesefactorswouldalsobethesame.Forexample,thecurrentratiosinthesetwoexamplesarebothidentical,3.4:1,butinthefirstcasethere’sareasonablechancethatsomecashwillcomeinfromdebtors,certainlyenoughtomeetthemodestcreditorposition.Inthesecondexamplethere’snopossibilityofusefulamountsofcashcominginfromtrading,withdebtorsatonly£100,whilecreditorsattherelativelysubstantialfigureof£6,600willposearealthreattofinancialstability.

Sointhiscasethecurrentratiosareidentical,butthesituationsbeingcomparedarenot.Infact,asageneralrule,ahigherworkingcapitalratioisregardedasamoveinthewrongdirection.Themoremoneyabusinesshastiedupinworkingcapital,themoredifficultitistomakeasatisfactoryreturnoncapitalemployed,simplybecausethelargerthedenominator,thelowerthereturnoncapitalemployed.

Insomecasestherightdirectionismoreobvious.Ahighreturnoncapitalemployedisusuallybetterthanalowone,buteventhissituationcanbeadangersignal,warningthathigherrisksarebeingtaken.Andnotallhighprofitratiosaregood:sometimesahigherprofitmargincanleadtoreducedsalesvolumeandsoleadtoalowerReturnonCapitalEmployed(ROCE).

Ingeneral,businessperformanceasmeasuredbyratiosisbestthoughtofaslyingwithinarange;liquidity(currentratio),forexample,stayingbetween1.2:1and1.8:1.Achangeineitherdirectionmayrepresentacauseforconcern.

Thetemptationtocomputecashflowpershare:Don’tgivein!

Businessesareprohibitedfromreportingacashflowpersharenumberontheirfinancialreports.Theaccountingrulebookspecificallyprohibitsveryfewthings,andcashflowpershareisonthissmalllistofcontraband.Why?Because–andthisissomewhatspeculativeonourpart–thepowersthatbewereworriedthatthecashflownumberwouldusurpnetincomeasthemainmeasureforprofitperformance.Indeed,manywritersinthefinancialpressweretalkinguptheimportanceofcashflowfromprofit,soweseetheconcernonthismatter.KnowinghowimportantEPSisformarketvalueofstocks,theauthoritiesdeclaredasimilarpershareamountforcashflowoutofboundsandprohibiteditfrombeingincludedinafinancialreport.Ofcourse,youcouldcomputeitquiteeasily–theruledoesn’tapplytohowfinancialstatementsare

interpreted,onlytohowtheyarereported.

Shouldwedaregiveyouanexampleofcashflowpershare?Heregoes:Abusinesswith£42millioncashflowfromprofitand4.2milliontotalcapitalstockshareswouldendupwith£10cashflowpershare.Shhh.

TheBiz/ed(www.bized.co.uk/compfact/ratios/index.htm)andHarvardBusinessSchool(http://harvardbusinessonline.hbsp.harvard.edu/b02/en/academic/edu_tk_acct_fin_ratio.jhtmlwebsitescontainfreetoolsthatcalculatefinancialratiosfromcompanyaccounts.Theyalsoprovideusefulintroductionstoratioanalysisanddefinitionsofeachratioandtheformulausedtocalculateit.Todownloadtheirspreadsheet,youfirstneedtoregisterwiththeHarvardwebsite.

Byregistering(forfree)withtheProsharewebsite(gotowww.proshareclubs.co.ukandclickon‘ResearchCentre’and‘PerformanceTables’),youhaveaccesstoanumberoftoolsthatcrunchpubliccompanyratiosforyou.Selectthecompaniesyouwanttolookat,andthentheratiosyou’remostinterestedin(EPS,P/E,ROI,DividendYieldandsoon).Allisrevealedwithinacoupleofseconds.Youcanthenrankthecompaniesbyperformanceinmoreorlessanywayyouwant.YoucanfindmorecomprehensivetoolsontheInternet,onthewebsitesofsharetradersforexample,butProshareisagreatsitetocutyourteethon–andthepriceisright!

FrolickingthroughtheFootnotes

FrolickingthroughtheFootnotesReadingthefootnotesinannualfinancialreportsisnopicnic.Theinvestmentproshavetoreadthembecauseinprovidingconsultationtotheirclients,theyarerequiredtocomplywithduediligencestandardsorbecauseoftheirlegaldutiesandresponsibilitiesofmanagingotherpeoples’money.

Wesuggestyoudoaquickread-throughofthefootnotesandidentifytheonesthatseemtohavethemostsignificance.Generally,themostimportantfootnotesarethosedealingwiththefollowingmatters:

Shareoptionsawardedbythebusinesstoitsexecutives:Theadditionalsharesissuedundershareoptionsdilute(thinout)theearningspershareofthebusiness,whichinturnputsdownsidepressureonthemarketvalueofitsshares,everythingelsebeingthesame.

Pendinglegalactions,litigationandinvestigationsbygovernmentagencies:Theseintrusionsintothenormalaffairsofthebusinesscanhaveenormousconsequences.

Segmentinformationforthebusiness:Mostpublicbusinesseshavetoreportinformationforthemajorsegmentsoftheorganisation–salesandoperatingprofitbyterritoriesorproductlines.Thisgivesabetterglimpseofthedifferentpartsmakingupthewholebusiness.(However,segmentinformationmaybereportedelsewhereinanannualfinancialreportthaninthefootnotes.)

Thesearejustthreeofthemanyimportantpiecesofinformationyoushouldlookforinfootnotes.Butyouhavetostayalertforothercriticalmattersthatabusinessmaydiscloseinitsfootnotes–scaneachandeveryfootnoteforpotentiallyimportantinformation.Findingafootnotethatdiscussesamajorlawsuitagainstthebusiness,forexample,maymakethesharestooriskyforyourportfolio.

CheckingforOminousSkiesontheAuditReport

Thevalueofanalysingafinancialreportdependsdirectlyandentirelyontheaccuracyofthereport’snumbers.Topmanagementwantstopresentthebestpossiblepictureofthebusinessinitsfinancialreport(whichisunderstandable,ofcourse).Themanagershaveavestedinterestintheprofitperformanceandfinancialconditionofthebusiness.

Independentauditorsarelikeumpiresinthefinancialreportingprocess.Theauditorcomesin,doesanauditofthebusiness’saccountingsystemandprocedures,andgivesareportthatisattachedtothecompany’sfinancialstatements.Youshouldchecktheauditreportincludedwiththefinancialreport.Publiclyownedbusinessesarerequiredtohavetheirannualfinancialreportsauditedbyanindependentaccountancyfirm,andmanyprivatelyownedbusinesseshaveauditsdone,too,becausetheyknowthatanauditreportaddscredibilitytothefinancialreport.

Whatifaprivatebusiness’sfinancialreportdoesn’tincludeanauditreport?Well,youhavetotrustthatthebusinesspreparedaccuratefinancialstatementsthatfollowgenerallyacceptedaccountingprinciplesandthatthefootnotestothefinancialstatementsprovideadequatedisclosure.

Unfortunately,theauditreportgetsshortshriftinfinancialstatementanalysis,maybebecauseit’ssofulloftechnicalterminologyandaccountantdoublespeak.Buteventhoughauditreportsareatoughread,anyonewhoreadsandanalysesfinancialreportsshoulddefinitelyreadtheauditreport.Chapter15providesalotmoreinformationonauditsandtheauditor’sreport.

Theauditorjudgeswhetherthebusinessusedaccountingmethodsandproceduresinaccordancewithacceptedaccountingprinciples.Inmostcases,theauditor’sreportconfirmsthateverythingishunky-dory,andyoucanrelyonthefinancialreport.However,sometimesanauditorwavesayellowflag–andinextremecases,aredflag.Herearethetwomostimportantwarningstowatchoutforinanauditreport:

Thebusiness’scapabilitytocontinuenormaloperationsisindoubtbecauseofwhatareknownasfinancialexigencies,whichmaymeanalowcashbalance,unpaidoverdueliabilitiesormajorlawsuitsthatthebusinessdoesn’thavethecashtocover.

Oneormoreofthemethodsusedinthereportisnotinlinewiththeprevailingaccountingbodyrules,leadingtheauditortoconcludethatthenumbersreportedaremisleadingorthatdisclosureisinadequate.

Althoughauditorwarningsdon’tnecessarilymeanthatabusinessisgoingdownthetubes,theyshouldturnonthatlightbulbinyourheadandmakeyoumorecautiousandscepticalaboutthefinancialreport.Theauditorisquestioningtheveryinformationonwhichthebusiness’svalueisbased,andyoucan’ttakethatkindofthinglightly.

Inverysmallbusinessesitislikelythattheaccountswillnotbeindependentlyauditedandtheiraccountscomewitharatheralarmingcaveat,runningsomethinglikethis:Theseaccountshavebeenpreparedonthebasisofinformationprovidedbytheownersandhavenotbeenindependentlyverified.Afullauditisanexpensiveprocessandfewbusinessesthatdon’thavetowillgototheexpenseandtroublejusttobetoldwhattheyprobablyalreadyknowanyway.

Justbecauseabusinesshasacleanauditreportdoesn’tmeanthatthefinancialreportiscompletelyaccurateandaboveboard.AsdiscussedinChapter15,auditorsdon’tnecessarilycatcheverything.Keepinmindthattheaccountingrulesareprettyflexible,leavingacompany’saccountantswithroomforinterpretationandcreativitythat’sjustshortofcookingthebooks(deliberatelydefraudingandmisleadingreadersofthefinancialreport).Windowdressingandprofitsmoothing–twocommonexamplesofmassagingthenumbers–areexplainedinChapter8.

FindingFinancialFactsUnderstandinghowtocalculatefinancialratiosandhowtointerpretthatdataisallfineanddandy,butbeforeyoucandoanythingusefulyouneedtogetacopyoftheaccountsinthefirstplace.Seeingtheaccountsforyourownbusinessshouldn’tbetoomuchofaproblem.Ifyou’retheboss,theaccountsshouldbeonyourdeskrightnow;ifyou’renottheboss,trysnugglinguptotheaccountsdepartment.Ifthey’retoocoytoletyouhavetoday’sfigures,thelatestauditedaccountsareinthepublicdomainanywayfiledawayatCompaniesHouse(www.companieshouse.gov.uk),asrequiredbylaw.

PubliccompanyaccountsMostcompaniesmaketheirglossyannualfinancialreportsavailabletodownloadfromtheirwebsites,whichyoucanfindbytypingthecompanynameintoanInternetsearchengine.YouneedtohaveAdobeAcrobatReaderonyourcomputertoopenthefiles.Noproblem,though:AdobeAcrobatReaderisfreeandyoucaneasily

downloadtheprogramfromAdobe’swebsite(http://adobe-reader.download-start.net/download).Thesoftwareenablesyoutosearchforkeywordsintheannualreport–ahandyfeatureindeedfortrackingdownthesectionsofthereportthatyou’remostinterestedin.

Yahoohasdirectonlinelinkstoseveralthousandpubliccompanyreportsandaccountsandperformanceratiosathttp://uk.finance.yahoo.com(enterthenameofthecompanyyou’relookingforintheboxontheleftofthescreenunderInvesting.Itappearsafteryou’veenteredaboutthreeletters,clickandfollowthethreads).Payingthissiteavisitsavesyouthetimeandtroubleofhuntingdowncompanywebsites.

PrivatecompanyaccountsFindingfinancialinformationonprivatecompaniesisoftenatime-consumingandfrustratingjob.Notfornothingdothesecompaniescallthemselves‘private’.Businesses,andparticularlysmallerbusinesses,canbeverysecretiveabouttheirfinancesandhaveplentyoftrickstohideinformationfrompryingeyes.ManysmallerbusinessescanelecttofileabbreviatedaccountswithCompaniesHousethatprovideonlythebarestdetails.YoucanfindoutjustwhattheseshortenedaccountsmustcontainattheBusinessLinkwebsite(gotowww.businesslink.gov.ukandclickon‘Taxes,returns,&payroll’,‘Introductiontobusinesstaxes’and‘Accountingandauditexceptionsforsmallcompanies’).Theaccountsofverysmallcompaniesdon’tneedtobeaudited,sotheobjectivereliabilityofthescantdatagivenmaybequestionable.Havingsaidthat,tensofthousandsofprivatecompaniesfilefullandgenerallyreliableaccounts.

Twofruitfulsourcesofprivatecompanyaccountsexist:

CompaniesHouse(www.companieshouse.gov.uk)istheofficialrepositoryofallcompanyinformationintheUK.TheirWebCHeckserviceoffersafreeCompanyNamesandAddressIndexthatcovers2millioncompanies,searchableeitherbycompanynameorbycompanyregistrationnumbers.YoucanuseWebCHecktopurchase(atacostof£1percompany)acompany’slatestaccountsthatgivedetailsofsales,profits,margins,directors,shareholdersandbankborrowings.

Keynote(www.keynote.co.uk)offersbusinessratiosandtrendsfor140industrysectorsandprovidesinformationtoassessaccuratelythefinancialhealthofeachindustrysector.Thisserviceenablesyoutofindouthowprofitableabusinesssectorisandhowsuccessfulthemaincompaniesoperatingineachsectorare.Executivesummariesarefree,butexpecttopaybetween£250and£500formostreports.

ScoringcreditIfallyouwantisaquickhandleonwhetheracompanyislikelytobearoundlongenoughtopayitsbills,includingadividendtoshareholders,thenawholeheapofinformationexistsaboutcreditstatusforbothindividualsoletradersandcompaniesofvaryingcomplexity.Expecttopayanywherefrom£5forbasicinformationupto£200foraverycomprehensivepictureofacompany’screditstatus.Soyoucanavoidtradingunknowinglywithindividualsorbusinessesthatposeacreditrisk.

Experian(www.ukexperian.com),Dun&Bradstreet(www.dnb.com),Creditgate.com(www.creditgate.com)andCreditReporting(www.creditreporting.co.uk/b2b)arethemajoragenciescompilingandsellingcredithistoriesandsmall-businessinformation.Betweenthemtheyofferacomprehensiverangeofcreditreportsinstantlyavailableonlinethatincludeadviceaboutcreditlimits.

UsingFAME(FinancialAnalysisMadeEasy)FAME(FinancialAnalysisMadeEasy)isapowerfuldatabasethatcontainsinformationon7millioncompaniesintheUKandIreland.Typically,thefollowinginformationisincluded:contactinformationincludingphone,emailandwebaddressesplusmainandothertradingaddresses;activitydetails;29profitandlossaccountand63balancesheetitems;cashflowandratios;creditscoreandrating;securityandpriceinformation(listedcompaniesonly);namesofbankers,auditors,previousauditorsandadvisors;detailsofholdingsandsubsidiaries(includingforeignholdingsandsubsidiaries);namesofcurrentandpreviousdirectorswithhomeaddressesandshareholderindicator;headsofdepartment;andshareholders.Youcancompareeachcompanywithdetailedfinancialswithitspeergroupbasedonitsactivitycodesandthesoftwareletsyousearchforcompaniesthatcomplywithyourowncriteria,combiningasmanyconditionsasyoulike.FAMEisavailableinbusinesslibrariesandonCDfromthepublishers,whoalsoofferafreetrial(www.bvdinfo.com/Products/Company-Information/National/FAME.aspx).

LookingbeyondfinancialstatementsInvestorscan’trelysolelyonthefinancialreportwhenmakinginvestment

Investorscan’trelysolelyonthefinancialreportwhenmakinginvestmentdecisions.Analysingabusiness’sfinancialstatementsisjustonepartoftheprocess.Youmayneedtoconsidertheseadditionalfactors,dependingonthebusinessyou’rethinkingaboutinvestingin:

Industrytrendsandproblems.

Nationaleconomicandpoliticaldevelopments.

Possiblemergers,friendlyacquisitionsandhostiletakeovers.

Turnoverofkeyexecutives.

Internationalmarketsandcurrencyexchangeratios.

Supplyshortages.

Productsurpluses.

Whew!Thiskindofstuffgoeswaybeyondaccounting,obviously,andisjustassignificantasfinancialstatementanalysiswhenyou’repickingstocksandmanaginginvestmentportfolios.AgoodbookfornewinvestorstoreadisInvestingForDummiesbyTonyLevene.

Chapter16

TenWaysSavvyBusinessManagersUseAccounting

InThisChapterMakingbetterprofitdecisions

Leveraging–boththeoperatingkindandthefinancialkind

Puttingyourfingeronthepulseofcashflow

Betterbudgetingforplanningandcontrol

Developingfinancialcontrols

Takingchargeoftheaccountingfunction

Explainingyourfinancialstatementstoothers

Sohowcanaccountinghelpmakeyouabetterbusinessmanager?Thisisthebottom-linequestion.Speakingofthebottomline,that’sexactlytheplacetostart.Accountingprovidesthefinancialinformationandanalysistoolsyouneedformakinginsightfulprofitdecisions–andstopsyoufromplungingaheadwithgutdecisionsthatmayfeelrightbutthatdon’tholdwaterafterdiligentanalysis.

MakeBetterProfitDecisionsMakingprofitstartswithearningmarginoneachunitsoldandthensellingenoughunitstoovercomeyourtotalfixedexpensesfortheperiod(thebasicconceptthatweexplainmorefullyinChapter9).Wecondensetheaccountingmodelofprofitintothefollowingequation:

equation:

(Marginperunit´salesvolume)–fixedexpenses=profit

Note:Profithereisbeforecorporationtax.Regularcorporationspaytaxbasedontheamountoftheirtaxableincome;differentratesapplytodifferentbracketsoftaxableincome.Thebottom-linenetincomeintheprofitandlossaccountofabusinessisafter-taxincome.Abusinessmaydistributeall,partornoneofitsprofitfortheyeartoitsowners.

Insistthatyouraccountantdeterminesthemarginperunitforallproductsyousell.Themarginisalsocalledthecontributionmargintoemphasisethatitcontributestowardthebusiness’sfixedexpenses.Here’sanexamplefordeterminingthemarginperunitforaproduct:

We’dbetthatyouraccountantprovidesthegrossmargin(alsocalledgrossprofit)onyourproducts.Sofar,sogood.Butdon’tstopatthegrossmarginline.Pushyouraccountanttodeterminethetwo

variableexpensesforeachproduct.Inthisexample,youdon’tmake£40perunitsold;youmakeonly£27fromsellingtheproduct.Twoproductsmayhavethesame£40grossprofit,butonecouldprovidea£27marginandtheothera£32marginbecausethesecondone’svariableexpensesarelower.

Haveyouraccountantdifferentiatebetweenrevenue-drivenandvolume-drivenvariableexpensesforeachproduct.Supposeyouraisethesalespriceto£110.00,a10percentincrease.Thesalesrevenue-drivenexpenseincreasesby10percentaswell,to£8.80,becausetheseexpenses(suchassalescommission)areacertainpercentageofthesalesprice.Yourmarginincreasesnot£10.00,butonly£9.20(the£10.00salespriceincreaseminusthe£0.80expenseincrease).Incontrast,thehighersalespricebyitselfdoesnotincreasethesalesvolume-drivenexpenses(suchasshippingcosts);theseexpensesremainat£5.00perunitunlessotherfactorscausethemtoincrease.

Youearnprofit(ortobeprecise,profitbeforetax)bysellingenoughproductsthatyourtotalmarginishigherthanyourtotalfixedexpensesfortheperiod.Theexcessoftotalmarginoverfixedexpensesisprofitbeforetax.Settingsalespricestogenerateanadequatetotalcontributionmarginisoneofthemostimportantfunctionsofmanagers.

Whenthinkingaboutchangingsalesprice,focusonwhathappenstothemarginperunit.Suppose,forexample,thatyou’reconsideringdroppingthesalesprice10percentfrom£100.00to£90.00.Youpredictthatyourproductcostandvariableexpenseswillremainunchanged.Here’swhatwouldhappentoyourmargin:

Yourmarginwouldplunge£9.20perunit–morethanone-third!

Supposeyousold100,000unitsofthisproductduringtheyearjustended.Thesesalesgenerated£2.7milliontotalmargin.Ifyoudropthesalesprice,yougiveup£920,000totalmargin.Wherewillthereplacementcomefromforthis£920,000contributionmargin?Highersalesvolume?Salesvolumewouldhavetoincreasemorethan50percenttooffsetthedrasticdropinthecontributionmarginperunit.You’dbetterhaveagoodanswer.Theprofitmodeldirectsattentiontothiscriticalquestionandgivesyoutheamountofmarginsacrificedbydroppingthesalesprice.

UnderstandThataSmallSalesVolumeChangeHasaBigEffectonProfit

Isthatbigpushbeforeyear-endforjust5percentmoresalesvolumereallythatimportant?Youunderstandthatmoresalesmeanmoreprofit,ofcourse.Butwhat’sthebigdeal?A5percentincreaseinsalesvolumemeansjust5percentmoreprofit,doesn’tit?Ohno.Ifyouthinkso,youneedtoread

Chapter9.Becausefixedexpensesarejustthat–fixedandunchangingovertheshortrun.Seeminglysmallchangesinsalesvolumecauselargeswingsinprofit.Thiseffectiscalledoperatingleverage.

Thefollowingexampleillustratesoperatingleverage.Supposeyour£12.5millionannualfixedexpensesprovidethepersonnelandphysicalresourcestosell625,000unitsovertheyear.However,youdidn’thitcapacity;yourcompany’sactualsalesvolumewas500,000unitsfortheyear,or80percentofsalescapacity–whichisn’tbad.Youraveragemarginacrossallproductsis£30perunit.Usingthebasicprofitequation,youdetermineprofitbeforeincometaxasfollows:

Now,whatifyouhadsold25,000moreunits,whichisjust5percentmoresalesvolume?Yourfixedexpenseswouldhavebeenthesamebecausesalesvolumewouldstillbewellbelowthesalescapacityprovidedbyyourfixedexpenses.Therefore,theprofitincreasewouldhavebeenthe£30marginperunittimesthe25,000additionalunitssold,or£750,000.Thisisa5percentgainincontributionmargin.Butcomparedtothe£2,500,000pre-taxprofit,theadditional£750,000isa30percentgain–fromonlya5percentsalesvolumegain,whichisa6-to-1payoff!

Operatingleveragereferstothewiderswinginprofitratherthanthesmallerswinginsalesvolume.Inthisexample,a5percentincreaseinsalesvolumewouldcausea30percent

increaseinprofit.Unfortunately,operatingleveragecutsbothways.Ifyoursalesvolumehadbeen5percentless,yourprofitwouldhavebeen£750,000less,whichwouldhaveresultedin30percentlessprofit.

Here’saquickexplanationofoperatingleverage.Inthisexample,totalcontributionmarginis6timesprofit:£15millioncontributionmargin÷£2.5millionprofit=6.Soa5percentswingincontributionmarginhasa6-timeseffect,ora30percentimpactonprofit.Supposeabusinesshadnofixedexpenses(highlyunlikely).Inthisoddsituation,thereisnooperatingleverage.Thepercentagegainorlossinprofitwouldequalthepercentagegainorlossinsalesvolume.

Thefundamentallessonofoperatingleverageistomakethebestuseyoucanofyourfixedexpenses–thatis,takeadvantageofthecapacityprovidedbytheresourcespurchasedwithyourfixedexpenses.Ifyoursalesvolumeislessthanyoursalescapacity,theunsoldquantitywouldhaveprovidedalotmoreprofit.Mostbusinessesaresatisfiediftheiractualsalesvolumeis80–90percentoftheirsalescapacity.Butkeepinmindonething:Thatlast10or20percentofsalesvolumewouldmakeadramaticdifferenceinprofit!

FathomProfitandCashFlowfromProfit

Profitequalssalesrevenueminusexpenses–youdon’tneedtoknowmuchaboutaccountingtounderstandthisdefinition.However,businessmanagersshoulddigalittledeeper.First,youshouldbeawareoftheaccountingproblemsinmeasuringsalesrevenueandexpenses.Becauseoftheseproblems,profitisnota

revenueandexpenses.Becauseoftheseproblems,profitisnotaclear-cutandprecisenumber.Second,youshouldknowtherealstuffofprofitandknowwheretofindprofitinyourfinancialstatements.

Profitisnotapoliticallycorrectterm.Instead,businessfinancialreportscallprofitnetincomeornetearnings.Sodon’tlookforthetermprofitinexternalfinancialstatements.Remember,netincome(ornetearnings)=bottom-lineprofitaftertax.

ProfitaccountingmethodsarelikehemlinesProfitisnotahard-and-fastnumberbutisrathersoftandflexibleontheedges.Forexample,profitdependsonwhichaccountingmethodisselectedtomeasurethecost-of-goods-soldexpense,whichisusuallythelargestexpenseforbusinessesthatsellproducts.Therulesofthegame,calledgenerallyacceptedaccountingprinciples(orGAAPforshort),permittwoorthreealternativemethodsformeasuringcostofgoodssoldandforotherexpensesaswell.(Chapter13discussesaccountingmethods.)

Whenevaluatingtheprofitperformanceofyourownbusinessorwhensizingupthenetincomerecordofabusinessyou’reconsideringbuying,lookcarefullyatwhetherprofitmeasurementisbasedonstingy(conservative)orgenerous(liberal)accountingmethods.YoucanassumethatprofitisintheGAAPballpark,butyouhavetodeterminewhetherprofitisintherightfieldortheleftfield(orperhapsincentrefield).Businessesarenotrequiredtodisclosehowdifferenttheprofitnumberwouldhavebeenfortheperiodifdifferentaccountingmethodshadbeenused,buttheydohavetorevealtheirmajoraccountingmethodsinthefootnotestotheirannualfinancialstatements.

Therealstuffofprofit

Mostpeopleknowthat,inthegeneralsenseoftheword,profitisagain,oranincreaseinwealth,orhowmuchbetteroffyouare.Butmanagersandinvestorshitthewallwhenaskedtoidentifytherealstuffofprofitearnedbyabusiness.Tomakeourpoint,supposethatyourbusiness’slatestannualprofitandlossaccountreports£10millionsalesrevenueand£9.4millionexpenses,whichyields£600,000bottom-linenetincome.Yourprofitratiois6percentofsalesrevenue,whichisabouttypicalformanybusinesses.Butwedigress.

Ourquestionisthis:Whereisthat£600,000ofprofit?Canyoufindandlocatetheprofitearnedbyyourbusiness?Isitincash?Ifnot,whereisit?Ifyoucan’tanswerthisquestion,aren’tyoualittleembarrassed?Quick–goandreadChapter5!

Profitaccountingismorecomplicatedthansimplecash-in,cash-outbookkeeping.Salesforcashincreasecash,ofcourse,butsalesoncreditinitiallyincreaseanassetcalleddebtors.Sotwoassetsareusedinrecordingsalesrevenue.Usually,aminimumoffourassetsandtwoliabilitiesareusedinrecordingabusiness’sexpenses.Tolocateprofit,youhavetolookatalltheassetsandliabilitiesthatarechangedbyrevenueandexpenses.Themeasureofprofitisfoundintheprofitandlossaccount.Butthesubstanceofprofitisfoundinassetsandliabilities,whicharereportedinthebalancesheet.

Youraccountantwillhavedeterminedthatyour£600,000netincomeconsistsofthefollowingthreecomponents:

£600,000profit=£420,000cash+£290,000netincreaseinotherassets–£110,000increaseinliabilities

Thisisatypicalscenarioforthemakeupofprofit–wedon’tmeanthepoundamountsbutratherthethreecomponentsofprofit.The

thepoundamountsbutratherthethreecomponentsofprofit.Thepoundamountsoftheincreasesordecreasesinassetsandliabilitiesvaryfrombusinesstobusiness,ofcourse,andfromyeartoyear.Butrarelywouldtheprofitequationbe

£600,000profit=£600,000cash

Cashisonlyonepieceoftheprofitpie.Businessmanagersneedaccountingtosortouthowprofitisdividedamongthethreecomponents–inparticular,youneedtoknowthecashflowgeneratedfromprofit.

GovernCashFlowBetterAbusinesswantstomakeprofit,ofcourse,butequallyimportant,abusinessmustconvertitsprofitintousablecashflow.Profitthatisneverturnedintocashorisnotturnedintocashforalongtimeisnotveryhelpful.Abusinessneedscashflowfromprofittoprovidemoneyforthreecriticaluses:

Todistributesomeofitsprofittoitsequity(owner)sourcesofcapital–toprovideacashincometothemascompensationfortheircapitalinvestmentinthebusiness.

Togrowthebusiness–toinvestinnewfixed(long-term)operatingassetsandtoincreaseitsstockandothershort-termoperatingassets.

Tomeetitsdebtpaymentobligationsandtomaintainthegeneralliquidityandsolvencyofthebusiness.

Oneexpense,depreciation,isnotacashoutlayintheperiodit’srecordedasanexpense.Rather,depreciation

expenseforaperiodisanallocatedamountoftheoriginalcostofthebusiness’sfixedassetsthatwereboughtandpaidforinpreviousyears.Moreimportantly,thesalesrevenuecollectedbythebusinessincludesmoneyforitsdepreciationexpense.Thusthebusinessconvertsbackintocashsomeofthemoneythatitputinitsfixedassetsyearsago.Understandinghowdepreciationworksincashflowanalysisisveryimportant.

Inonesense,youcansaythatdepreciationgeneratescashflow.Butpleasebecarefulhere.Thisdoesnotmeanthatifyouhadrecordedmoredepreciationexpense,youwouldhavehadmorecashflow.Whatitmeansisthatthroughmakingsalesatpricesthatincluderecoveryofsomeofthecostoffixedassets,yoursalesrevenue(totheextentthatitiscollectedbyyear-end)includescashflowtooffsetthedepreciationexpense.

Toillustratethiscriticalpoint,supposeabusinessdidnotmakeaprofitfortheyearbutdidmanagetobreakeven.Inthiszero-profitsituation,thereiscashflowfromprofitbecauseofdepreciation.Thecompanywouldrealisecashflowequaltoitsdepreciationfortheyear–assumingthatitcollecteditssalesrevenue.Depreciationisaprocessofrecyclingfixedassetsbackintocashduringtheyear,whetherornotthebusinessmakesaprofit.

Intheexampleintheprecedingsection,thebusinessearned£600,000netincome(profit).Butitscashincreasedonly£420,000.Why?Thecashflowstatementprovidesthedetails.Inadditiontoreportingthedepreciationfortheyear,thefirstsectionofthecashflowstatementreportstheshort-termoperatingassetandliabilitychangescausedbythebusiness’ssalesandexpenses.Thesechangeseitherhelporhurtcashflowfromprofit(fromoperatingactivities,tousethecorrecttechnicalaccountingterm).

Anincreaseindebtorshurtscashflowfromprofitbecausethebusinessdidnotcollectallitssalesoncreditfortheyear.Anincreaseinstockhurtscashflowfromprofitbecausethebusinessreplacestheproductssoldandspendsmoremoneytoincreaseitsstockofproducts.Ontheotherhand,anincreaseincreditorsoraccruedexpensespayablehelpscashflowfromprofit.Thesetwo

accruedexpensespayablehelpscashflowfromprofit.Thesetwoliabilitiesare,basically,unpaidexpenses.Whentheseliabilitiesincrease,thebusinessdidnotpayallitsexpensesfortheyear–anditscashoutflowsforexpenseswerelessthanitsexpenses.

Generallyspeaking,growthhurtscashflowfromprofit.Togrowitssalesandprofit,abusinessusuallyhastoincreaseitsdebtorsandstock.Someofthistotalincreaseisoffsetbyincreasesinthebusiness’sshort-termoperatingliabilities.Usually,theincreaseinassetsismorethantheincreaseinliabilities,particularlywhengrowthisfasterthanusual,andthereforecashflowfromprofitsuffers.Whenabusinesssuffersadeclineinsalesrevenue,itsbottom-lineprofitusuallygoesdown–butitscashflowfromprofitmaynotdropasmuchasnetprofit,orperhapsnotatall.Abusinessshoulddecreaseitsdebtorsandstockatthelowersaleslevel;thesedecreaseshelpcashflowfromprofit.Evenifabusinessreportedalossfortheyear,itscashflowfromprofitcouldbepositivebecauseofthedepreciationfactorandbecausethebusinessmayhavereduceditsdebtorsandstock.

CalltheShotsonYourManagementAccountingMethods

Businessmanagerstoooftendefertotheiraccountantsinchoosingaccountingmethodsformeasuringsalesrevenueandexpenses.Youshouldgetinvolvedinmakingthesedecisions.Thebestaccountingmethodistheonethatbestfitstheoperatingmethodsandstrategiesofyourbusiness.Asabusinessmanager,youknowtheseoperatingmethodsandstrategiesbetterthanyouraccountant.Chapter13givesyouthedetailsonvariousaccountingmethods.

Forexample,considersalesprices.Howdoyousetyoursalesprices?Manyfactorsaffectyoursalesprices,ofcourse.Whatwe’reaskinghereconcernsyourgeneralsalespricingpolicyrelativetoproductcostchanges.Forexample,ifyourproductcostgoesup,doyouallowyour‘old’stockoftheseproductstoselloutbeforeyouraisethesalesprice?Inotherwords,doyougenerallywaituntilyoustartsellingthemorerecentlyacquired,higher-costproductsbeforeyouraiseyoursalesprice?Ifso,you’reusingthefirst-in,first-out(FIFO)method.Youmightprefertokeepyourcost-of-goods-soldexpensemethodconsistentwithyoursalespricingmethod.Buttheaccountantmaychoosethelast-in,first-out(LIFO)expensemethod,whichwouldmismatchthehigher-costproductswiththelower-sales-priceproducts.

Thepointisthis:Businessmanagersformulateabasicstrategyregardingexpenserecovery.Salesrevenuehastorecoupyourexpensestomakeaprofit.Howdoyoupassalongyourexpensestoyourcustomersinthesalespricesyouchargethem?Doyouattempttorecoverthecostofyourfixedassetsasquicklyaspossibleandsetyoursalespricesonthisbasis?Thenyoushoulduseafast,oraccelerated,depreciationmethod.Ontheotherhand,ifyoutakelongertorecoverthecostofyourfixedassetsthroughsalesrevenue,thenyoushouldprobablyusethelonger-lifestraight-linedepreciationmethod.

Inshort,weencourageyoutotakechargeandchoosetheaccountingmethodsthatbestfityourstrategicprofitplan.Youneedtospeaksomeoftheaccountinglanguageandknowwhichaccountingmethodsareavailable.Inshort,businessmanagersshouldtakechargeoftheaccountingfunctionjustliketheytakechargeofmarketingandotherkeyfunctionsofthebusiness.

Thisappliesonlytomanagementaccounting.Youraccountantsandauditorswillcalltheshotswhenpreparingaccountsfortheoutsideworld.

BuildBetterBudgetsBudgeting(explainedinChapter10)providesimportantadvantages–first,forunderstandingtheprofitdynamicsandfinancialstructureofyourbusiness,andsecond,forplanningforchangesinthecomingperiod.Budgetingforcesyoutofocusonthefactorsthathavetoimproveinordertoincreaseprofitandhelpsyouprepareforthefuture.Thebasicprofitmodelprovidestheframeworkfortheprofitbudget.Agoodprofitmodelistheessentialstartingpointforbudgeting.Todevelopyourprofitplanforthecomingyear,focusonthefollowing:

Margins

Salesvolume

Fixedexpenses

Theprofitbudget,inturn,laysthefoundationforchangesinyouroperatingassetsandliabilitiesthataredrivenbysalesrevenueandexpenses.Supposeyouprojecta10percentriseinsalesrevenue.Howmuchwillyourdebtorsassetincrease?Supposeyoursalesvolumetargetfornextyearis15percenthigherthanthisyear.Howmuchwillyourstockincrease?Thebudgetedchangesinsalesrevenueandexpensesfornextyearleaddirectlytothebudgetedchangesinoperatingassetsandoperatingliabilities.Thesechanges,inturn,directattentiontotwootherkeyissues.

First,ifthingsgoaccordingtoplan,howmuchcashflowfromprofitwillbegenerated?Second,willyouneedmorecapital,andwhere

willbegenerated?Second,willyouneedmorecapital,andwherewillyougetthismoney?Youneedthebudgetedcashflowfromprofit(operatingactivities)forthecomingyearforthreebasicfinancialplanningdecisions:

Cashdistributionsfromprofittoowners(cashdividendstoshareholdersofcompaniesandcashdistributionstopartners).

Capitalexpenditures(purchasesofnewfixedassetstoreplaceandupgradeoldfixedassetsandtoexpandthebusiness’scapacity).

Raisingcapitalfromborrowingondebtand,possibly,raisingnewequitycapitalfromowners.

Thehigheryourbudgetedcashflowfromprofit,themoreflexibilityyouhaveinhavingmoneyavailableforcashdistributionsfromprofitandforcapitalexpendituresandthelesspressuretogooutandraisenewcapitalfromdebtandequitysourcesofcapital.

Tosumup,yourprofitbudgetisdovetailedwiththeassetsandliabilitiesbudgetandthecashflowbudget.Youraccountanttakesyourprofitbudget(yourstrategicplanforimprovingprofit)andbuildsthebudgetedbalancesheetandthebudgetedcashflowstatement.Thisinformationisessentialforgoodplanning–focusinginparticularonhowmuchcashflowfromprofitwillberealisedandhowmuchcapitalexpenditureswillberequired,whichinturnleadtohowmuchadditionalcapitalyouhavetoraiseandhowmuchcashdistributionfromprofityouwillbeabletomake.

OptimiseCapitalStructureand

FinancialLeverageOurfriendRon,aflorist,madethispointonenight:‘Tomakeprofit,youmustmakesales.’Wequicklyaddedthatyoualsomustinvestinoperatingassets,whichmeansthatyoumustraisecapital.Wheredoyougetthismoney?Debtandequityarethetwobasicsources.Equityreferstothemoneythatownersinvestinabusinesswiththehopesthatthebusinesswillturnaprofit.Profitbuildsthevalueofowners’equity;profitfundamentallyisanincreaseinassetsthataccruestothebenefitoftheowners.Chapter11discussesownershipstructures;Chapter6coversdebtandequity.

Thereturnontheowners’equityinterestinthebusinessconsistsoftwoquitedistinctparts:

Cashdistributionsfromprofittotheowners.

Increasesinthevalueoftheirownershipinterestinthebusiness.

Incontrast,lendersarepaidafixedrateofinterestontheamountborrowed.Thisfixednatureofinterestexpensecausesafinancialleverageorgearingeffectthateitherbenefitsorhurtstheamountofprofitremainingfortheequityinvestorsinthebusiness.

Financialleveragerefersingeneraltousingdebtinadditiontoequitycapital.Afinancialleveragegain(orloss)referstothedifferencebetweentheearningsbeforeinterestandtax(EBIT)thatabusinesscanmakeonitsdebtcapitalversustheinterestpaidonthedebt.Thefollowingexampleillustratesacaseoffinancialleveragegain.

Yourbusinessearned£2.1millionEBITfortheyearjustended.Yournetoperatingassetsare£12million–recallthat

netoperatingassetsequaltotalassetslessnon-interest-bearingoperatingliabilities(mainlycreditorsandaccruedexpensespayable).Thusyourtotalcapitalsourcesequal£12million.Supposeyouhave£4milliondebt.Theother£8millionisowners’equity.Youpaid8percentannualinterestonyourdebt,or£320,000totalinterest.Debtfurnishesone-thirdofyourcapital,soone-thirdofEBITisattributedtothiscapitalsource.One-thirdofEBITis£700,000.Butyoupaidonly£320,000interestforthiscapital.Youearned£380,000morethantheinterest.Thisistheamountofyourpre-taxfinancialleveragegain.

Threefactorsdeterminefinancialleveragegain(orloss):

Proportionoftotalcapitalprovidedfromdebt.

Interestrate.

Returnonassets(ROA),ortherateofEBITthebusinesscanearnonitstotalcapitalinvestedinitsnetoperatingassets.

Intheexample,yourbusinessearned17.5percentonitsnetoperatingassets(£2.1millionEBIT÷£12milliontotalnetoperatingassets).Youused£4milliondebtcapitalfortheinvestmentinyournetoperatingassets,andyoupaid8percentannualinterestonthedebt,whichgivesafavourable9.5percentspread(17.5percent–8percent).The9.5percentfavourablespreadtimes£4milliondebtequalsthe£380,000leveragegainfortheyear(beforetax).

Businessmanagersshouldwatchhowmuchfinancialleveragegaincontributestotheearningsforownerseachyear.Inthisexample,theafter-interestearningsforownersis£1,780,000(equaltoEBITlessinterestexpense).The£380,000financialleveragegainprovidedagoodpartofthisamount.Nextyear,oneormoreofthethreefactorsdrivingthefinancialleveragegainmaychange.Savvybusinessmanagerssortouteachyearhowmuchfinancialleverageimpactstheearningsavailableforowners.CheckoutChapter14formoreonleverage,orgearingasitisalsoknown.

Afinancialleveragegainenhancestheearningsonowners’equitycapital.Theconventionalwisdomisthatabusinessshouldtakeadvantageofdebtthatchargesalowerinterestratethanitcanearnonthedebtcapital.Lookingatthebiggerpicture,however,thelong-runsuccessofabusinessdependsmainlyonmaintainingandimprovingthefactorsthatdetermineitsprofitfromoperations(EBIT)–ratherthangoingoverboardanddependingtoomuchonfinancialleverage.

DevelopBetterFinancialControlsExperiencedbusinessmanagerscantellyouthattheyspendagooddealoftimedealingwithproblems.Thingsdon’talwaysgoaccordingtoplan.Murphy’sLaw(ifsomethingcangowrong,itwill,andusuallyattheworstpossibletime)isalltootrue.Tosolveaproblem,youfirsthavetoknowthatyouhaveone.Youcan’tsolveaproblemifyoudon’tknowaboutit.Managersareproblemsolvers;theyneedtogetontopofproblemsassoonaspossible.Inshort,businessmanagersneedtodevelopgoodfinancialcontrols.

Financialcontrolsactliketripwiresthatsoundalarmsandwaveredflagsforamanager’sattention.Manyfinancialcontrolsareaccounting-based.Forexample,actualcostsarecomparedwithbudgetedcostsoragainstlastperiod’scosts;seriousvariancesarehighlightedforimmediatemanagementattention.Actualsalesrevenueforproductlinesandterritoriesarecomparedwithbudgetedgoalsorlastperiod’snumbers.Cashflowfromprofitperiodbyperiodiscomparedwiththebudgetedamountofcashflowfortheperiodfromthissource.Thesemanydifferentfinancialcontrolsdon’tjusthappen.Youshouldidentifythehandfulofcriticalfactorsthatyouneedtokeepacloseeyeonandinsistthatyourinternalaccountingreportshighlighttheseoperatingratiosandnumbers.

andnumbers.

Youmustcloselywatchthemarginsonyourproducts.Anydeviationfromthenorm–evenarelativelysmalldeviation–needsyourattentionimmediately.Rememberthatthemarginperunitismultipliedbysalesvolume.Ifyousell100,000unitsofaproduct,aslippageofjust50pencecausesyourtotalmargintofall£50,000.Ofcourse,salesvolumemustbecloselywatched,too;thatgoeswithoutsaying.Fixedexpensesshouldbewatchedintheearlymonthsoftheyeartoseewhetherthesecostsaredevelopingaccordingtoplan–andthroughtheentireyear.

Debtors’collectionsshouldbemonitoredclosely.Averagedaysbeforecollectionisagoodcontrolratiotokeepyoureyeon,andyoushoulddefinitelygetalistingofpast-duecustomers’accounts.Stockisalwaysaproblemarea.Watchcloselytheaveragedaysinstockbeforeproductsaresold,andgetalistingofslow-movingproducts.Experienceisthebestteacher.Overtimeyoulearnwhichfinancialcontrolsarethemostimportanttohighlightinyourinternalaccountingreports.Thetrickistomakesurethatyouraccountantsprovidethisinformation.

MinimiseTaxThefirstdecisionregardingtaxconcernswhichtypeoflegalownershipstructuretouseforcarryingontheactivitiesofthebusiness,whichisdiscussedinChapter11.Whentwoormoreownersprovidecapitalforthebusiness,youhavetwobasicchoices:

Apartnership–aspecificcontractualagreementamongtheownersregardingdivisionofmanagementauthority,responsibilitiesandprofit.

Alimitedliabilitycompany,whichhasmanycharacteristicsofapartnershipbutisaseparatelegalentity,likea

corporation.

Partnershipsarepass-throughtaxentities.Apass-throughbusinessentitypaysnotaxonitstaxableincomebutpassestheobligationtoitsowners,whopickuptheirsharesofthetotaltaxableincomeintheirindividualincometaxreturns.Incontrast,theindividualshareholdersofcompaniespaytaxonlyontheamountofactualcashdividendsfromprofitdistributedbythecompany.Keepinmindherethatthecompanypayscorporationtaxbasedonitstaxableincome.Factorsotherthantaxaffectthechoiceofownershipstructure.Youneedtheadviceoftaxprofessionalsandfinancialconsultants.

Regardlessoftheownershipstructure,youshouldunderstandhowaccountingmethodsdeterminetaxableincome.Basically,thechoiceofaccountingmethodsenablesyoutoshiftthetimingofexpenses–suchasdepreciationandcostofgoodssold–betweenearlyyearsandlateryears.Doyouwantmoreexpensedeductionsthisyear?Thenchoosethelast-in,first-out(LIFO)methodforcost-of-goods-soldexpenseandanacceleratedmethodfordepreciation.Butkeepinmindthatwhatyougaintoday,youlosetomorrow.Higherexpensedeductionsinearlyyearscauselowerdeductionsinlateryears.Also,theseincome-tax-drivenaccountingchoicesmakethestockandfixedassetsinyourbalancesheetlookanaemic.Rememberthatexpensesareassetdecreases.Youwantmoreexpense?Thenlowerassetvaluesasreportedinyourbalancesheet.

Thinktwicebeforejumpingonthetaxminimisationbandwagon.Knowingaboutaccountingmethodsandtheireffectsinboththeprofitandlossaccountandthebalancesheethelpsyoumaketheseimportantdecisions.

ExplainYourFinancialStatementsto

ExplainYourFinancialStatementstoOthers

Onmanyoccasions,asabusinessmanageryouhavetoexplainyourfinancialstatementstoothers:

Whenapplyingforaloan.

Whentalkingwithpeopleorotherbusinesseswhomaybeinterestedinbuyingyourbusiness.

Whendealingwiththepress.

Whendealingwithunionsorotheremployeegroupsinsettingnewwagesandbenefitpackages.

Whenexplainingtheprofit-sharingplantoyouremployees.

Whenreportingfinancialstatementdatatonationaltradeassociationsthatcollectthisinformationfromtheirmembers.

Whenpresentingtheannualfinancialreportbeforetheannualmeetingofowners.

Knowledgeoffinancialstatementreportingandaccountingmethodsisalsoextremelyusefulwhenyousitonabank’sboardofdirectors,orahospitalboard,oranyofseveralothertypesofoversightboards.Intheprecedinglist,you’retheexplainer,theonewhohastodotheexplaining.Asaboardmember,you’retheexplainee,thepersonwhohastomakesenseofthefinancialstatementsandaccountingmethodsbeingpresented.Agoodaccountingfoundationisinvaluable.

PartIIofthisbookshowsyouhowtounderstandfinancialreports.Inbrief,youneedagoodgriponthepurpose,natureandlimitationsofeachofthethreeprimaryfinancialstatementsreportedbyabusiness:

Theprofitandlossaccount:Manypeoplethinkthatbottom-lineprofitiscashinthebank,butyouknowbetter.

Thecashflowstatement:Manypeoplejustaddbackdepreciationtonetincometodeterminecashflowfromprofit,butyouknowbetter.

Thebalancesheet:Manypeoplethinkthatthisfinancialstatementreportsthecurrentvaluesforassets,butyouknowbetter.

We’lltellyouonedisadvantageofknowingsomeaccounting:Theothermembersoftheboardwillbeveryimpressedwithyouraccountingknowledgeandmaywanttoelectyouchairperson.

Ashortwordonmassagingthenumbers:Don’t!

I(John)taughtaccountingtofuturebusinessmanagersandaccountants.Ididn’tencourageprofitsmoothing,windowdressingandothertechniquesformanipulatingaccountingnumberstomakeacompany’sfinancialstatementslookbetter–nomorethanmymarketingprofessorcolleaguesencouragedtheirstudentstoengageindeceptiveadvertisingtactics.Yetthesethingsgoon,andIfeltobligatedtoexposemystudentstothesepracticesasawarningthataccountantsfacedifficultmoraldecisions.Inasimilarvein,Icautionyou,abusinessmanager,thatyouwillsurelyfacepressuresfromtimetotimetomassagetheaccountingnumbers–tomakeprofitlooksmootherfromyeartoyear,ortomaketheshort-termsolvencyofthebusinesslookbetter(bywindowdressing).Don’t!

Chapter17

TenPlacesaBusinessGetsMoneyFrom

InThisChapterCheckingoutstockmarkets

Gettingprivateinvestorsonboard

Bankingonthebanks

Financingshort-andlong-termassets

Lookingforgovernmentloot

Winningfreedosh

Redeployingpensions

Allbusinessventuresneedsomecashtogetgoingandneedmoremoneyastheybecomemoresuccessful.Theyhavetoinvestinstaff,equipmentandwebsites,andneedtoremaincompetitiveandvisiblebykeepingproductsandservicesuptodate.

Manysourcesoffundsareavailabletobusinesses,bothbigandsmall.However,notallofthemareequallyappropriatetoallbusinessesatalltimes.Differentsourcesoffinancecarryverydifferentobligations,responsibilitiesandopportunitiesforprofitablebusiness.Havingsomeappreciationofthesedifferencesenablesbusinesspeopletomakeinformedchoices.

StockMarkets

Astockmarketisquitesimplyamarketplacefortradingcompanystock.AcompanylistingontheLondonStockExchange,TheNewYorkStockExchangeorFWBFrankfurtStockExchangeisthewayseriousplayersraisemoney.Thenewbreedof‘superexchanges’suchasNYSEEuronextarealsobecomingpopular.Ifyouwantafewhundredmillion,orabillionorso,stockmarketsaretheplacestocometo.

Allthestockmarketshavedifferentrulesanddifferentoutcomes.Forexample,thevalueplacedonnewcompaniesonUSstockmarketsisbetween1.5and3timesthatofUKandEuropeanmarkets.

Togetlistedonamajorstockexchange,acompanyneedsatrackrecordofmakingsubstantialprofits,withdecentseven-figuresumsbeingmadeintheyearyouplantofloat,asthisprocessisknown.Alargeproportion(usuallyatleast25percent)ofthecompany’ssharesmustbeputupforsaleattheoutset.Also,companiesareexpectedtohave100shareholdersnowandtodemonstratethat100morewillcomeonboardasaresultofthelisting.

YoucancheckoutalltheworldstockmarketsfromAmsterdamtoZagrebontheStockExchangesWorldwideLinkswebsiteatwww.tdd.lt/slnews/Stock_Exchanges/Stock.Exchanges.htmandatwww.worldwide-tax.com/stockexchanges/worldstockexchanges.asp.AlmostallstockexchangewebsiteshavepagesinEnglish.Lookoutforatermsuchas‘ListingCenter’,‘Listing’or‘Rules’andyou’llfindthelatestcriteriaforfloatingacompanyonthatexchange.

JuniorstockmarketssuchasLondon’sAlternativeInvestmentMarket(AIM)wereformedinthemidtolate1990’sspecificallytoprovideriskcapitalfornewratherthanestablishedventures.Thesemarketshaveanaltogethermorerelaxedatmospherethanthe

marketshaveanaltogethermorerelaxedatmospherethanthemajorexchanges.

Thesejuniormarketsareanattractivepropositionforentrepreneursseekingequitycapital.AIMisparticularlyattractivetoanydynamiccompanyofanysize,ageorbusinesssectorthathasrapidgrowthinmind.ThesmallestfirmonAIMenteredtoraiselessthan£1millionandthelargestraisedover£500million.

Aswiththemajorstockmarkets,thesejuniorversionsexpectsomethinginreturn.Theformalitiesforfloatingareminimalbutthecostsofentryarehigh,andyoumusthaveanominatedadvisersuchasamajoraccountancyfirm,stockbrokerorbanker.Thecostoffloatingonthejuniormarketisaround6.5percentofallfundsraised,andcompaniesvaluedatlessthan£2millioncanexpecttoshelloutaquarteroffundsraisedincostsalone.ThemarketisregulatedbytheLondonStockExchange.Youcanfindoutmorebygoingtotheirwebsite(www.londonstockexchange.com)andclickingon‘AIM’.

OnerungdownfromAIMisPLUS-QuotedMarketwhoserootslieinthemarketformerlyknownasOfex.ItbeganlifeinNovember2004andwasgrantedRecognisedInvestmentExchange(RIE)statusbytheFinancialServicesAuthority(FSA)in2007.Aimedatsmallercompanieswantingtoraiseupto£10million,itdrawsonapoolofcapitalprimarilyfromprivateinvestors.Themarketisregulated,butrequirementsaren’tasstringentasthoseofAIMorthemainmarketandthecostsofflotationandongoingcostsarelower.Keycomusedthismarkettoraise£4.4millioninSeptember2008tobuyoutacompetitortogivethemacombinedcontracttoprovidebroadbandaccessto40,000studentroomsinUKuniversities.Thereare174companiesquotedonPLUSwithacombinedmarketcapitalisationof£2.3billion.Evenin2009,aparticularlybadyearforstockmarketactivity,30companiesappliedforentrytoPLUSand18wereadmitted.YoucanfindoutmoreaboutPLUSatwww.plusmarketsgroup.com.

PrivateEquity

PrivateEquityOrganisationsknownasventurecapitalistsprovideprivateequitybyinvestingotherpeople’smoney,oftenfrompensionfunds.Theyarelikelytobeinterestedininvestinglargesumsofmoney,oftenmorethancanberaisedonAIM.Some7,000orsocompaniesworldwidegetprivateequitybackingeachyear,aroundhalfofwhichareintheUSwheretheaveragedealis$7.8million.

Venturecapitalistsgenerallyexpecttheirinvestmenttopayoffwithinsevenyears,buttheyarehardenedrealists.Twoineveryteninvestmentstheymakearetotalwrite-offs,andsixperformaveragelywellatbest.So,theonestarineveryteninvestmentstheymakehastocoveralotofduds.Venturecapitalistshaveatargetrateofreturnofover30percent,tocoverthispoorhitrate.

Raisingventurecapitalisanexpensiveoptionanddealsareslowtoarrange.Sixmonthsisnotunusual,andoverayearhasbeenknown.Everyventurecapitalisthasadealdoneinsixweeksinitsportfolio,butthattrulyistheexceptionratherthantherule.

PricewaterhouseCoopersproducetheMoneyTreeReport(www.pwcmoneytree.com),whichisaquarterlystudyofventurecapitalinvestmentactivityintheUnitedStates,andindividualcountryassociationsdosomethingsimilarfortheirownmarkets.ThePSEPSVentureCapitalandPrivateEquityDirectory(www.pseps.com/associations.php)liststheventurecapitalassociationsofvariouscountries.

TheBritishVentureCapitalAssociation(www.bvca.co.uk),theEuropeanVentureCapitalAssociation(www.evca.com)andtheNationalVentureCapitalAssociation(www.nvca.org)intheUShaveonlinedirectoriesgivingdetailsofhundredsofventurecapitalprovidersbothinsideandoutsideoftheirrespectivecountriesandcontinents.

YoucanseehowthosenegotiatingwithorreceivingventurecapitalratethefirminquestionattheFundedwebsite(www.thefunded.com)intermsofthedealoffered,thefirm’sapparentcompetenceandhowgoodtheyareatmanagingtherelationship.

BusinessAngelsOnepossiblefirstsourceofequityorriskcapitalisaprivateindividualwithhisorherownfundsandperhapssomeknowledgeofyourtypeofbusiness.Inreturnforashareinthebusiness,suchinvestorswillinvestmoneyattheirownrisk.About40percentoftheseindividualssufferapartialorcompletelossoftheirinvestment,whichsuggeststhatmanyarepreparedtotakebigrisks.They’vebeenchristened‘businessangels’,atermfirstcoinedtodescribeprivatewealthyindividualswhobackedaplayonBroadwayorinLondon’sWestEnd.

Mostbusinessangelshaveworkedinasmallfirmorhaveownedtheirownbusinessesbefore,soknowthebusinessworldwell.Theyaremorelikelytoinvestinearly-stageinvestmentswhererelativelysmallamountsofmoneyareneeded.10percentofbusinessangelinvestmentisforlessthan£10,000and45percentisforover£50,000.Theyareuptofivetimesmorelikelytoinvestinstart-upsandearly-stageinvestmentsthanventurecapitalprovidersingeneral.Mostbusinessangelsinvestclosetohome,andsyndicateddealsmakeupmorethanaquarterofalldeals,provingthatangelsflocktogether!

Inreturnfortheirinvestment,mostangelswantsomeinvolvementbeyondmerelysigningachequeandmayhopetoplayapartinyourbusinessinsomeway.Theyarelookingforbigrewards.OneangelwhobackedthefledglingsoftwarecompanySage(whosupplyaccounting,payrollandbusinessmanagementsoftwareforsmallandmediumsizedcompanies)with£10,000initsfirstroundof£250,000financingsawhisstakeriseto£40million.Variousindustryestimatessuggestthatupwardsof£6.5billionofangels’moneyislookingforinvestmenthomes,althoughthesumactuallyinvestedeachyearisprobablymuchsmallerthanthat.

Tofindabusinessangel,checkouttheonlinedirectoryoftheBritishBusinessAngelsAssociation(www.bbaa.org.uk).TheEuropeanBusinessAngelsNetworkwebsitehasdirectoriesofnationalbusinessangelassociationsbothinsideandoutsideofEurope.Gotowww.eban.organdclickon‘Members’tofindindividualbusinessangels.

CorporateVentureFundsVenturecapitalfirmsoftengettheirhandsdirtytakingahandinthemanagementofthebusinessestheyinvestin.Anothertypeofbusinessisalsointheriskcapitalbusiness,withoutitnecessarilybeingtheirmainlineofbusiness.Thesefirms,knownascorporateventurers,usuallywantaninsidetracktonewdevelopmentsinandaroundtheedgesoftheirownfieldsofinterest.

SinclairBeechamandJulianMetcalfefoundedtakeawayfoodchainPretaMangerwitha£17,000loanandanameborrowedfromaboarded-upshop.Theyhadglobalambitionsandtheyjoinedforceswiththecorporateventuringarmofabigfirm.ItwasonlybycuttinginMcDonald’s,theburgergiant,thattheycouldseeanyrealisticwaytodominatetheworld.Theysolda33%stakefor£25millionin2001toMcDonald’sVentures,LLC,awholly-ownedsubsidiaryofMcDonald’sCorporation,thearmofMcDonaldsthatlooksafteritscorporateventuringactivities.TheycouldalsohaveconsideredCisco,AppleComputers,IBMandMicrosoftwhoalsoallhavecorporateventuringarms.

Foranentrepreneur,corporateventurefundscanprovidea‘friendlycustomer’andhelptoopendoors.Forthe‘parent’itprovidesaprivilegedring-sideseatasabusinessgrowsandsobeabletodecideiftheareaisworthplungingintomoredeeply,oratleastgainvaluableinsightsintonewtechnologiesorbusinessprocesses.

GlobalCorporateVenturing(www.globalcorporateventuring.com)isanewwebsitedevotedtopublishinginformationonwho’swhoandwho’sdoingwhatinthesector.

BanksBanksaretheprincipal,andfrequentlytheonly,sourceoffinanceforbusinessesthatarenotlistedonastockmarketorthatdon’thaveprivateequitybackers.

Forlong-termlending,bankscanprovidetermloansforanumberofyears,witheitheravariableinterestratepayableoraninterestratefixedforanumberofyearsahead.Theproportionoffixed-rateloanshasincreasedfromathirdofalltermloanstoaroundoneintwo.Insomecases,movingbetweenafixedinterestrateandavariableoneatcertainintervalsmaybepossible.Unlikeinthecaseofanoverdraft,thebankcannotpulltherugfromunderyouifcircumstances(orthelocalmanager)change.

Bankerslookforassetsecuritytobacktheirloanandtoprovideanear-certaintyofgettingtheirmoneyback.Theyalsochargeaninterestratethatreflectscurrentmarketconditionsandtheirviewoftheriskleveloftheproposal.

Bankersliketospeakofthe‘fiveCs’ofcreditanalysis–factorstheylookatwhentheyevaluatealoanrequest.

Character.Bankerslendmoneytoborrowerswhoappearhonestandwhohaveagoodcredithistory.Beforeyouapplyforaloan,obtainacopyofyourcreditreportandcleanupanyproblems.

YoucancheckoutyourownbusinesscreditratingatCheckSure(www.checksure.biz).Byusingthecomparativeratiosforyourbusinesssectoryoucanseehowtoimproveyourownrating.Theservicecostsaround£6to£10dependingonthelevelofdetailyourequire.

Capacity.Thisisapredictionoftheborrower’sabilitytorepaytheloan.Foranewbusiness,bankerslookatthebusinessplan.Foranexistingbusiness,bankersconsider

financialstatementsandindustrytrends.

Collateral.Bankersgenerallywantaborrowertopledgeanassetthatcanbesoldtopayofftheloaniftheborrowerlacksfunds.

Capital.Bankersscrutiniseaborrower’snetworth,theamountbywhichassetsexceeddebts.

Conditions.Whetherbankersgivealoancanbeinfluencedbythecurrenteconomicclimateaswellasbytheamount.

YoucanseeanAtoZlistingofbusinessbankaccountsatwww.find.co.uk/commercial/commercial_banking_centre/business-

bankingwherethetopsixorsoareratedandreviewed.

Governmentsaroundtheworldhaveschemestomakeraisingmoneyfrombankseasierforsmallandnewbusinesses.TheseSmallFirmLoanGuaranteeSchemesareoperatedbybanksattheinstigationofgovernments.Theyareaimedatsmallandnewbusinesseswithviablebusinessproposalsthathavetriedandfailedtoobtainaconventionalloanbecauseofalackofsecurity.Loansareavailableforperiodsofbetweentwoandtenyearsonsumsfrom£5,000to£250,000.Thegovernmentguarantees70–90percentoftheloan.Inreturnfortheguarantee,theborrowerpaysapremiumof1–2percentperyearontheoutstandingamountoftheloan.Thecommercialaspectsoftheloanaremattersbetweentheborrowerandthelender.

YoucanfindoutmoreabouttheUKSmallFirmsLoan

GuaranteeSchemeontheBusinessLinkwebsite(gotowww.businesslink.gov.ukandclickon‘Financeandgrants’,‘Financeoptions,‘Borrowing’,and‘Governmentlendingschemes’).

Asameansofshort-termborrowing,bankscanofferoverdrafts–afacilitytocoveryouwhenyouwanttowithdrawmoremoneyfromabankaccountthanithasfundsavailable.Theoverdraftwasoriginallydesignedtocoverthetimingdifferencesof,say,havingtoacquirerawmaterialstomanufacturefinishedgoodsthatarelatersold.However,overdraftshavebecomepartofthecorefundingofmostbusinesses,withalittleoveraquarterofallbankfinanceprovidedinthisway.

Almosteverytypeandsizeofbusinessusesoverdrafts.Theyareveryeasytoarrangeandtakelittletimetosetup.Thatisalsotheirinherentweakness.Thekeywordsinthearrangementdocumentarerepayableondemand,whichleavesthebankfreetomakeandchangetherulesasitseesfit.(Thistermisunderconstantreview,andsomebanksmayremoveitfromthearrangement.)Withotherformsofborrowing,aslongasyousticktothetermsandconditions,theloanisyoursfortheduration,butnotwithoverdrafts.Smallbusinessescanexpecttopayinterestatthreetofourpercentabovebase–therateatwhichbankscanborrow.Largerandmorecreditworthyfirmsmaypaymuchless.

Bonds,DebenturesandMortgagesBonds,debenturesandmortgagesareallkindsofborrowingwithdifferentrightsandobligationsforthepartiesconcerned.Amortgageismuchthesameforabusinessasforanindividual.Theloanisforbuyingaparticularpropertyassetsuchasafactory,officeorwarehouse.Interestispayableandtheloanitselfissecuredagainsttheproperty,soifthebusinessfails,themortgagecansubstantiallyberedeemed.

Companieswantingtoraisefundsforgeneralbusinesspurposes,

Companieswantingtoraisefundsforgeneralbusinesspurposes,ratherthanamortgagewhereaparticularpropertyisbeingbought,issuedebenturesorbonds.Theserunforanumberofyears,typicallythreeyearsandupwards,withthebondordebentureholderreceivinginterestoverthelifeoftheloanwiththecapitalreturnedattheendoftheperiod.

Thekeydifferencebetweendebenturesandbondsliesintheirsecurityandranking.Debenturesareunsecured,sointheeventofthecompanybeingunabletopayinterestorrepaythesum,theloanermaywellgetlittleornothingback.Bondsaresecuredagainstspecificassetsandsorankaheadofdebenturesforanypayout.

Unlikebankloansthatareusuallyheldbytheissuingbank,bondsanddebenturesaresoldtothepublicinmuchthesamewayasshares.Theinterestdemandedisafactoroftheprevailingmarketconditionsandthefinancialstrengthoftheborrower.

YoucanfindoutmoreaboutraisingtheseformsoffinanceontheBusinessLinkwebsite(www.businesslink.gov.uk).

LeasingandHire-PurchaseYoucanusuallyfinancephysicalassetssuchascars,vans,computersandofficeequipmentbyleasingthemorbuyingthemonhirepurchase.Thisleavesotherfundsfreetocoverthelesstangibleelementsinyourcashflow.Inthisway,abusinessgetstheuseofassetswithoutpayingthefullcostallatonce.

Companiestakeoutoperatingleaseswhereyouusetheequipmentforlessthanitsfulleconomiclife,asyoumightwithamotorvehicle,forexample.Thelessortakestheriskoftheequipmentbecomingobsolete,andassumesresponsibilityfor

repairs,maintenanceandinsurance.Asyou,thelessee,payforthis,theserviceismoreexpensivethanafinancelease,whereyouleasetheequipmentformostofitseconomiclife,takingcareofthemaintenanceandinsuranceyourself.Leasescannormallybeextended,oftenforfairlynominalsums,inthelatteryears.

Businessesthatneedlotsoffixedassetssuchascomputers,machineryorvehiclesarethebigcustomersforleasing.Theobviousattractionofleasingisthatyouneednodeposit,whichleavesyourworkingcapitalfreeformoreprofitableuseelsewhere.Also,youknowthecostfromthestart,makingforwardplanningsimpler.Taxadvantagesoverotherformsoffinancemayevenexist.

Hirepurchasediffersfromleasinginthatyouhavetheoptiontoeventuallybecometheowneroftheasset,afteryoumakeaseriesofpayments.

YoucanfindaleasingorhirepurchasecompanythroughtheFinanceandLeasingAssociation.Theirwebsite(gotowww.fla.org.ukandclickon‘ForBusinesses’and‘BusinessFinanceDirectory’)givesdetailsofallUK-basedbusinessesthatofferthistypeoffinance.Thewebsitealsohasgeneralinformationontermsoftradeandcodeofconduct.EuromoneyproduceanannualWorldLeasingYearbookthatcontainsdetailsabout4,250leasingcompaniesworldwide(gototheirwebsiteatwww.euromoney.comandclickon‘Leasing&AssetFinance’and‘Books’fororderinginformation).Youcan,however,seealistingofmostcountries’leasingassociationsforfreeinthe‘Contributors’listingonthissite.

FactoringandInvoiceDiscounting

Customerstakeonaveragearound60to90daystopaytheirsuppliers.Ineffect,thismeansthatcompaniesaregrantingaloantocustomersforthattime.Inperiodsofrapidgrowth,thiscanputastrainoncashflow.Onewaytoalleviatethatstrainistofactorcreditworthycustomers’billstoafinancialinstitutionandreceivesomeofthefundsasgoodsleavethedoor,andthisspeedsupthecashflow.

Factoringisanarrangementthatallowsabusinesstoreceiveupto80percentofthecashduefromcustomersmorequicklythannormal.Thefactoringcompanyineffectbuysthetradedebts,providesa100percentprotectionagainstbaddebtsandcanalsoprovideadebtoraccountingandadministrationservice.

Factoringcostsalittlemorethannormaloverdraftrates.Thefactoringservicecostsbetween0.5and3.5percentoftheturnover,dependingonvolumeofwork,thenumberofdebtors,averageinvoiceamountandotherrelatedfactors.

Factoringisgenerallyonlyavailabletoabusinessthatinvoicesotherbusinesscustomersforservicesprovided.Thesecustomerscanbeeitherinthebusiness’shomemarketoroverseas.Companiesthatselldirectlytothepublic,sellcomplexandexpensivecapitalequipment,orexpectprogresspaymentsonlong-termprojectsmayfindfactoringtheirdebtorbooktobedifficult,ifnotimpossible.

Invoicediscountingisavariationonthesametheme.Factorscollectinmoneyowedbytheirclients’customers,takeafeeandpassthebalanceon,whereasinvoicediscountersleavetheirclientstocollectthemoneythemselves.Thiscould

beanadvantageforfirmsthatfearthefactoringmethodmightreducetheircontactwithclients.Invoicediscountingis,inanycase,typicallyavailableonlytobusinesseswithaturnoverinexcessof£1million.

YoucanfindaninvoicediscounterorfactoringbusinessthroughtheAssetBasedFinanceAssociation’sdirectoryatwww.thefda.org.uk/public/membersList.asp.

Grants,IncentivesandCompetitionsSurprisingly,therereallyissuchathingasafreelunchinthemoneyworld.Thesefreelunchescomefrombenevolentgovernmentswhoseagendaiseithertogetbusinessestolocateinanareabereftofbusinessbutjammedfullofpeoplelookingforwork,ortopioneernew,unprovenandriskytechnologies.Absolutelynoevidenceexiststhatgovernmentsgetanyvalueoutofthisgenerosity,butthat’sthethingwithgovernments–theyfeeltheyhavetogovern,andpeoplearemorepreparedtolistentoothersthathaveopenwallets.

Grantsareconstantlybeingintroduced(andwithdrawn),butnosystemexiststoletyouknowautomatically.Youhavetokeepyourselfinformed.TheBusinessLinkwebsite(gotowww.businesslink.gov.ukandclickon‘Financeandgrants’and‘Grantsandgovernmentsupport’)hasadviceonhowtoapplyforagrantaswellasadirectoryofgrantsonoffer.TheMicrosoftSmallBusinessCentre(www.microsoft.com/uk/businesscentral/euga/home.aspx)hasaEuropeanUnionGrantAdvisorwithasearchfacilitytohelpyoufindwhichofthe6,000grantsonoffermightsuityourbusinessneeds.www.grants.govisaguidetohowtoapplyforover1,000

federalgovernmentgrantsintheUS.

Governmentsaren’ttheonlyguyswithopenwallets.Morethanathousandannualawardsaroundtheworldaimedatbusinessesexist.Theyareawardedforsuchachievementsasbeingthegreenest,cleanest,fastest(growing,thatis),bestcompanytoworkforandathousandotherplausiblesuperlativestomakeyoufeelgood.Theguysgivingtheseawardsareinitforthepublicity,andheck,ifyoucangetyourhandsonsomefreemoney,swallowyourprideandheadondown.Businessplansarecentraltomostofthesecompetitions,whicharesponsoredbybanks,themajoraccountancybodies,chambersofcommerce,localornationalnewspapers,businessmagazinesandthetradepress.Governmentdepartmentsmayalsohavetheirowncompetitionsasameansofpromotingtheirinitiativesforexporting,innovation,jobcreationandsoforth.Youcanfinddirectoriesofbusinessplancompetitionsatwww.smallbusinessnotes.com/planning/competitions.htmlandwww.awardsintelligence.co.uk.

UsingthePensionFundThisfinancingstrategyismostlyavailabletoprivatecompanieswitharelativelylimitednumberofparticipants–usuallydirectors,partners,topmanagersandshareholders.Inthesecases,thecompanycanpaymoneyoutofbusinessprofits,thusescapingtax,intoeitheraSmallSelf-AdministeredScheme(SSAS)oraSelf-InvestedPersonalPensionPlan(SIPP).Thatschemecantheninvestinanarrowrangeofassetclassessuchasthecompany’sownshares,purchaseofcommercialpropertyandloanstothecompany,subjecttocertainconditionsandwiththeapprovalofthepensiontrustees.ThetrusteesarethemselvesregulatedbythePensions

Regulator(www.thepensionsregulator.gov.uk).Theaimofanypensioninvestmentmustbetoenhancethevalueofthepensionfundfortheultimatebenefitofallthepensionersequally.

Thefundoesn’tstopatbeingabletousepensioners’moneytoinvestinthebusinesstheyworkin.BothSSASandSIPPschemescan(sinceApril2006)borrowupto50percentoftheirnetassetstopurchaseproperty.So,ifanSSAS/SIPPhastotalassetsof£100,000,itcanborrowafurther£50,000,thusprovidingupto£150,000toinvestinqualifyingbusinessassets.

YoucangetthelowdownonSSASandSIPPpensionschemesfromcompaniessuchasWesterbyTrusteeService(www.sipp-ssas-pensions.co.uk)andSIPPSGuide(www.sippsguide.com).

Chapter18

Ten(PlusOne)QuestionsInvestorsShouldAskWhenReadingaFinancial

Report

InThisChapterAnalysingsalesandprofitperformance

Investigatingchangesinassetsandliabilities

Lookingforsignsoffinancialdistress

Examiningassetutilisationandreturnoncapitalinvestment

Youhaveonlysomuchtimetosearchforthemostimportantsignalsinabusiness’sfinancialreport.Foraquickreadthroughafinancialreport–onethatallowsyoutodecodethecriticalsignalsinthefinancialstatements–youneedachecklistofkeyquestionstoask.

Beforeyoureadabusiness’sannualfinancialreport,getuptospeedonwhichproductsandservicesthebusinesssellsandlearnaboutthehistoryofthebusinessandanycurrentproblemsit’sfacing.Oneplacetofindmuchofthisinformationisthecompany’sannualaccountsfiledatCompaniesHouse,whichisapublicdocumentavailabletoeveryone.(Youcanalsousuallyfindthisinformationonthecompany’swebsite,in

theinvestoraffairssection.)Companyprofilesarepreparedbysecuritiesbrokersandinvestmentadvisers,andthey’reveryuseful.TheEconomist,InvestorsChronicleandothernationalnewspapers,suchasTheFinancialTimes,aregoodsourcesofinformationaboutpubliccompanies.

DidSalesGrow?Abusinessmakesprofitbymakingsales(althoughyoudohavetotakecontrollingexpensesintoaccount).Salesgrowthisthekeytolong-runsustainedprofitgrowth.Evenifprofitisup,investorsgetworriedwhensalesrevenueisflat.

Startreadingafinancialreportbycomparingthisyear’ssalesrevenuewithlastyear’s,andwithallprioryearsincludedinthefinancialreport.Acompany’ssalestrendisthemostimportantfactoraffectingitsprofittrend.Wedareyoutofindabusinessthathashadasteadydownwardsalestrendlinebutasteadyupwardprofitline–you’dbelookingforalongtime.

DidtheProfitRatiosHold?Highersalesfromoneyeartothenextdon’tnecessarilymeanhigherprofit.Youalsoneedtolookatwhetherthebusinesswasabletomaintainitsprofitratioatthehighersaleslevel.Recallthattheprofitratioisnetincomedividedbysalesrevenue.Ifthebusinessearned,say,a6percentprofitratiolastyear,diditmaintainorperhapsimprovethisratioonitshighersalesrevenuethisyear?

Alsocomparethecompany’sgrossmarginratiosfromyeartoyear.Cost-of-goods-soldexpenseisreportedbycompaniesthatsellproducts.Recallthatgrossmarginequalssalesrevenuelesscostofgoodssold.Anysignificantslippageinacompany’sgrossmarginratio(grossmargindividedbysalesrevenue)isaveryseriousmatter.Supposethatacompanygivesuptwoorthreepoints(onepoint=1percent)ofitsgrossmarginratio.Howcanitmakeupforthisloss?Decreasingitsotheroperatingexpensesisn’teasyorverypractical–unlessthebusinesshasalloweditsoperatingexpensestobecomebloated.

Inmostexternalfinancialreports,profitratiosarenotdiscussedopenly,especiallywhenthingshavenotgonewellforthebusiness.Youusuallyhavetogodiggingfortheseimportantratiosanduseyourcalculator.Articlesinthefinancialpressonthemostrecentearningsofpubliccorporationsfocusongrossmarginandprofitratios–forgoodreason.Wealwayskeepaneyeonprofitasapercentageofsalesrevenue,eventhoughwehavetocalculatethiskeyratioformostbusinesses.Wewishthatallbusinesseswouldprovidethisratio.

WereThereAnyUnusualorExtraordinaryGainsorLosses?

Everynowandthen,abusinessrecordsanunusualorextraordinarygainorloss.Thefirstsectionoftheprofitandlossaccountreportssalesrevenueandtheexpensesofmakingthesalesandoperatingthebusiness.Also,interestandincometaxexpensesarededucted.Becareful:Theprofitdowntothispointmaynotbethefinalbottomline.Theprofitdowntothispointisfromthebusiness’songoing,normaloperationsbeforeanyunusual,one-timegainsorlossesare

recorded.Thenextlayeroftheprofitandlossaccountreportstheseextraordinary,non-recurringgainsorlossesthatthebusinessrecordedduringtheperiod.

Thesegainsorlossesarecalledextraordinarybecausetheydonotrecur–oratleastshouldnotrecur,althoughsomecompaniesreportthesegainsandlossesonaregularbasis.Thesegainsandlossesarecausedbyadiscontinuityinthebusiness–suchasamajororganisationalrestructuringinvolvingareductionintheworkforceandpayingsubstantialseverancepackagestolaid-offemployees,sellingoffmajorassetsandproductlinesofthebusiness,retiringahugeamountofdebtatabiggainorloss,orsettlingahugelawsuitagainstthebusiness.Generally,thegainorlossisreportedononelinenetofthecorporationtaxeffectforeachextraordinaryitem,andabriefexplanationcanbefoundinthefootnotestothefinancialstatements.

Investorshavetowatchthepatternoftheseitemsovertheyears.Anextraordinarygainorlossnowandthenisanormalpartofdoingbusinessandisnothingtobealarmedabout.However,abusinessthatreportsoneortwoofthesegainsorlosseseveryyearoreveryotheryearissuspect.Thesegainsorlossesmaybeevidenceofpastturmoilandfutureturbulence.Weclassifythesebusinessesashigh-riskinvestments–becauseyoudon’tknowwhattoexpectinthefuture.

Inanycase,weadviseyoutoconsiderwhetheranunusuallossisthecumulativeresultofinadequateaccountingforexpensesinpreviousyears.Alargelegalsettlement,forexample,maybeduetothebusinessrefusingtoadmitthatitissellingunsafeproductsyearafteryear;itsliabilityfinallycatchesupwithit.

DidEarningsPerShareKeepUp

DidEarningsPerShareKeepUpwithProfit?

Chapter14explainsthatapubliclyownedbusinesswithasimplecapitalstructure–meaningthatthebusinessisnotrequiredtoissueadditionalsharesinthefuture–reportsjustoneearningspershare(EPS)fortheperiod,whichiscalledbasicEPS.YoucalculatebasicEPSbyusingtheactualnumberofsharesownedbyshareholders.However,manypubliclyownedbusinesseshavecomplexcapitalstructuresthatrequirethemtoissueadditionalsharesinthefuture.ThesebusinessesreporttwoEPSnumbers–basicEPSanddilutedEPS.ThedilutedEPSfigureisbasedonalargernumberofsharesthatincludestheadditionalnumberofsharesthatwillbeissuedundertermsofmanagementshareoptions,convertibledebtandothercontractualobligationsthatrequirethebusinesstoissuesharesinthefuture.

Inanalysingearningspershare,therefore,youmayhavetoputonyourbifocals,asitwere.Formanybusinesses,youhavetolookatbothbasicEPSanddilutedEPS.WesupposeyoucouldinvestonlyincompaniesthatreportonlybasicEPS,butthisinvestmentstrategywouldeliminatealargenumberofbusinessesfromyourstockinvestmentportfolio.Oddsare,yourstockinvestmentsincludecompaniesthatreportbothbasicanddilutedEPS.ThetwoEPSfiguresmaynotbetoofarapart,butthenagain,dilutedEPSmaybesubstantiallylessthanbasicEPSforsomebusinesses.

Supposeyouownstockinapubliccorporationthatreportsbottom-linenetincomethatis10percenthigherthanlastyear’s.Sofar,sogood.Butyouknowthatthemarketpriceofyoursharesdependsonearningspershare(EPS).AskwhathappenedtobasicanddilutedEPS.DidbothEPSfiguresgoup10percent?Notnecessarily–theanswerisoften‘no’,infact.Youhavetocheck.

Publiccompanieswhosesharesaretradedononeofthenationalstockexchanges(LondonStockExchange,NewYorkStockExchange,NASDAQandsoon)arerequiredtoreportEPSintheir

Exchange,NASDAQandsoon)arerequiredtoreportEPSintheirprofitandlossaccounts,soyoudon’thavetodoanycomputations.(PrivatebusinesseswhosesharesarenottradeddonothavetoreportEPS.)

EPSincreasesexactlythesamepercentagethatnetincomeincreasesonlyifthetotalnumberofsharesremainsconstant.Usually,thisisnotthecase.Manypubliccorporationshaveafairamountofactivityintheirsharesduringtheyear.Sotheyincludeascheduleofchangesinshareholders’equityduringtheyear.(Chapter8discussesthisfinancialsummaryofchangesinshareholders’equity.)Lookatthisscheduletofindouthowmanyshareswereissuedduringtheyear.Also,companiesmaypurchasesomeoftheirownsharesduringtheyear,whichisreportedinthisschedule.

Supposenetincomeincreased,say,10percent,butbasicEPSincreasedonly6.8percentbecausethenumberofsharesissuedbythebusinessincreased3percentduringtheyear.(Youcancheckthecomputationifyoulike.)Youshoulddefinitelylookintowhyadditionalshareswereissued.AndifdilutedEPSdoesnotkeeppacewiththecompany’searningsincrease,youshouldpinpointwhythenumberofsharesincludedinthecalculationofdilutedEPSincreasedduringtheperiod.(Maybemoremanagementshareoptionswereawardedduringtheyear.)Thenumberofsharesmayincreaseagainnextyearandtheyearafter.BusinessesdonotcommentonwhythepercentagechangeintheirEPSisnotthesameasthepercentagechangeintheirnetincome.WewishthatcompanieswererequiredtoleaveaclearexplanationofanydifferenceinthepercentageofchangeinEPScomparedwiththepercentageofchangeinnetincome.However,thisisjustwishfulthinkingonourpart.Youhavetoferretoutthisinformationyourself,whichweadviseyoutodo.

AnincreaseinEPSmaynotbedueentirelytoanincreaseinnetincome,butrathertoadecreaseinthenumberofshares.Cash-richcompaniesoftenbuytheirsharestoreducethetotalnumberofsharesthatisdividedintonetincome,therebyincreasingbasicanddilutedEPS.YoushouldpaycloseattentiontoincreasesinEPSthatresultfromdecreasesinthenumberofshares.Thelong-runbasisofEPSgrowthisprofitgrowth,althoughadecreaseinthenumberofshareshelpsEPSand,hopefully,themarketpriceoftheshares.

DidtheProfitIncreaseGenerateaCashFlowIncrease?

Increasingprofitisallwellandgood,butyoualsoshouldask:Didcashflowfromprofitincrease?Cashflowfromprofitisfoundinthefirstsectionofthecashflowstatement,whichisoneofthethreeprimaryfinancialstatementsincludedinafinancialreport.Thecashflowstatementbeginswithanexplanationofcashflowfromprofit.

Accountantsusethetermcashflowfromoperatingactivities–which,inouropinion,isnotnearlyasdescriptiveascashflowfromprofit.Thetermprofitisavoidedliketheplagueinexternalfinancialreports;it’snotapoliticallycorrectword.Soyoumaythinkthataccountantswouldusethephrasecashflowfromnetincome.Butno,theofficialpronouncementonthecashflowstatementmandatedthetermcashflowfromoperatingactivities.Operatingactivitiesreferssimplytosalesrevenueand

expenses,whicharetheprofit-makingoperationsofabusiness.We’llstickwithcashflowfromprofit–pleasedon’treportustotheaccountingauthorities.

Almostallexpensesarebadforcashflow,exceptone:depreciation.Depreciationexpenseisactuallygoodforcashflow.Eachyear,abusinessconvertspartofthecostofitsfixedassetsbackintocashthroughthecashcollectionsfromsalesmadeduringtheyear.Overtime,fixedassetsaregraduallyusedup,soeachyearischargedwithpartofthefixedassets’costbyrecordingdepreciationexpense.Andeachyear,abusinessretrievescashforpartofthecostofitsfixedassets.Thusdepreciationexpensedecreasesprofitbutincreasescashflow.Butnetincomeplusdepreciationdoesnotequalcashflowfromprofit–exceptintheimaginaryscenarioinwhichallthecompany’sotheroperatingassets(mainlydebtorsandstock)andallitsoperatingliabilities(mainlycreditorsandaccruedexpensespayable)don’tincreaseordecreaseduringtheyear.

Here’sthekeyquestion:Shouldcashflowfromprofitchangeaboutthesameamountasnetincomechanged,orisitnormalforthechangeincashflowtobehigherorlowerthanthechangeinnetincome?

Asageneralrule,salesgrowthpenalisescashflowfromprofitintheshortrun.Abusinesshastobuildupitsdebtorsandstock,andtheseincreaseshurtcashflow–although,duringgrowthperiods,abusinessalsoincreasesitscreditorsandaccruedexpensespayable,whichhelpscashflow.Theassetincreases,inmostcases,dominatetheliabilityincreases,

andcashflowfromprofitsuffers.

Westronglyadviseyoutocomparecashflowfromoperatingactivities(see,weusetheofficiallycorrecttermhere)withnetincomeforeachofthepasttwoorthreeyears.Iscashflowfromprofitaboutthesamepercentageofnetincomeeachyear?Whatdoesthetrendlooklike?Forexample,lastyear,cashflowfromprofitmayhavebeen90percentofnetincome,butthisyearitmayhavedroppedto50percent.Don’thitthepanicbuttonjustyet.

Adipincashflowfromprofitinoneyearactuallymaybegoodfromthelong-runpointofview–thebusinessmaybelayingagoodfoundationforsupportingahigherlevelofsales.Butthenagain,theslowdownincashflowfromprofitcouldpresentashort-termcashproblemthatthebusinesshastodealwith.

Acompany’scashflowfromprofitmaybeatrickleinsteadofastream.Infact,cashflowfromprofitcouldbenegative;inmakingaprofit,thecompanycouldbedrainingitscashreserves.Cashflowfromprofitislow,inmostcases,becausedebtorsfromsaleshaven’tbeencollectedandbecausethebusinesshasmadelargeincreasesinitsinventories.Theselargeincreasesraisequestionsaboutwhetherallthereceivableswillbecollectedandwhetherallthestockwillbesoldatregularprices.Onlytimecantell.Butgenerallyspeaking,youshouldbecautiousandtakethenetincomenumberthatthebusinessreportswithagrainofsalt.

Analysingcashflowfromloss(insteadoffromprofit)isveryimportant.Whenacompanyreportsalossfortheyear–insteadofaprofit–animmediatequestioniswhetherthe

company’scashreservewillbuyitenoughtimetomoveoutofthelosscolumnintotheprofitcolumn.Whenabusinessisinalosssituation(theearlyyearsofastart-upbusiness,forexample)anditscashflowfromoperatingactivitiesisnegative,focusonthecompany’scashbalanceandhowlongthebusinesscankeepgoinguntilitturnsthecornerandbecomesprofitable.Stockanalystsusethetermburnratetorefertohowmuchcashoutflowthebusinessisusingupeachperiod.Theycomparethismeasureofhowmuchcashthebusinessishaemorrhagingeachperiodtoitspresentcashbalance.Thekeyquestionisthis:Doesthebusinesshaveenoughcashonhandtotideitoveruntilitstartstogeneratepositivecashflowfromprofit,andifnot,wherewillitgetmoremoneytoburnuntilitcanrecordaprofit?

AreIncreasesinAssetsandLiabilitiesConsistentwiththeBusiness’sGrowth?

Publiclyownedbusinessespresenttheirfinancialstatementsinathree-yearcomparativeformat(orsometimesatwo-yearcomparativeformat).Strictlyspeaking,youdon’thavetoprovidecomparativefinancialstatements–althoughallbusinesses,privateandpublic,areencouragedtopresentcomparativefinancialstatements.Furthermore,businessinvestorsandlendersdemandcomparativefinancialstatements.Thus,threecolumnsofnumbersarereportedinprofitandlossaccounts,balancesheetsandcashflowstatements–forthecurrentandtwoprecedingyears.Tokeepfinancialstatementillustrationsinthisbookasbriefaspossible,wepresentonlyoneyear;wedonotincludetwoadditionalcolumnsforthetwopreviousyears.Pleasekeepthispointinmind.

Presentingfinancialstatementsinathree-yearcomparativeformat,

asmaybeobvious,helpsthereadermakeyear-to-yearcomparisons.Ofcourse,youhavetodealwiththreetimesasmanynumbersinathree-yearcomparativefinancialstatementcomparedwithaone-yearfinancialstatement.Andweshouldpointoutthattheamountsofchangesarenotpresented;youeithereyeballthechangesoruseacalculatortocomputetheamountsofchangesduringtheyear.Forexample,theendingbalancesofabusiness’sproperty,plantandequipmentassetaccountmaybereportedasfollows(inmillionsofpounds):£4,097,£4,187and£3,614forthelastthreefiscalyears.Onlytheseendingbalancesarepresentedinthecompany’scomparativebalancesheet–theincreaseordecreaseduringtheyearisnotpresented.

Athree-yearcomparativeformatenablesyoutoseethegeneraltrendofsalesrevenueandexpensesfromyeartoyearandthegeneraldriftintheamountsofthecompany’sassets,liabilitiesandowners’equityaccounts.Youcaneasilyspotanymajordifferencesineachlineofthecashflowstatementacrosstheyears.Whetheryoujustcastaglanceatadjacentamountsoractuallycalculatechanges,askyourselfwhethertheincreasesofacompany’sassetsandliabilitiesreportedinitsbalancesheetareconsistentwiththesalesgrowthofthebusinessfromyeartoyear.

Unusuallylargeincreasesinassetsthataregreatlyoutoflinewiththecompany’ssalesrevenuegrowthputpressureoncashflowandcouldcastseriousdoubtsonthecompany’ssolvency–whichweexplaininthenextsection.

CantheBusinessPayItsLiabilities?

Abusinesscanbuildupagoodsalesvolumeandhaveverygoodprofitmargins,butifthecompanycan’tpayitsbills

ontime,itsprofitopportunitiescouldgodownthedrain.Solvencyreferstotheprospectsofabusinessbeingabletomeetitsdebtandotherliabilitypaymentobligationsontime.Solvencyanalysisaskswhetherabusinesswillbeabletopayitsliabilities,lookingforsignsoffinancialdistressthatcouldcauseseriousdisruptionsinthebusiness’sprofit-makingoperations.Inshort,evenifabusinesshasacoupleofbillionquidinthebank,youshouldask:Howdoesitssolvencylook?

Tobesolventdoesn’tmeanthatabusinessmusthavecashinthebankequaltoitstotalliabilities.Suppose,forexample,thatabusinesshas£2millioninnon-interest-bearingoperatingliabilities(mainlycreditorsandaccruedexpensespayable),£1.5millioninoverdraft(dueinlessthanoneyear)and£3.5millioninlong-termdebt(dueoverthenextfiveyears).Thus,itstotalliabilitiesare£7million.Tobesolvent,thebusinessdoesnotneed£7millioninitsbankaccount.Infact,thiswouldbefoolish.

There’snopointinhavingliabilitiesifallthemoneywerekeptinthebank.Thepurposeofhavingliabilitiesistoputthemoneytogooduseinassetsotherthancash.Abusinessusesthemoneyfromitsliabilitiestoinvestinnon-cashassetsthatitneedstocarryonitsprofit-makingoperations.Forexample,abusinessbuysproductsoncreditandholdsthesegoodsinstockuntilitsellsthem.Itborrowsmoneytoinvestinitsfixedassets.

Solvencyanalysisaskswhetherassetscanbeconvertedquicklybackintocashsothatliabilitiescanbepaidontime.Willtheassetsgenerateenoughcashflowtomeetthebusiness’sliabilitypaymentobligationsastheycomedue?

Short-termsolvencyanalysislooksafewmonthsintothefutureofthebusiness.Itfocusesonthecurrentassetsofthebusinessinrelationtoitscurrentliabilities;thesetwoamountsarereportedinthebalancesheet.Aroughmeasureofacompany’sshort-termliabilitypaymentabilityisitscurrentratio–currentassets(cash,debtors,stockandprepaidexpenses)aredividedbycurrentliabilities(creditorsandaccruedexpensespayable,plusinterest-

bearingdebtcomingdueintheshortterm).A2-to-1currentratiousuallyisareasonablebenchmarkforabusiness–butdon’tswallowthisratiohook,lineandsinker.

A2-to-1currentratioisfairlyconservative.Manybusinessescangetbyonalowercurrentratiowithoutalarmingtheirsourcesofshort-termcredit.

Businessinvestorsandcreditorsalsolookatasecondsolvencyratiocalledthequickratio.Thisratioincludesonlyacompany’squickassets–cash,debtorsandshort-termmarketableinvestmentsinothercompanyshares(ifthecompanyhasany).Quickassetsaredividedbycurrentliabilitiestodeterminethequickratio.It’salsocalledtheacid-testratiobecauseit’saverydemandingtesttoputonabusiness.Moreinformally,it’scalledthepounceratio,asifalltheshort-termcreditorspouncedonthebusinessanddemandedpaymentinshortorder.

Manypeopleconsiderasafeacid-testratiotobe1-to-1–£1ofquickassetsforevery£1ofcurrentliabilities.However,becarefulwiththisbenchmark.Itmaynotbeappropriateforbusinessesthatrelyonheavyshort-termdebttofinancetheirinventories.Forthesecompanies,it’sbettertocomparetheirquickassetswiththeirquickliabilitiesandexcludetheirshort-termnotespayablethatdon’thavetobepaiduntilstockissold.

Thecurrentandacid-testratiosarerelevant.Butthesolvencyofabusinessdependsmainlyontheabilityofitsmanagerstoconvincecreditorstocontinueextendingcredittothebusinessandrenewingitsloans.Thecredibilityofmanagementisthemainfactor,notratios.Creditorsunderstandthatabusinesscangetintoatemporarybindandfallbehindonpayingitsliabilities.Asageneralrule,creditorsareslowtopulltheplugonabusiness.Shuttingoffnewcreditmaybetheworstthinglendersandothercreditorscoulddo.Thismayputthebusinessinatailspin,anditscreditorsmayendupcollectingverylittle.Usually,it’snotintheirinteresttoforceabusinessintobankruptcy,exceptasalastresort.

Alsocheckoutthegearing.Ifborrowingsaregrowingfasterthanretainedprofitsornewshareholderinvestments,thengearingisgoingup,asarethefinancingrisks.HavealookatChapter14toseewhatgearing/leverageisallabout.

AreThereAnyUnusualAssetsandLiabilities?

Mostbusinessesreportamiscellaneous,catch-allaccountcalledotherassets.Whoknowswhatmightbeincludedinhere?Ifthebalanceinthisaccountisnotverylarge,trustthattheauditordidnotletthebusinessburyanythingimportantinthisaccount.

Marketablesecuritiesistheassetaccountusedforinvestmentsinsharesandbonds(aswellasotherkindsofinvestments).Companiesthathavemorecashthantheyneedfortheirimmediateoperatingpurposesputtheexcessfundstoworkearninginvestmentincomeratherthanletthemoneyliedormantinabank

checkingaccount.Theaccountingrulesformarketablesecuritiesarefairlytight;youneedn’tbeconcernedaboutthisasset.

Ifyouencounteranassetorliabilityyou’renotfamiliarwith,lookinthefootnotestothefinancialstatements,whichpresentabriefexplanationofwhattheaccountsareandwhethertheyaffectprofitaccounting.(Weknow,youdon’tlikereadingfootnotes;neitherdowe.)Forexample,manybusinesseshavelargeliabilitiesforunfundedpensionplanobligationsforworkdoneinthepastbytheiremployees.Theliabilityrevealsthatthebusinesshasrecordedthiscomponentoflabourexpenseindeterminingitsprofitovertheyears.Theliabilitycouldbeaheavydemandonthefuturecashflowofthebusiness.

HowWellAreAssetsBeingUtilised?Theoveralltestofhowwellassetsarebeingusedistheassetturnoverratio,whichequalsannualsalesrevenuedividedbytotalassets.(Youhavetocalculatethisratio;mostbusinessesdonotreportthisratiointheirfinancialstatements,althoughaminoritydo.)Thisratioteststheefficiencyofusingassetstomakesales.Somebusinesseshavelowassetturnoverratios,lessthan2-to-1.Somehaveveryhighratios,suchas5-to-1.Eachindustryandretailsectorintheeconomyhasastandardassetturnoverratio,butthesedifferquiteabitfromindustrytoindustryandfromsectortosector.Thereisnostandardassetturnoverratioforallbusinesses.Asupermarketchaincouldn’tmakeitifitsannualsalesrevenueswereonlytwiceitsassets.Capital-intensiveheavymanufacturers,ontheotherhand,wouldbedelightedwitha2-to-1assetturnoverratio.

Financialreportreadersarewisetotrackacompany’sassetturnoverratiofromyeartoyear.Ifthisratioslips,the

companyisgettinglesssalesrevenueforeachpoundofassets.Ifthecompany’sprofitratioremainsthesame,itgetslessprofitoutofeachpoundofassets,whichisnotgoodnewsforequityinvestorsinthebusiness.

WhatIstheReturnonCapitalInvestment?

Weneedapracticalexampletoillustratethereturnoncapitalinvestmentquestionsyoushouldask.Supposeabusinesshas£12milliontotalassets,anditscreditorsandaccruedliabilitiesforunpaidexpensesare£2million.Thus,itsnetoperatingassets–totalassetslessitsnon-interest-bearingoperatingliabilities–are£10million.Wewon’ttellyouthecompany’ssalesrevenuefortheyearjustended.Butwewilltellyouthatitsearningsbeforeinterestandtax(EBIT)were£1.32millionfortheyear.Thebasicquestionyoushouldaskisthis:Howisthebusinessdoinginrelationtothetotalcapitalusedtomakethisprofit?

EBITisdividedbyassets(netoperatingassets,inourwayofthinking)togetthereturnonassets(ROA)ratio.Inthiscase,thecompanyearned13.2percentROAfortheyearjustended:

£1,320,000EBIT÷£10,000,000netoperatingassets=13.2%ROA

Wasthisratehighenoughtocovertheinterestrateonitsdebt?Sure;it’sdoubtfulthatthebusinesshadtopaya13.2percentinterestrate.Nowforthebottom-linequestion:Howdidthebusinessdoforitsowners,whohavealotofcapitalinvestedinthebusiness?

Thebusinessuses£4milliontotaldebt,onwhichitpays8percentannualinterest.Thus,itstotalowners’equityis£6million.Thebusinessisorganisedasacompanythatpays,forexample,30percenttaxonitstaxableincome.

Giventhecompany’scapitalisationstructure,itsEBIT(orprofitfromoperations)fortheyearjustendedwasdividedthreeways:

£320,000interestondebt:£4,000,000debt´8percentinterestrate=£320,000

£300,000incometax:£1,320,000EBIT–£320,000interest=£1,000,000taxableincome;£1,000,000taxableincome´30percenttaxrate=£300,000incometax

£700,000netincome:£1,320,000operatingearnings–£320,000interest–£300,000incometax=£700,000netincome

Netincomeisdividedbyowners’equitytocalculatethereturnonequity(ROE)ratio,whichinthisexampleis

£700,000netincome÷£6,000,000owners’equity=12%ROE

SomebusinessesreporttheirROEratios,butmanydon’t–generallyacceptedaccountingprinciplesdon’trequirethedisclosureofROE.Inanycase,asaninvestorinthebusiness,wouldyoubesatisfiedwitha12percentreturnonyourmoney?

Youmadeonly4percentmorethanthedebtholders,whichmaynotseemmuchofapremiumfortheadditionalrisksyoutakeonasanequityinvestorinthebusiness.Butyoumaypredictthatthebusinesshasabrightfutureandovertimeyourinvestmentwillincreasetwoorthreetimesinvalue.Inanycase,ROEisagoodpointofreference–althoughthisoneratiodoesn’tgiveyouafinalanswerregardingwhattodowithyourcapital.ReadingTonyLevene’sInvestingForDummies(Wiley)canhelpyoumakeawisedecision.

WhatDoestheAuditorSay?Abusinesspaysalotofmoneyforitsaudit,andyoushouldreadwhattheauditorhastosay.We’llbefrank:Thewordingoftheauditor’sreportistoughgoing.Talkaboutjargon!Inanycase,focusonthesentencethatstatestheauditor’sopiniononthefinancialstatements.Inroughterms,theauditorgivesthefinancialstatementsagreenlight,ayellowlightoraredlight–greenmeaningthateverything’sokay(asfarascanbeascertainedbytheprocessoftheaudit),yellowmeaningthatyoushouldbeawareofsomethingthatpreventstheauditorfromgivingagreenlightandredmeaningthatthefinancialstatementsareseriouslydeficient.

Lookforthekeywordstrueandfair.Thesecodewordsmeanthattheauditfirmhasnoseriousdisagreementwithhowthebusinessprepareditsfinancialstatements.Thisunqualifiedopinioniscalledacleanopinion.Onlyinthemostdesperatesituationsdoestheauditorgiveanadverseopinion,whichinessencesaysthatthefinancialstatementsaremisleading.Iftheauditfirmcan’tgiveacleanopiniononthefinancialstatementsorthinksthatsomethingaboutthefinancialstatementsshouldbeemphasised,afourthparagraphisaddedtothestandardthree-paragraphformatoftheauditreport(oradditionallanguageisaddedtotheone-paragraphauditreportusedbythebigaccountancyfirmPricewaterhouseCoopers).Theadditionallanguageisthetip-off;lookforafourthparagraph(oradditionallanguage),andbesuretoreadit.Theauditormayexpressdoubtaboutthebusinessbeingabletocontinueasagoingconcern.Thesolvencyratiosdiscussedearliershouldhavetippedyouoff.Whentheauditormentionsit,thingsareprettyserious.

Chapter19

TenWaystoGetaBetterHandleontheFinancialFuture

InThisChapterAppreciatingthedifferencebetweenforecastsandobjectives

Puttingyourmathstowork

Unravellingthereasonsfortrends

Gettingattherealfacts

Keepingprojectionscurrent

Buildinginassumptions

Managersareaccustomedtousingaccountingtounravelthepast.Accountsareusuallyarecordoftheeffectoflastyear’s,month’sorweek’sdecisions.Didyourstrategiesforcollectingmoneyfromcustomersmorequicklyorreducingstocklevelsactuallyhappen,andifso,didtheydeliverbetterprofits?(WecoverthisareainChapter6.)

Butthepast,asthesayinggoes,isanothercountry.Thefutureiswherereputationsaremadeandpromotionachieved.Managersgetmaximumvaluefromtheirgraspofaccountingandfinancefrombeingabletoblendthatknowledgewithsomerelatedskillstogetabetterhandleonthegroundahead.

SalesForecastsversusSalesObjectives

ObjectivesSalesdrivemuchofabusiness’sactivities;theydeterminecashflow,stocklevels,productioncapacityandultimatelyhowprofitableorotherwiseabusinessis.So,unsurprisingly,mucheffortgoesintoattemptingtopredictfuturesales.Asalesforecastisn’tthesameasasalesobjective.Anobjectiveiswhatyouwanttoachieveandwillshapeastrategytodoso.Aforecastisthemostlikelyfutureoutcomegivenwhathashappenedinthepastandthemomentumthatprovidesforthebusiness.

Aforecastismadeupofthreecomponentsandtogetanaccurateforecastyouneedtousethehistoricdatatobetterunderstandtheimpactofeachontheendresult:

Underlyingtrend:Thisisthegeneraldirection–up,flatordown–overthelongerterm,showingtherateofchange.

Cyclicalfactors:Thesearetheshort-terminfluencesthatregularlysuperimposethemselvesonthetrend.Forexample,inthesummermonthsyouexpectsalesofswimwear,icecreamandsuntanlotion,tobehigherthaninthewinter.Skiequipmentwouldfollowareversepattern.

Randommovements:Theseareirregular,randomspikesupordowncausedbyunusualandunexplainedfactors.

DealingwithDemandCurvesThepriceyouchargeforyourgoodsandservicesisperhapsthesinglemostimportantnumberinthefinancialfirmament.Predictionsaboutwhatpricetosetinfluenceseverythingfromtheamountofmaterialsyouhavetobuytoachieveagivenlevelofprofit(thehighertheprice,thelessyouhavetopurchase),totheamountofmoneyyouhavetoinvestinfixedassets(alowpricemayinvolvesellingalotmoretomakeagivenlevelofprofit,requiringahigherlevelofproductiveresources).

Figure19-1:Thedemandcurve.

higherlevelofproductiveresources).

Themaineconomicconceptthatunderpinsalmostthewholesubjectofpricingisthatofthepriceelasticityofdemand.Theconceptitselfissimpleenough.Thehigherthepriceofanitemorservice,thelessofityou’relikelytosell.Obviouslyit’snotquitethatsimpleinpractice;youalsoneedtoconsiderthenumberofbuyers,theirexpectations,preferenceandabilitytopay,andtheavailabilityofsubstituteproducts.Figure19-1showsatheoreticaldemandcurve.

Figure19-1showshowthevolumeofsalesofaparticulargoodorservicealterswithchangesinprice.Youcalculatetheelasticityofdemandbydividingthepercentagechangeindemandbythepercentagechangeinprice.Ifapriceisreducedby50%(say,from£100to£50)andthequantitydemandedincreasedby100%(from1,000to2,000),theelasticityofdemandcoefficientis2(100/50).Herethequantitydemandedchangesbyabiggerpercentagethanthepricechange,sodemandisconsideredtobeelastic.Werethedemandinthiscasetorisebyonly25%,thentheelasticityofdemandcoefficientwouldbe0.5(25/100).Herethedemandisinelastic,asthepercentagedemandchangeissmallerthanthatofthepricechange.

Havingafeelforelasticityisimportantindevelopingabusiness’sfinancialstrategy,butthere’snoperfectscientificwaytoworkoutwhatthedemandcoefficientis;ithastobeassessedby‘feel’.Unfortunatelythepriceelasticitychangesatdifferentpricelevels.Forexample,reducingthepriceofvodkafrom£10to£5mightdoublesales,buthalvingitagainmaynothavesuchadramaticeffect.Infactitcouldencourageacertaingroupofbuyers,thosegivingitasagiftforexample,tofeelthatgivingsomethingsocheapisratherinsulting.

MathsMattersThesimplestwaytopredictthefutureistoassumethatitwillbemoreorlessthesameastherecentpast.DespiteHenryFord’sattributedquotethathistoryisbunk,veryoftenthepastisaverygoodguidetowhat’slikelytohappeninthefairlyimmediatefuture–farenoughaheadforbudgetingpurposes,ifnotforshapinglong-termstrategy.

Thethreemostcommonmathematicaltechniquesthatusethisapproachareasfollows:

Movingaveragetakesaseriesofdatafromthepast,say,thelastsixmonths’sales,addsthemup,dividesbythenumberofmonthsandusesthatfigureasthemostlikelyforecastofwhatwillhappeninmonthseven.Thismethodworkswellinastatic,maturemarketplacewherechangehappensslowly,ifatall.

Weightedmovingaveragegivesmorerecentdatamoresignificancethanearlierdatabecauseitgivesabetterrepresentationofcurrentbusinessconditions.Sobeforeaddinguptheseriesofdata,eachfigureisweightedbymultiplyingitbyanincreasinglyhigherfactorasyougetclosertothemostrecentdata.

Exponentialsmoothingisamoresophisticatedaveragingtechniquethatgivesexponentiallydecreasingweightsasthedatagetsolder.Morerecentdataisgivenrelativelymoreweightinmakingtheforecasting.Youcanusedoubleandtripleexponentialsmoothingtohelpwithdifferenttypesoftrend.

Fortunatelyallyouneedtoknowisthattheseandotherstatisticalforecastingmethodsexist.Thechoiceofwhichisthebestforecastingtechniquetouseisusuallydowntotrialanderror.

Varioussoftwareprogramscalculatethebest-fittingforecastbyapplyingeachofthesetechniquestothehistoricdatayouenter.Seewhatactuallyhappensandusetheforecasttechniquethat’sclosesttotheactualoutcome.ProfessorHosseinArshamoftheUniversityofBaltimoreprovidesausefultoolthatenablesyoutoenterdataandseehowdifferentforecastingtechniquesperform.(http://home.ubalt.edu/ntsbarsh/Business-stat/otherapplets/ForecaSmo.htm#rmenu)

DukeUniversity’sFuquaSchoolofBusinessprovidesahelpfullinktoalltheirlecturematerialonforecasting(www.duke.edu/~rnau/411home.htm).

AveragingOutAveragesAcommonwayforecastsarepredictedisaroundasinglefigurethatpurportstoberepresentativeofawholemassofoftenconflictingdata.Thissinglefigureisusuallyknownasanaverage,withtheprocessofaveragingseenasawayofsmoothingoveranyconflicts.Whensomecustomerspayonepriceandothersquiteadifferent

one,anaverageisusedasthebasisforforecasting.Thatwouldbeallfineanddandywereitnotforthefactthatyouhavethreedifferentwaysofmeasuringanaverage(themean,medianandmode).Infact,averagesarethemostfrequentlyconfusedandmisrepresentedsetofnumbersinthewholefieldofforecasting.

ToanalyseanythingforforecastingpurposesyoufirstneedadatasetsuchasthatinTable19-1.

Youthenhavethreewaysofworkingwiththenumbers:

Themean(oraverage):Thisisthemostcommontendencymeasureandisusedasaroughandreadycheckformanytypesofdata.InTable19-1youadduptheprices(£105)anddividebythenumberofcustomers(5),toarriveatamean,oraveragesellingpriceof£21.

Themedian:Themedianisthevalueoccurringatthecentreofadataset.RecastingthefiguresinTable19-1inorderputsCustomer4’spurchasepriceof£15incentralposition,withtwohigherandtwolowerprices.Themediancomesintoitsowninsituationswheretheoutlyingvaluesinadatasetareextreme,astheyareintheexample,where,infact,mostofthecustomersbuyforwellbelow£21.Inthiscasethemedianisabettermeasureoftheaverage.

Figure19-2:Scatterdiagram.

Alwaysusethemedianwhenthedistributionisskewed.Youcanuseeitherthemeanorthemedianwhenthepopulationissymmetricalbecausethey’llgiveverysimilarresults.

Themode:Themodeistheobservationinadatasetthatappearsthemost;inthisexampleitis£10.Soifyouweresurveyingasampleofcustomersyou’dexpectmoreofthemtosaytheywerepaying£10fortheproducts,eventhoughyouknowtheaveragepriceis£21.

LookingforCausesOftenwhenlookingathistoricdata(thebasisofallprojections),arelationshipbetweencertainfactorsbecomesapparent.LookatFigure19-2,whichisachartshowingthemonthlysalesofbarbequesandtheaveragetemperatureintheprecedingmonthforthepasteightmonths.

Youcanclearlyseearelationshipbetweentemperature(theindependentvariable)andsales(thedependantvariable).By

Figure19-3:Scatterdiagramwiththelineofbestfit.

drawingthelinethatmostaccuratelyrepresentstheslope,calledthelineofbestfit(seeFigure19-3),youhaveausefultoolforestimatingwhatsalesmightbenextmonth,giventhetemperaturethatoccurredthismonth.

Thisexampleisasimpleone.Reallifedataisusuallymorecomplicated,soit’shardertoseearelationshipbetweentheindependentanddependantvariableswithreallifedatathanitishere.Fortunately,analgebraicformulaknownaslinearregressioncancalculatethelineofbestfitforyou.

Acoupleofcalculationscantestifacausalrelationshipisstrong(evenifstronglynegative,thetestisstillusefulforpredictivepurposes)andsignificant–thestatisticianswayoftellingyouifyoucanrelyonthedataasanaidtopredictingthefuture.ThetestsareknownasR-SquaredandtheStudentsttest,andallyouneedtoknowisthattheyexistandthatyoucanprobablyfindthesoftwaretocalculatethemonyourcomputer.

TryWeb-EnabledScientificServices&Applications’(www.wessa.net/slr.wasp)freesoftware,whichcoversalmosteverytypeofstatisticcalculation.Forhelpinunderstandingstatisticaltechniques,readGerardE.Dallal’sbookTheLittleHandbookofStatisticalPracticeavailablefreeonline(www.tufts.edu/~gdallal/LHSP.HTM).AtPrincetonUniversity’swebsiteyoucanfindatutorialandlecturenotesonthesubjectastaughttotheirMasterofInternationalBusinessstudents(http://dss.princeton.edu/online_help/analysis/interpreting_regression.htm

StraddlingCyclesEconomiestendtofollowacyclicalpatternthatmovesfromboom,whendemandisstrong,toslump,economists’shorthandforadownturn.Politiciansbelievetheyhavebecomebettermanagersofdemandandproclaimthedeathofthecycle,butthe‘thistimeit’sdifferent’schoolofthinkinghasbeenprovedwrongtimeandtimeagain.Thecycleitselfiscausedbythecollectivebehaviourofbillionsofpeople–theunfathomable‘animalspirits’ofbusinessesandhouseholds.MaynardKeynes,theBritisheconomistwhosestrategyofencouraginggovernmentstostepupinvestmentinbadtimesdidmuchtoalleviatetheslumpinthe1930s,explainedanimalspiritsinthefollowingway:‘Most,probably,ofourdecisionstodosomethingpositive,thefullconsequencesofwhichwillbedrawnoutovermanydaystocome,canonlybetakenastheresultofanimalspirits–aspontaneousurgetoactionratherthaninaction,andnotastheoutcomeofaweightedaverageofquantitativebenefitsmultipliedbyquantitativeprobabilities’.

Addedtotheurgetoactistheequallyinevitableherd-likebehaviourthatleadstoexcessiveoptimismandpessimism.Fromthetulipmaniain17th-centuryHollandandtheSouthSeaBubble(1711–1720),totheInternetBubblein1999andthecollapseinUS

Figure19-4:Thetextbookeconomiccycle.

(1711–1720),totheInternetBubblein1999andthecollapseinUSrealestatein2008,thestorybehindeachbubblehasbeenuncomfortablyfamiliar.Strongmarketdemandforsomecommodity(suchasgold,copperoroil),currency,propertyortypeofshareleadsthegeneralpublictobelievethetrendcannotend.Over-optimismleadsthepublicatlargetooverextenditselfinacquiringtheobjectofthemania,whilelendersfallovereachothertofantheflames.Finally,eitherthemoneyrunsoutorgroupsofinvestorsbecomecautious.Fearturnstopanicselling,socreatingaviciousdownwardspiralthatcantakeyearstorecoverfrom.

Economicsisascienceoftheindistinctlyknowableratherthantheexactlypredictable.Althoughallcyclesaredifficulttounderstandorpredictwithmuchaccuracy,theydohavediscernablepatternsandsomedistinctivecharacteristics.Givesomeconsiderationtowhereyouthinkyouareinthecycleandbuildthatintoyourprojections.

Figure19-4showsanelegantcurve,whichdepictsthetheoreticaltextbookcycle.

TheNationalBureauofEconomicResearchprovidesahistoryofallUSbusinesscycleexpansionsandcontractionssince1854(www.nber.org/cycles.htm).TheFoundationfortheStudyofCycles,aninternationalresearchandeducationalinstitution,providesadetailedexplanationofdifferentcycles(http://foundationforthestudyofcycles.org).TheCentreforGrowthandBusinessCycleResearchbasedinManchesterUniversity’sSchoolofSocialSciencesprovidesdetailsofcurrentresearch,recentpublicationsanddownloadablediscussionpapersonallaspectsofbusinesscycles(www.socialsciences.manchester.ac.uk/cgbcr).

SurveyingFutureTrendsSurveysarethemostcommonresearchmethodusedinorganisationstogetahandleonalmosteveryaspectoffuturedemand.Ifyouaskyourcustomershowmuchtheyplantospendontheirnextholiday,car,haircutorlaptop,youhaveafiguretobaseyourprojectionson.Leavingasidethepracticalaspectsofpreparingandexecutingsurveys(readStatisticsForDummiesbyDeborahJ.Rumsey(Wiley)tofindoutaboutthat),tobesureofthedegreetowhichsurveysarelikelytobemeaningful,youneedamodestgraspofmaths.

Thesizeofthesurveyyouundertakeisvitaltoitsaccuracy.Youfrequentlyhearofpoliticalopinionpollstakenonsamplesof1,500–2,000voters.Thisisbecausetheaccuracyofyoursurveyclearlyincreaseswiththesizeofsample,asTable19-2shows:

Ifonasamplesizeof500,yoursurveyshowedthat40percentofyourcustomersplantospend£1,000onyourproducts,thetrueproportionwouldprobablyliebetween35.6and44.4percent.Asampleof250completedrepliesisabouttheminimumtoprovidemeaningfulinformation.

AndrewsUniversityintheUnitedStateshasafreesetoflecturenotesexplainingthesubjectofsamplesizecomprehensively(www.andrews.edu/~calkins/math/webtexts/prod12.htm).Atwww.auditnet.org/docs/statsamp.xlsyoucanfindsomegreatspreadsheetsthatdotheboringmathsofcalculatingsamplesizeandaccuracyforyou.

TalkingToTheTroopsFinancialforecastsareusuallyinthedomainoftopmanagementandseniorstaffsuchasCFOs.Howeverallthedecisionsthathaveadirectbearingontheseforecastsrelyoninformationprovidedbypeopleonthefrontline.Theyknowwherethebodiesare,soitmakesgoodsensetotalktothemearlyintheplanningprocess.

makesgoodsensetotalktothemearlyintheplanningprocess.Also,youneedtheircommitmentbecausechancesarethey’llhaveabiginfluenceonwhetheryourprojectionsbearfruit.

Thisprocessisknownasbottomupprojection.Itinvolves,forexample,buildingupasalesforecastcustomerbycustomerforeveryproductorservicetheybuyormaybuy.Bottomupprojectionalsorequiresanestimateofhowmanycustomerswillbelostandwon.Clearlyonlysomeonewithdetailedknowledgecanpreparethis.Youcancheckthisagainstyourtopdownprojection,basedon,say,usingasalesforecastingtechniquesuchasthosecoveredearlierinthischapter.Ifyoufindawidedivergencebetweenyourtheoreticalprojectionsandthosemadebythefrontlinetroops,discussthemandcomeupwithaconsensusthateveryonecanbuyinto.

SettingOutAssumptionsAllfutureprojectionsarebasedonassumptions–thestageoftheeconomiccycle,governmentstrategiesontaxandexpenditure,marketsizeandgrowthrates,thelevelandtypeofcompetition...ohyes,andtheweathercomesintofutureprojectionstoo.ThepeoplerunningHeathrowhadn’texpectedthelastweekof2010todeliversomuchsnowitshuttheairportjustaspeakChristmasdemandwasabouttogetunderway.

Eventheenvironmentgetsalookinhere.Eyjafjallajökull,theIcelandicvolcanothateruptedinApril2010,causedairtrafficaroundEuropeandacrosstheAtlantictogrindtoahaltforsixdays.Airlineslostuptohalftheirannualprofits,businesspassengerswerestrandedfordaysandsupplychainsshortenedbyjust-in-timepurchasingstrategiesdriedup.Now,arguably,businesscoulddolittledirectlyorimmediatelytomitigatetheseproblems,butthe

littledirectlyorimmediatelytomitigatetheseproblems,buttheexperienceservedtodemonstratetheinterconnectionofseeminglyremoteenvironmentalfactorsandmademoreobviousthereasonsbusinesseshavetotakeissuessuchasclimatechangeseriously.Evenifyouareinnodanger–unlikeLohachara,thefirstinhabitedislandtobewipedoffthefaceoftheEarthbyglobalwarmingin2006–you’lleventuallybeaffectedbyenvironmentalissues.Sobuildthemintoyourthinkingwhenmakingfuturefinancialprojections,ifonlytostate,forexample,‘theseplansarebasedontheassumptionthattheweatherwillbenomoreextremethaninthepastfiftyyears’.

Payparticularattentiontoanyoutsidefactorsthatcanhaveasignificanteffectonsalesrevenue–demandorpricepressures;costoravailabilityofmaterialsandkeyservices;labourcosts,rents,taxesandexchangerates.

MakingRegularRevisionsLucaPaccioli,whowrotetheworld’sfirstaccountingbookover500yearsago,claimedthat‘frequentaccountingmakesforlongfriendships’.Nodoubthewashopingtosellmorecopiesofhisbook(whatauthorisn’t?),buthecouldhavesaidmuchthesameaboutfinancialprojections.Thebusinessworldisdynamic,recentlytoanalarmingdegree.Frequentlyrevisityourprojectionstoseeiftheystillholdgood.Unforeseenandunforeseeableeventssuchasthelossofamajorcustomerortheentryofanewplayerintothemarketcanthrowplansoffcourse.Sure,youmaybeabletogetbackontrack,butthatmaymeanmakingmorechangesintheshorttermtogettoyourlong-termdestination.

Somemanagersthinkrevisingprojectionstobeasignofweakness.MaynardKeynes,oneofthegreatesteconomicgurusofalltimeand

MaynardKeynes,oneofthegreatesteconomicgurusofalltimeandamanwhomadeafortuneoutofthestockmarketovertheperiodofthegreatdepression,summedupthesubjectneatly:‘Whenthefactschange,Ichangemymind.’

Revisionsareonething;constantsailtrimmingissomethingquitedifferent.Thearmymaxim–order,counterorder,disorder–isonethatholdsgoodhere.Rollingquarterlyprojectionsworkbest,givingtheremainingplanningperiodtheonce-overwhileaddinganewquarter.Thatwayyoualwayshaveatleastonefullyear’shorizontoyourprojection.

AppendixA

Glossary:SlashingthroughtheAccountingJargonJungleYoucan

keepupwiththelatestfinancialjargonontheFreeDictionaryWebsiteat

http://financial-

dictionary.thefreedictionary.com.accounting:Themethodsandproceduresforanalysing,recording,accumulatingandstoringfinancialinformationabouttheactivitiesofanentity,andpreparingsummaryreportsoftheseactivitiesinternallyformanagersandexternallyforthoseentitledtoreceivefinancialreportsabouttheentity.

accountingequation:Assets=Liabilities+Owners’Equity.Thisbasicequationisthefoundationfordouble-entryaccountingandreflectsthebalancebetweenabusiness’sassetsandthesourcesofcapitalthatisinvestedinitsassets.

AccountingStandardsBoard(ASB):Thehighestauthoritativeprivate-sectorstandard-settingbodyoftheaccountingprofessionintheUnitedKingdom.TheASBissuespronouncementsthatestablishgenerallyacceptedaccountingprinciples(GAAP).

accrual-basisaccounting:Fromtheprofitaccountingpointofviewthisreferstorecordingrevenueatthetimesalesaremade(ratherthanwhencashisactuallyreceivedfromcustomers),andrecordingexpensestomatchwithsalesrevenueorintheperiodbenefited(ratherthanwhenthecostsarepaid).Fromthefinancialconditionpointofviewthisreferstorecordingseveralassets,suchasreceivablesfromcustomers,costofstock(productsnotyetsold)

andcostoflong-termassets(fixedassets);andrecordingseveralliabilitiesinadditiontodebt(borrowedmoney),suchaspayablestovendorsandpayablesforunpaidexpenses.

accruedexpensespayable:Onemaintypeofshort-termliabilitiesofabusinessthatarisefromthegradualbuild-upofunpaidexpenses,suchasholidaypayearnedbyemployeesorprofit-basedbonusplansthataren’tpaiduntilthefollowingperiod.Caution:Thespecifictitlesofthisliabilityvaryfrombusinesstobusiness;youmayseeaccruedliabilities,accruedexpensesorsomeothersimilaraccountname.

accumulateddepreciation:Thetotalcumulativeamountofdepreciationexpensethathasbeenrecordedsincethefixedassetsbeingdepreciatedwereacquired.Inthebalancesheettheamountinthisaccountisdeductedfromthecostoffixedassets.(Thusitissometimesreferredtoasacontraaccount.)Thepurposeistoreporthowmuchofthetotalcosthasbeendepreciatedovertheyears.Thebalanceofcostlessaccumulateddepreciationisincludedinthetotalassetsofabusiness–whichisknownasthebookvalueoftheassets.

acid-testratio:Seequickratio.

activitybasedcosting(ABC):TheABCapproachclassifiesoverheadcostsintoseparatecategoriesofsupportactivitiesthatareneededinmanufacturingoperationsandinotherareasofthebusinessorganisation(suchasasalesterritory).Costdriversaredevelopedforeachsupportactivitytomeasuretheextentofusageofthatsupport.Theannualcostofeachsupportactivityisallocatedtomanufacturingandotherareasaccordingtohowmanycostdriverunitsareused.

AlternativeInvestmentMarket(AIM):AstockmarketinLondonforsharesinsmallandrelativelyunprovenbusinesses.

annualisedrateofinterestandrateofreturn:Theresultoftakingarateofinterestorarateofreturnoninvestmentforaperiodshorter

thanoneyearandconvertingitintoanequivalentratefortheentireyear.Supposeyouearn2percentinterestrateeveryquarter(threemonths).Yourannualisedrateofinterest(asifyoureceivedinterestonceayearattheendoftheyear)equals8.24percentrounded–whichisnotsimply4timesthe2percentquarterlyrate.(Theannualisedrateequals[1+0.02]raisedtothefourthpowerminusone.)Seealsocompoundinterest.

assetturnoverratio:Ameasureofhoweffectivelyassetswereusedduringaperiod,usuallyoneyear.Tofindtheassetturnoverratio,divideannualsalesrevenueeitherbytotalassetsorbynetoperatingassets,whichequalstotalassetslessshort-term,non-interest-bearingliabilities.

AssociationofCharteredAccountants(ACA):TheACAdesignationisawidelyrecognisedandrespectedbadgeofaprofessionalaccountant.Apersonmustmeeteducationalandexperiencerequirementsandpassanationaluniformexamtoqualify.

auditreport:Aone-pagestatementissuedbyanaccountancyfirm,afterhavingexaminedacompany’saccountingsystem,records,andsupportingevidence,thatgivesanopinionwhetherthecompany’sfinancialstatementsandfootnotesarepresentedfairlyinconformitywithgenerallyacceptedaccountingprinciples.Annualauditsarerequiredbylimitedcompaniesofpubliclyownedcorporations;manyprivatelyheldbusinessesalsohaveaudits.Theauditormustbeindependentofthebusiness.Anauditorexpressesdoubtsaboutthefinancialviabilityofabusinessifitisindirefinancialstraits.

baddebts:Theparticularexpensethatarisesfromacustomer’sfailuretopaytheamountowedtothebusinessfromapriorcreditsale.Whenthecreditsalewasrecorded,theaccountsreceivableassetaccountwasincreased.Whenitbecomesclearthatthisdebtowedtothebusinesswillnotbecollected,theassetaccountiswritten-offandtheamountischargedtobaddebtsexpense.

balancesheet:Thefinancialstatementthatsummarisestheassets,

liabilitiesandowners’equityofabusinessataninstantmomentintime.Preparedattheendofeveryprofitperiod,andwheneverneeded,thebalancesheetshowsacompany’soverallfinancialsituationandcondition.

basicearningspershare(EPS):Equalsnetincomefortheyear(themostrecenttwelvemonthsreported,calledthetrailingtwelvemonths)dividedbythenumberofsharesofabusinesscorporationthathavebeenissuedandareownedbyshareholders(calledthenumberofsharesoutstanding).Seealsodilutedearningspershare.BasicEPSanddilutedEPSarethemostimportantfactorsthatdrivethemarketvalueofsharesissuedbypubliclyownedcorporations.

bookvalueofassets:Referstotherecordedamountsofassetswhicharereportedinabalancesheet–usuallythetermisusedtoemphasisethattheamountsrecordedintheaccountsofthebusinessmaybelessthanthecurrentreplacementcostsofsomeassets,suchasfixedassetsboughtmanyyearsagothathavebeendepreciated.

bookvalueofowners’equity,intotalorpershare:Referstothebalancesheetvalueofowners’equity,eitherintotaloronaper-sharebasisforcorporations.Bookvalueofowners’equityisnotnecessarilythepricesomeonewouldpayforthebusinessasawholeorpershare,butitisausefulreference,orstartingpointforsettingmarketprice.

break-evenpoint(salesvolume):Theannualsalesvolume(totalnumberofunitssold)atwhichtotalcontributionmarginequalstotalannualfixedexpenses–thatis,theexactsalesvolumeatwhichthebusinesscoversitsfixedexpensesandmakesazeroprofit,orazerolossdependingonyourpointofview.Salesinexcessofthebreak-evenpointcontributetoprofit,insteadofhavingtogotowardscoveringfixedexpenses.Thebreak-evensalesvolumeisausefulpointofreferenceforanalysingprofitperformanceandtheeffectsofoperatingleverage.

budgeting:Theprocessofdevelopingandadoptingaprofitand

financialplanwithdefinitegoalsforthecomingperiod–includingforecastingexpensesandrevenues,assets,liabilitiesandcashflowsbasedontheplan.

burdenrate:Anamountperunitthatisaddedtothedirectcostsofmanufacturingaproductaccordingtosomemethodfortheallocationofthetotalindirectfixedmanufacturingcostsfortheperiod,whichcanbeacertainpercentageofdirectcostsorafixedpoundamountperunitofthecommondenominatoronwhichtheindirectcostsareallocatedacrossdifferentproducts.Thus,theindirectcostsarea‘burden’onthedirectcosts.

businessangel:Privateindividualswhoinvestinentrepreneurialbusinesseswithaviewtomakingasubstantialcapitalgainandperhapshelpingwiththemanagement.

capitalexpenditures:Outlaysforfixedassets–tooverhaulorreplaceoldfixedassets,ortoexpandandmodernisethelong-livedoperatingresourcesofabusiness.Fixedassetshaveusefullivesfrom3to39(ormore)years,dependingonthenatureoftheassetandhowit’susedintheoperationsofthebusiness.Theterm‘capital’hereimpliesthatsubstantialamountsofmoneyarebeinginvestedthataremajorcommitmentsformanyyears.

capitalstock:Thecertificatesofownershipissuedbyacorporationforcapitalinvestedinthebusinessbyowners;totalcapitalisdividedintounits,calledsharesofcapitalstock.Holdersofsharesparticipateincashdividendspaidfromprofit,voteinboardmemberelections,andreceiveassetliquidationproceeds;andhaveseveralotherrightsaswell.Abusinesscorporationmustissueatleastoneclassofsharecalledordinaryshares,whichintheUSareknownascommonstock.Itmayalsoissueotherclassesofstock,suchaspreferenceshares.

cashflow(s):Inthemostgeneralandbroadestsensethistermreferstoanykindofcashinflowsandoutflowsduringaperiod–moniescomingin,andmoniespaidout.

cashflowfromoperatingactivities:Seecashflowfromprofit.

cashflowfromprofit:Inthecashflowstatementthisiscalledcashflowfromoperatingactivities,whichequalsnetincomefortheperiod,adjustedforchangesincertainassetsandliabilities,andfordepreciationexpense.Somepeoplecallthisfreecashflowtoemphasisethatthissourceofcashisfreefromtheneedtoborrowmoney,issuecapitalstocksharesorsellassets.Becareful:Thetermfreecashflowisalsousedtodenotecashflowfromprofitminuscapitalexpenditures.(Somewritersdeductcashdividendsalso;usagehasnotcompletelysettleddown.)cashflowstatement:Thisfinancialstatementofabusinesssummarisesitscashinflowsandoutflowsduringaperiodaccordingtoathreefoldclassification:cashflowfromprofit(or,operatingactivities),investingactivitiesandfinancingactivities.

chartofaccounts:Theofficial,designatedsetofaccountsusedbyabusinessthatconstituteitsgeneralledger,inwhichthetransactionsofthebusinessarerecorded.

CompaniesActs:AseriesofUKlawsgoverningtheestablishmentandconductofincorporatedbusinesses,consolidatedintotheCompaniesAct2006.

compoundinterest:‘Compound’isacodewordforreinvested.Interestincomecompoundswhenyoudon’tremoveitfromyourinvestment,butinsteadleaveitinandaddittoyourinvestmentorsavingsaccount.Thus,youhaveabiggerbalanceonwhichtoearninterestthefollowingperiod.

comprehensiveincome:Includesnetincomewhichisreportedintheprofitandlossaccountpluscertaintechnicalgainsandlossesinassetsandliabilitiesthatarerecordedbutdon’tnecessarilyhavetobeincludedintheprofitandlossaccount.Mostcompaniesreporttheircomprehensivegainsandlosses(iftheyhaveany)intheirstatementofchangesinowners’equity.

conservatism:Ifthereischoiceastotheamountofcertainfigures,

whenpreparingaccountsthelowerfigureforassetsandthehigherforliabilitiesshouldbeused.

contributionmargin:Equalssalesrevenueminuscostofgoodssoldexpenseandminusallvariableexpenses(inotherwords,contributionmarginisprofitbeforefixedexpensesarededucted).Onaperunitbasis,contributionmarginequalssalespricelessproductcostperunitandlessvariableexpensesperunit.

cookingthebooks:Referstoanyoneofseveralfraudulent(deliberatelydeceitfulwithintenttomislead)accountingschemesusedtooverstateprofitandtomakethefinancialconditionlookbetterthanitreallyis.Cookingthebooksisdifferentfromprofitsmoothingandwindowdressing,whicharetolerated–thoughnotencouraged–infinancialstatementaccounting.Cookingthebooksforincometaxisjustthereverse:Itmeansoverstating,orexaggerating,deductibleexpensesorunderstatingrevenuetominimizetaxableincome.

corporateventuring:Referstolargecompaniestakingashareofsmallentrepreneurialventuresinordertohaveaccesstoanewtechnology.Ifthisapproachworks,theyoftenbuyoutthewholebusiness.

corporationtax:TaxpaidbyUKcompanies(withsomeexceptions)on‘chargeableprofits’.Ratesarefixedeachyearbythegovernment.Reducedratesapplyforsmallbusinesses.

cost-benefitanalysis:Analysisofthecostsandbenefitsofaparticularinvestmentoraction,conductedtoestablishifthatactionisworthwhilefromapurelyaccountingperspective.

costofcapital:Forabusiness,thisreferstojointtotaloftheinterestpaidondebtcapitalandtheminimumnetincomeitshouldearntojustifytheowner’sequitycapital.Interestisacontractuallysetamountofinterest;nolegallysetamountofnetincomeispromisedtoowners.Abusiness’sreturnonassets(ROA)rateshouldideallybehigherthanitsweighted-averagecostofcapitalrate

(basedonthemixofitsdebtandequitycapitalsources).

creativeaccounting:Theuseofdubiousaccountingtechniquesanddeceptionsdesignedtomakeprofitperformanceorfinancialconditionappearbetterthanthingsreallyare.Seeprofitsmoothingandcookingthebooks.

creditors:Onemaintypeoftheshort-termliabilitiesofabusiness,representingtheamountsowedtovendorsorsuppliersforthepurchaseofvariousproducts,supplies,partsandservicesthatwereboughtoncredit;thesedonotbearinterest(unlessthebusinesstakestoolongtopay).IntheUS,creditorsortradecreditorsareusuallycalledaccountspayable.

creditcrunch:Atimewhencashisinshortsupply;businessesfinditdifficulttoraiseloansandwhentheycan,interestratesarerelativelyhigh.

currentassets:Includescashplusdebtors,stockandprepaidexpenses(andmarketablesecuritiesifthebusinessownsany).Theseassetsarecashorassetsthatwillbeconvertedintocashduringoneoperatingcycle.Totalcurrentassetsaredividedbytotalcurrentliabilitiestocalculatethecurrentratio,whichisatestofshort-termsolvency.

currentliabilities:Short-termliabilities,principallycreditors,accruedexpensespayable,corporationtaxpayable,overdraftsandtheportionoflong-termdebtthatfallsduewithinthecomingyear.Thisgroupincludesbothnon-interestbearingandinterest-bearingliabilitiesthatmustbepaidintheshort-term,usuallydefinedtobeoneyear.Totalcurrentliabilitiesaredividedintototalcurrentassetstocalculatethecurrentratio.

currentratio:Atestofabusiness’sshort-termsolvency(debt-payingcapability).Findthecurrentratiobydividingthetotalofitscurrentassetsbyitstotalcurrentliabilities.

debitsandcredits:Thesetwotermsareaccountingjargonfor

decreasesandincreasesthatarerecordedinassets,liabilities,owners’equity,revenueandexpenses.Whenrecordingatransaction,thetotalofthedebitsmustequalthetotalofthecredits.

debtors:Theshort-termassetsrepresentingtheamountsowedtothebusinessfromsalesofproductsandservicesoncredittoitscustomers.IntheUStheseareknownasaccountsreceivable.

deferredincome:Incomereceivedinadvanceofbeingearnedandrecognised.

depreciationexpense:Allocating(orspreadingout)afixedasset’scostovertheestimatedusefullifeoftheresource.Eachyearoftheasset’slifeischargedwithpartofitstotalcostastheassetgraduallywearsoutandlosesitseconomicvaluetothebusiness.Eitherreducingbalanceorstraight-linedepreciationisused;bothareacceptableundergenerallyacceptedaccountingprinciples(GAAP).

dilutedearningspershare(EPS):Dilutedearningspershareequalsnetincomedividedbythesumoftheactualnumberofsharesoutstandingplusanyadditionalsharesthatwillbeissuedundertermsofshareoptionsawardedtomanagersandfortheconversionofseniorsecuritiesintocommonstock(ifthecompanyhasissuedconvertibledebtorpreferenceshares).Inshort,thismeasureofprofitpershareisbasedonalargernumberofsharesthanbasicEPS(earningspershare).Thelargernumbercausesadilutionintheamountofnetincomepershare.Althoughhardtoproveforcertain,marketpricesofsharesaredrivenbydilutedEPSmorethanbasicEPS.

dividendyield:Measuresthecashincomecomponentofreturnoninvestmentinsharesofacorporation.Thedividendyieldequalsthemostrecent12monthsofcashdividendspaidonashare,dividedbytheshare’scurrentmarketprice.Ifashareissellingfor£100andoverthelast12monthshaspaid£3cashdividends,itsdividendyieldequals3percent.

double-entryaccounting:Symbolisedintheaccountingequation,whichcoversboththeassetsofabusinessaswellasthesourcesofmoneyfortheassets(whicharealsoclaimsontheassets).

duediligence:aprocessofthoroughlycheckingeveryaspectofabusiness’sposition,includingitsfinancialstateofaffairs,usuallyasapreludetoasaleortoraisingadditionalfunds.

earningsbeforeinterestandtaxes(EBIT):Salesrevenuelesscostofgoodssoldandalloperatingexpenses–butbeforedeductinginterestondebtandtaxexpenses.Thismeasureofprofitalsoiscalledoperatingearnings,operatingprofitorsomethingsimilar;terminologyisnotuniform.

earningsmanagement:Seeprofitsmoothing.

earningspershare:Seebasicearningspershareanddilutedearningspershare.

earn-out:Whenabusinessissold,buyersoftenmakepartoftheirofferconditionalonthefutureprofitsbeingasforecasted.This,ineffect,makesthesellerearnoutthatportion.

effectiveinterestrate:Therateactuallyappliedtoyourloanorsavingsaccountbalancetodeterminetheamountofinterestforthatperiod.Seealsoannualisedrateofinterestandrateofreturn.

equitycapital:Seeowners’equity.

externalfinancialstatements:Thefinancialstatementsincludedinfinancialreportsthataredistributedoutsideabusinesstoitsshareholdersanddebt-holders.

extraordinarygainsandlosses:Theseareunusual,non-recurringgainsandlossesthathappeninfrequentlyandthatareasidefromthenormal,ordinarysalesandexpensesofabusiness.

FinancialAccountingStandardsBoard(FASB):Thehighestauthoritativeprivate-sectorstandard-settingbodyoftheaccounting

professionintheUS.

financialleverage:Thetermisusedgenerallytomeanusingdebtcapitalontopofequitycapitalinanytypeofinvestment.Forabusinessitmeansusingdebtinadditiontoequitycapitaltoprovidethetotalcapitalneededtoinvestinitsnetoperatingassets.Thestrategyistoearnarateofreturnonassets(ROA)higherthantheinterestrateonborrowedmoney.Afavourablespreadbetweenthetworatesgeneratesafinancialleveragegaintothebenefitofowners’equity.

financialreports:Theperiodicfinanciallyorientedcommunicationsfromabusiness(andothertypesoforganisations)tothoseentitledtoknowaboutthefinancialperformanceandpositionoftheentity.Financialreportsofbusinessesincludethreeprimaryfinancialstatements(balancesheet,profitandlossaccountandstatementofcashflows),aswellasfootnotesandotherinformationrelevanttotheownersofthebusiness.

financialstatement:Thegenerictermforbalancesheet,cashflowstatementandprofitandlossaccount,allthreeofwhichpresentsummaryfinancialinformationaboutabusiness.

financingactivities:Oneofthreetypesofcashflowsreportedinthecashflowstatement.Thesearethedealingsbetweenabusinessanditssourcesofdebtandequitycapital–suchasborrowingsandrepaymentsofdebt,issuingnewsharesandbuyingsomeofitsownshares,andpayingdividends.

first-in,first-out(FIFO):Oneoftwowidely-usedaccountingmethodsbywhichcostsofproductswhentheyaresoldarechargedtocostofgoodssoldexpense.AccordingtotheFIFOmethod,costsofgoodsarechargedinchronologicalorder,sothemostrecentacquisitioncostsremaininstockattheendoftheperiod.However,thereverseorderalsoisacceptable,whichiscalledthelast-in,first-out(LIFO)method.

fixedassets:Theshorthandtermforthelong-life(generallythree

yearsorlonger)resourcesusedbyabusiness,whichincludesland,buildings,machinery,equipment,toolsandvehicles.Themostcommonaccounttitlefortheseassetsyouseeinabalancesheetis‘property,plantandequipment’.

fixedexpenses(costs):Thoseexpensesorcoststhatremainunchangedovertheshortrunanddonotvarywithchangesinsalesvolumeorsalesrevenue–commonexamplesarepropertyrentalandrates,salariesofmanyemployeesandtelephoneleasecosts.

footnotes:Footnotesareattachedtothethreeprimaryfinancialstatementstopresentdetailedinformationthatcannotbeputdirectlyinthebodyofthefinancialstatements.

freecashflow:Manypeopleusethistermtomeantheamountofcashflowfromprofit–althoughsomewritersdeductcapitalexpendituresfromthisnumber,andothersdeductcashdividendsaswell.

gearing:Therelationshipbetweenafirm’sdebtcapitalanditsequity.Thehighertheproportionofdebt,themorehighlygearedisthebusiness.IntheUS,thetermleverageisusuallyusedhere.

generalledger:Thecompletecollectionofalltheaccountsusedbyabusiness(orotherentity)torecordthefinancialeffectsofitsactivities.Moreorlesssynonymouswithchartofaccounts.

generallyacceptedaccountingprinciples(GAAP):Theauthoritativestandardsandapprovedaccountingmethodsthatshouldbeusedbybusinessesandprivatenot-for-profitorganisationstomeasureandreporttheirrevenueandexpenses,andtopresenttheirassets,liabilitiesandowners’equity,andtoreporttheircashflowsintheirfinancialstatements.

going-concernassumption:Theaccountingpremisethatabusinesswillcontinuetooperateandwillnotbeforcedtoliquidateitsassets.

goodwill:Goodwillhastwodifferentmeanings,sobecareful.The

termcanrefertotheproductorbrandnamerecognitionandtheexcellentreputationofabusinessthatprovideastrongcompetitiveadvantage.Goodwillinthissensemeansthebusinesshasanimportantbutinvisible‘asset’thatisnotreportedinitsbalancesheet.Second,abusinessmaypurchaseandpaycashforthegoodwillthathasbeenbuiltupovertheyearsbyanotherbusiness.Onlypurchasedgoodwillisreportedasanassetinthebalancesheet.

grossmargin(profit):Equalssalesrevenuelesscostofgoodssoldfortheperiod.Onaperunitbasis,grossmarginequalssalespricelessproductcostperunit.Makinganadequategrossmarginisthestartingpointformakingbottom-linenetincome.

hedgefund:Afundthatusesderivatives,shortsellingandarbitragetechniques,sellingassetsthatonedoesnotownintheexpectationofbuyingthembackatalowerprice.Thisgiveshedgefundmanagersarangeofwaystogenerategrowthinfalling,risingandeveninrelativelystaticmarkets.

hedging:Atechniqueusedtomanagecommercialriskortominimiseapotentiallossbyusingcounterbalancinginvestmentstrategies.

hostilemerger:Thetermusedwhereabusinessisacquiredagainstthewishesoftheincumbentmanagement.

hurdlerate:Therateofreturnrequiredbeforeaninvestmentisconsideredworthwhile.

hyperinflation:Asituationwherepricesincreasesoquicklythatmoneyisvirtuallyuselessasastoreofvalue.

imputedcost:Ahypotheticalcostusedasabenchmarkforcomparison.Oneexampleistheimputedcostofequitycapital.Noexpenseisrecordedforusingowners’equitycapitalduringtheyear.However,injudgingnetincomeperformance,thecompany’srateofreturnonequity(ROE)iscomparedwiththerateofearnings

thatcouldbeaccruedonthecapitalifitwereinvestedelsewhere.Thisalternativerateofreturnisanimputedcost.Closeinmeaningtotheeconomicconceptofopportunitycost.

incomesmoothing:Seeprofitsmoothing.

incomestatement:Americantermusedfortheprofitandlossaccount.

incometaxpayable:Thetaxdue,butasyetunpaid,onprofitsearned.

incubator:Usuallybothapremisesandsomeoralloftheservices(legal,managerialortechnical)neededtolaunchabusinessandaccessseedcapital.

initialpublicoffering(IPO):Thefirstofferofacompany’ssharesmadetothegeneralpublic.

insidertrading:Buyingorsellingsharesbasedoninformationnotinthepublicdomain.

internal(accounting)controls:Accountingforms,proceduresandprecautionsthatareestablishedprimarilytopreventandminimiseerrorsandfraud(beyondwhatwouldberequiredforrecordkeeping).

investingactivities:Oneofthreeclassesofcashflowsreportedinthecashflowstatement.Inlargepartthesearethecapitalexpendituresbyabusinessduringtheyear,whicharemajorinvestmentsinlong-termassets.Abusinessmaydisposeofsomeofitsfixedassetsduringtheyear,andproceedsfromthesedisposals(ifany)arereportedinthissectionofthecashflowstatement.

juniormarket:Astockmarket(suchastheAIM)wheresharesofsmalleroryoungercompaniesaretraded.

last-in,first-out(LIFO):Oneoftwowidelyusedaccountingmethodsbywhichcostsofproductswhentheyaresoldarechargedtocost

ofgoodssoldexpense.AccordingtotheLIFOmethod,costsofgoodsarechargedinreversechronologicalorder,oneresultbeingthattheendingstockcostvalueconsistsofthecostsoftheearliestgoodspurchasedormanufactured.Theoppositeorderisalsoacceptable,whichiscalledthefirst-in,first-out(FIFO)method.TheactualphysicalflowofproductsseldomfollowsaLIFOsequence.Themethodisjustifiedonthegroundsthatthecostofgoodssoldexpenseshouldbethecostofreplacingtheproductssold,andthebestapproximationisthemostrecentacquisitioncostsoftheproducts.

leverage:seefinancialleverageandoperatingleverage.

leveragedbuyout:Asituationwhereacompanyisboughtbyanotherfinancedmainlybydebt,suchasbankborrowings.

LIFOliquidationgain:Auniqueresultofthelast-in,first-out(LIFO)method,whichhappenswhenfewerunitsarereplacedthansoldduringtheperiod.Thedecreaseinstockrequiresthattheaccountantgobackintotheoldcostlayersofstockforpartofthecostofgoodssoldexpense.Thus,thereisaone-timewindfallgainingrossmargin,roughlyequaltothedifferencebetweenthehistoricalcostandthecurrentcostofthestockdecrease.AlargeLIFOliquidationgainshouldbedisclosedinafootnotetothefinancialstatements.

limitedliabilitycompany(Ltd):Companywhoseshareholdershavelimitedtheirliabilitytotheamountstheysubscribetothesharestheyhold.

listedcompany:Acompanywhosesharesareontheofficiallistofamajorstockmarket,suchastheLondonStockExchange.

managementaccounting:Thebranchofaccountingthatpreparesinternalfinancialstatementsandvariousotherreportsandanalysestoassistmanagerstodotheirjobs.

managementbuy-out:Thetermusedwhenthemanagementofa

businessbuysouttheexistingshareholders,usuallywiththehelpofaventurecapitalfirm.

marginofsafety:Equalstheexcessofactualsalesvolumeoverthecompany’sbreak-evenpoint;oftenexpressedasapercentage.Thisinformationisusedinternallybymanagersandisnotdisclosedinexternalfinancialreports.

marketcap:Thetotalvalueofabusinesscalculatedbymultiplyingthecurrentmarketpriceofitscapitalstockbythetotalnumberofsharesissuedbythebusiness.Thiscalculatedamountisnotmoneythathasbeeninvestedinthebusiness,andtheamountissubjecttothewhimsofthestockmarket.

netincome:Americantermusedtodescribeprofit.

netoperatingassets:Thetotalamountofassetsusedinoperatingabusiness,lessitsshort-termnon-interest-bearingliabilities.Abusinessmustraiseanequalamountofcapital.

netrealisablevalue(NRV):Aspecialaccountingtestappliedtostockthatcanresultinawrite-downandchargetoexpenseforthelossinvalueofproductsheldforsale.Therecordedcostsofproductsinstockarecomparedwiththeircurrentreplacementcosts(marketprice)andwithnetrealisablevalueifnormalsalespriceshavebeenreduced.Ifeithervalueislower,thenrecordedcostiswrittendowntothislowervalue.Note:Stockisnotwrittenupwhenreplacementcostsriseafterthestockwasacquired.

networth:Balancesheetvalueofowner’sstakeinthebusiness.Itconsistsbothofthemoneyputinatthestartandanyprofitsmadesinceandleftinthebusiness.

notestofinancialstatements:Notesattachedtothebalancesheetandincomestatementwhichexplain:(a)Significantaccountingadjustments;(b)Informationrequiredbylaw,ifnotdisclosedinthefinancialstatements.

operatingactivities:Theprofit-makingactivitiesofabusiness–thatis,thesalesandexpensetransactionsofabusiness.Seealsocashflowfromoperatingactivities.

operatingassets:Theseveraldifferentassets,oreconomicresources,usedintheprofit-makingoperationsofabusiness.Includescash,accountsreceivablefrommakingsalesoncredit,stockofproductsawaitingsale,prepaidexpensesandvariousfixed,orlong-lifeassets.

operatingcycle:Therepetitivesequenceoveraperiodoftimeofproducingoracquiringstock,holdingit,sellingitoncreditandfinallycollectingtheaccountreceivablefromthesale.Itisa‘cash-to-cash’circle–investingcashinstock,thensellingtheproductsoncredit,andthencollectingthereceivable.

operatingearnings(profit):Seeearningsbeforeinterestandincometax(EBIT).

operatingleverage:Onceabusinesshasreacheditsbreak-evenpoint,arelativelysmallpercentageincreaseinsalesvolumegeneratesamuchlargerpercentageincreaseinprofit;thiswiderswinginprofitistheideaofoperatingleverage.Makingsalesinexcessofitsbreak-evenpointdoesnotincreasetotalfixedexpenses,soalltheadditionalcontributionmarginfromthesalesgoestoprofit.

operatingliabilities:Short-termliabilitiesgeneratedspontaneouslyintheprofit-makingoperationsofabusiness.Themostcommononesarepayablecreditors,accruedexpensespayableandincometaxpayable–noneofwhichareinterest-bearingunlessalatepaymentpenaltyispaid,whichisinthenatureofinterest.

opportunitycost:Aneconomicdefinitionofcostreferringtoincomeorgainthatcouldhavebeenearnedfromthebestalternativeuseofmoney,timeortalentforegonebytakingaparticularcourseofaction.

ordinaryshares:Normalsharesinbusinessusedtoapportionownership.

overheadcosts:Salesandadministrativeexpenses,andmanufacturingcoststhatareindirect,whichmeanstheycannotbenaturallymatchedorlinkedwithaparticularproduct,revenuesource,ororganisationalunit–oneexampleistheannualpropertytaxonthebuildinginwhichallthecompany’sactivitiesarecarriedout.

owners’equity:Theownershipcapitalbaseofabusiness.Owners’equityderivesfromtwosources:investmentofcapitalinthebusinessbytheowners(forwhichsharesareissuedbyacompany)andprofitthathasbeenearnedbythebusinessbuthasnotbeendistributedtoitsowners(calledretainedearningsorreservesforacompany).

partnership:Whentwoormorepeopleagreetocarryonabusinesstogetherintendingtosharetheprofits.

preferenceshare:Asecondclass,ortype,ofsharethatcanbeissuedbyacompanyinadditiontoitsordinaryshares.Preferencesharesderivetheirnamefromthefactthattheyhavecertainpreferencesovertheordinaryshares–theyarepaidcashdividendsbeforeanycanbedistributedtoordinaryshareholders,andintheeventofliquidatingthebusiness,preferencesharesmustberedeemedbeforeanymoneyisreturnedtotheordinaryshareholders.Preferenceshareholdersusuallydonothavevotingrightsandmaybecallablebythecompany,whichmeansthatthebusinesscanredeemthesharesforacertainpricepershare.

preferredstock:Americantermforpreferenceshare.

prepaidexpenses:Expensesthatarepaidinadvanceforfuturebenefits.

price/earnings(P/E)ratio:Thecurrentmarketpriceofacapitalstockdividedbyitsmostrecent,or‘trailing’,twelvemonths’diluted

earningspershare(EPS),orbasicearningspershareifthebusinessdoesnotreportdilutedEPS.AlowP/Emaysignalanundervaluedsharepriceorapessimisticforecastbyinvestors.

privateequity:Large-scalepooledfunds,usuallygearedup(seegearing)withborrowingsthatbuyoutquotedcompanies.Thistakesthosecompaniesoffthestockmarketandmakesthemprivate,butthecompaniesareoftenreturnedtothemarketafterafewyearsoffinancialengineering.

productcost:Equalsthepurchasecostofgoodsthatareboughtandthenresoldbyretailersandwholesalers(distributors).

profit:Equalssalesrevenuelessallexpensesfortheperiod.

profitandloss(P&L)statement:Thefinancialstatementthatsummarisessalesrevenueandexpensesforaperiodandreportsoneormoreprofitlines.

profitratio:Equalsnetincomedividedbysalesrevenue.Measuresnetincomeasapercentageofsalesrevenue.

profitsmoothing:Manipulatingthetimingofwhensalesrevenueand/orexpensesarerecordedinordertoproduceasmootherprofittrendyeartoyear.

proxystatement:Theannualsolicitationfromacompany’stopexecutivesandboardofdirectorstoitsshareholdersthatrequeststhattheyvoteacertainwayonmattersthathavetobeputtoavoteattheannualmeetingofshareholders.Inlargerpubliccompaniesmostshareholderscannotattendthemeetinginperson,sotheydelegateaproxy(standinperson)tovotetheirshares’yesornooneachproposalontheagenda.

quickratio:Thenumbercalculatedbydividingthetotalofcash,accountsreceivableandmarketablesecurities(ifany)bytotalcurrentliabilities.Thisratiomeasuresthecapabilityofabusinesstopayoffitscurrentshort-termliabilitieswithitscashandnear-cash

assets.Notethatstockandprepaidexpenses,theothertwocurrentassets,areexcludedfromassetsinthisratio.(Alsocalledtheacid-testratio.)reducingbalance:Oneoftwobasicmethodsforallocatingthecostofafixedassetoveritsusefullifeandforestimatingitsusefullife.Reducingbalance(sometimescalledaccelerateddepreciation)allocatesgreateramountsofdepreciationinearlyyearsandloweramountsinlateryears,andalsousesshortlifeestimates.Forcomparison,seestraight-linedepreciation.

reserves:Anothertermusedforretainedearnings.

retainedearnings:Oneoftwobasicsourcesofowners’equityofabusiness(theotherbeingcapitalinvestedbytheowners).Annualprofit(netincome)increasesthisaccount,anddistributionsfromprofittoownersdecreasetheaccount.

returnonassets(ROA):Equalsearningsbeforeinterestandtaxes(EBIT)dividedbythenetoperatingassets(orbytotalassets,forconvenience),andisexpressedasapercentage.

returnonequity(ROE):Equalsnetincomedividedbythetotalbookvalueofowners’equity,andisexpressedasapercentage.ROEisthebasicmeasureofhowwellabusinessisdoinginproviding‘compensation’ontheowners’capitalinvestmentinthebusiness.

returnoninvestment(ROI):Averybroadandgeneraltermthatreferstotheincome,profit,gainorearningsoncapitalinvestments,expressedasapercentageoftheamountinvested.ThemostrelevantROIratiosforabusinessarereturnonassets(ROA)andreturnonequity(ROE).

roadshow:Presentationswherecompaniesandtheiradviserspitchtopotentialinvestorsto‘sell’themonbuyingintoabusiness.

salesrevenue-drivenexpenses:Expensesthatvaryinproportionto,orasafixedpercentageof,changesintotalsalesrevenue(totalpounds).Examplesaresalescommissions,credit-carddiscountexpenses,andrentexpenseandfranchisefeesbasedontotalsales

revenue.(Comparewithsalesvolume-drivenexpenses.)salesvolume-drivenexpenses:Expensesthatvaryinproportionto,orasafixedamountwith,changesinsalesvolume(quantityofproductssold).Examplesincludedeliverycosts,packagingcostsandothercoststhatdependmainlyonthenumberofproductssoldorthenumberofcustomersserved.(Comparewithsalesrevenue-drivenexpenses.)SecuritiesandExchangeCommission(SEC):TheUSfederalagencyestablishedbythefederalSecuritiesExchangeActof1934,whichhasbroadjurisdictionandpowersoverthepublicissuanceandtradingofsecurities(stocksandbonds)bybusinesscorporations.IntheUK,theLondonStockExchangeandtheDepartmentofTradeandIndustrycoversomeofthesameground.

seedcapital:Theinitialcapitalrequiredtostartabusinessandprovethattheconceptisviable.

soletrader:Simplesttypeofbusiness.Noshareholders,justtheowner’smoneyandborrowings.Alsoknownasasoleproprietor.

statementofcashflows:Seecashflowstatement.

statementofchangesinowners’(shareholders’)equity:Moreinthenatureofasupplementaryschedulethanafullyfledgedfinancialstatement–but,anyway,itspurposeistosummarisethechangesintheowners’equityaccountsduringtheyear.

stock:Goodsonhandforresale,orheldinrawmaterials,orasworkinprocess.IntheUS,theterminventoryismorecommonlyused.Stock,intheUS,isusuallyusedtodescribesharecapital.

straight-linedepreciation:Spreadingthecostofafixedassetinequalamountsofdepreciationexpensetoeachyearofitsusefullife.Depreciationisthesameamounteveryyearbythismethod.

trueandfair:Theauditors’confirmationthatthebalancesheetandincomestatementshowa‘trueandfair’viewofthebusiness,inaccordancewithgenerallyacceptedaccountingprinciples.

variableexpenses(costs):Anyexpenseorcostthatissensitivetochangesinsalesvolumeorsalesrevenue.

venturecapital:Professionallymanagedfundsthatbuystakes,usuallyinprivatecompanies,tohelpthemrealisetheirgrowthpotential.

warranties:Aguaranteegivenbytheofficersofacompanytoabuyerofthatcompanythatallthematerialfactshavebeendisclosed.Seriousfinancialpenaltiesawaitifthisisfoundnottobethecase.

windowdressing:Accountingdevicesthatmaketheshort-termliquidityandsolvencyofabusinesslookbetterthanitreallyis.

workingcapital:Thedifferencebetweencurrentassetsandcurrentliabilities.

zerobasedbudgeting:Whereeveryexpensehastobejustifiedinfullforanupcomingperiodasopposedtojustaccountingforanyhigherrateofexpenditure.

Z-Score:Analgorithmthatusesvariousfinancialratiostoarriveatafigurebelowwhichfirmshaveahighchanceoffailure.

AppendixB

AccountingSoftwareandOtherWaystoGettheBooksinGoodOrderThischaptergivesyousomegeneralpointersfornarrowingdownyour

choiceswhendecidingwhichwaytokeepyourbooksuptodate.Therouteyouchoosehastoberightforyouandrightforyourbusiness: Getthepersonresponsibleforkeepingyourbooks

involvedintheselectionprocessearlyon.

Makealistofthefeaturesthatyouneed.

Getarecommendationfromyourbusinessfriendsandassociateswhoarealreadyusinganaccountingprogram,bookkeeperoraccountant.

Thinkabouthowsimpleordifficulttheprogramorprocessistosetup.

PopularAccountingProgramsWiththecostofabasiccomputerised

thecostofabasiccomputerisedbookkeepingandaccountingsystemstartingatbarely£50,andareasonablepackagecostingbetween£200and£500,itmakesgoodsensetoplantousesuchasystemfromtheoutset.KeyadvantagesincludespeedypreparationofVATreturnsandhavingnomorearithmeticalerrors;preparingyouraccountsattheyear-endcanbeawholelotsimpler.

SourcingaccountingandbookkeepingsoftwareYoucanfinddozensofperfectlysatisfactorybasicaccountingandbookkeepingsoftwarepackagesonthemarket.Someoftheleadingprovidersare:BananaAccountingforEuropean

Companies,www.banana.ch/cms/en:A

double-entryaccountingprogramforEuropeansmallbusinesses,associationsandfinancialcompanies,whichcosts€79.BananaisaCzechfirm.

BusinessManagementSystemforBookPublishers,www.acumenbook.com:Businessmanagementsoftware,includingroyaltyaccountingandjobcosting,designedspecificallyforbookpublishers.

C.A.T.,www.catsoftware.com:Softwarepackagesaddressingthespecificaccountingtasksthatareuniquetotheoutdooramusementandcarnivalbusiness.

CheckMarkSoftwareInc,www.checkmark.com:Payrollandaccountingsoftware.

CreativeSolutions,www.creativesolutions.com:Integratedtax,accountingandpracticemanagementsoftwaredesignedexclusivelyforpractisingaccountants.

DBASoftware,www.dbasoftware.com:Asmallbusinesssoftwarepackagefocusedexclusivelyontheneedsofsmallmanufacturersandjobbingshops.

Dosh,www.mamut.com/uk/dosh:PartofMamut,aleadingEuropeanproviderofcomplete,integratedsoftwaresolutionsandInternetservicesforSMEs.Youcandownloadtrialversionsofthesoftwarefromthewebsite.Pricesstartat£49.50.

QuickUSEAccounting,www.quickuse.com:Integratedaccountingsoftwarewithfreedownloadsfromthesite.

Sage,http://shop.sage.co.uk/accountssoftware.aspx:Themarketleaderinaccountingsoftwarewithpackagesfrom£120,plusVAT.

RedWing,www.redwingsoftware.com:Mid-rangesoftwaresystemsdesignedforsmalltomid-sizebusinesses,agribusinessesandnonprofits.

R.T.I.,www.internetRTI.com:Accountingandoperationalsoftwareforrestaurants.

Ifyouwantsomehelpinchoosingasystem,visitAccountingSoftwareReviews(www.accounting-software-review.toptenreviews.com),whichranksthetoptenaccountingpackagespricedfromaround$40upto$2,000.Over100criteriaareusedintheirtest,whichtheycarryoutyearly.Atthetimeofwriting,Sage’sPeachTreeCompletepackage,pricedat$299.99,isratedasthebestofthebunch,whichjustgoestoshowthatmoneyisn’teverythingwhenitcomestocountingit!

UsingaBookkeepingServiceProfessionalassociationssuchastheInternationalAssociationofBookkeepers(IAB)(www.iab.org.uk)andtheInstituteofCertifiedBookkeepers(www.bookkeepers.org)offerfreematchingservicestohelpsmallbusinessesfindabookkeeperto

suittheirparticularneeds.Expecttopayupwardsof£20($30/€23.50)anhourforservicesthatcanbeasbasicassimplyrecordingthetransactionsinyourbooks,throughtoproducingaccounts,preparingtheVATreturnordoingthepayroll.Thebigplushereisthattheseguysandgalshavetheirownsoftware.

HiringanAccountantIfyouplantotradeasapartnershiporlimitedcompanyorlookasthoughyou’llgrowfastfromtheoutset,youmaybereadytohireanaccountanttolookafteryourbooks.Personalrecommendationfromsomeoneinyourbusinessnetworkisthebest

startingpointtofindinganaccountant.Meettheperson,andifyouthinkyoucouldworkwithhimorher,takeupreferencesasyouwouldwithanyoneyouemploy,andmakesureheorsheisaqualifiedmemberofoneoftheprofessionalbodies.TakealookattheAssociationofCharteredCertifiedAccountants(www.accaglobal.com)andtheInstituteofCharteredAccountants(www.icaewfirms.co.uk).

Toaccessthecheatsheetspecificallyforthisbook,gotowww.dummies.com/cheatsheet/understandingbusinessaccountinguk

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