Certified Financial Consultant - CFC® · Certified Financial Consultant - CFC® Part Financial Skills Chapter 1: Financial Ratios Chapter 2: Cash Flow Analysis Chapter 3: Lease vs

Certified Financial Consultant - CFC® Part ❶

Financial Skills

Chapter 1: Financial Ratios

Chapter 2: Cash Flow Analysis

Chapter 3: Lease vs. Buy Equipment Analysis

Notice

The topics mentioned in this book are considered to be basics and a starting point, as the candidate is supposed to expand

his research and reading these topics from the available sources via the internet and others, where the questions were

developed in a way that aims to exam the understanding of applicant to the subject.

The exam for this section includes 50 questions that vary between multiple choice questions (4 options) and true / false

questions.

The full period of the exam for the 50 questions is an hour and 15 minutes only, during which the applicant can move

between questions, meaning that there is no commitment to a specific time for one question.

The system will automatically end the exam at the end of the period (an hour and 15 minutes) and calculate the questions

that have been answered. And questions that have not been answered, the system will calculate them as questions that

were answered incorrectly.

Please pay attention to the time counter on the exam page, and it is advised to answer all questions even if there are

questions that have not been confirmed.

If you weren’t successful in this exam, it’s not considered the end of the world. You can re-apply the exam at any time after

re-studying and understanding your subject.

With our best wishes for all to success

Advanced Institute for Professional Certifications

Certified Financial Consultant - CFC®

Part ❶ – Financial Skills

2 Copyright © by aipc.ae. All rights reserved Be Certified ….. Be at the top

Contents Chapter 1: Financial Ratios .................................................................................................................. 3

Introduction ...................................................................................................................................... 3

Interpreting Key Financial Ratios ......................................................................................................... 4

Purpose and Types of Key Financial ratios ............................................................................................ 5

Solvency Ratios .................................................................................................................................. 6

Profitability Ratios .............................................................................................................................. 7

Performing Ratios ............................................................................................................................ 10

Investment Ratios ............................................................................................................................ 13

Chapter 2: Cash Flow Analysis ........................................................................................................... 17

Introduction .................................................................................................................................... 17

Cash Flow Definition ......................................................................................................................... 18

Importance of Managing working Capital ........................................................................................... 18

Cash Flow Forecast ........................................................................................................................... 22

Cash Flow Statement ........................................................................................................................ 23

Understanding the Changes in Cash ................................................................................................... 25

Direct Format Cash Flow Statement ................................................................................................... 26

Indirect Format Cash Flow Statement ................................................................................................ 28

Adjustments .................................................................................................................................... 30

Cash for Investing ............................................................................................................................. 32

Capital Expenditures ......................................................................................................................... 33

Short-Term Investments Sold ............................................................................................................ 33

Cash from Financing ......................................................................................................................... 34

Chapter 3: Lease vs. Buy Equipment Analysis ...................................................................................... 35

Introduction .................................................................................................................................... 35

What Is a Lease? .............................................................................................................................. 35

Types of Leases ................................................................................................................................ 35

Kinds of Lessors ............................................................................................................................... 36

Advantages of Leasing ...................................................................................................................... 36

Disadvantages of Leasing .................................................................................................................. 37

Accounting Treatment of Leases ........................................................................................................ 37

Cost Analysis of Lease v. Loan/Purchase ............................................................................................. 37

Look Before You Lease ...................................................................................................................... 39





Chapter 1: Financial Ratios

Introduction

The ability to evaluate the financial position of the organization is a valuable skill for any manager to have,

whether you are choosing a supplier, considering a strategic partnership, or trying to work out how much

credit to extend to a customer. Many organizations can appear successful despite deep structural

problems with the way they are financed and managed. Just think for a moment about the consequences

of working with a supplier or partner organization who goes bust, or who, despite appearing credible,

never seems able to deliver on their promises because of hidden financial problems within their own

organization.

Very few managers take the time and trouble to learn how to make a simple financial assessment of

another organization, even though doing so is straightforward and the necessary information can usually

be obtained online either free of charge or for only a few dollars.

This eBook explains the tools used to assess the financial performance of an organization. These are known

as ‘key financial ratios’ and they help you interpret financial information in a way that can aid you in

making the right decisions when choosing who to work with or sell to. This information can also give you

valuable insight into how well an organization is managed at the highest level.

A key financial ratio is calculated by comparing certain values taken from an organization’s financial

statements, including the income statement, balance sheet, and cash flow statement.

Generally, financial ratios are not useful unless they are benchmarked against something else, for example

past performance or another organization in the same business area. Whilst you can compare the ratios of

organizations in different industries, this is usually of limited value because of differences in market

conditions, capital requirements, and competition.

Key financial ratios allow for useful comparisons between:

Organizations in the same industry sector

Different time periods for the same organization

An organization and its industry average

Comparing ratios for different industries can be interesting from a purely academic point of view or can

help with investment decisions, but is of limited use to you as a manager. However, comparing ratios for

potential suppliers, partners, acquisitions, or competitors can provide you with useful data to help with

decision making.





Interpreting Key Financial Ratios

Key financial ratios may not be directly comparable between organizations that use different accounting

methods. Most public organizations are required by law to use generally accepted accounting principles for

their home countries, but private organizations, partnerships, and sole proprietorships generally have

more freedom in reporting their accounts.

Before you start your calculations you will need to make sure that the accounting treatments are the same

when making comparisons. This is not only between the organizations you wish to compare but also for

each year you wish to compare. For example, an organization may change policy and decide to capitalize

research and development, holding it in the balance sheet as having a long-term value or it may consider

development costs as overheads as soon as they are incurred.

Either treatment is perfectly reasonable, but comparing figures that have been arrived at in these two

different ways would be pointless.

When you need to make comparisons with global organizations it is important to remember that there is

no international standard. How an organization calculates the summary data presented in all financial

statements, as well as the terminology used, is not always consistent between organizations, industries,

countries, and time periods.

If you are trying to make global comparisons then you need to appreciate how operational differences

within each industry or country can impact the validity of such a comparison. These differences include

such things as seasonal conditions and traditional industry practices.

Ensure your investigation in this area is thorough; as such operational differences are so predictable that

people in these industries take them as read and rarely mention them. If you remain ignorant of such

issues then your ratios will give you misleading information.

For example:

If you were investigating the European car industry then you would need to be aware that in the United

Kingdom new vehicle sales peak in March and September. In fact, there are typically five times as many

cars sold in March as in the previous month. If you did not allow for this, because you were not aware of

the operational practices of the UK automotive industry, then some of your calculations could be

meaningless.





Purpose and Types of Key Financial ratios

There are several different key financial ratios and they are categorized according to the financial

characteristic they measure. These are:

Solvency

Profitability

Performance

Investment

Solvency

An organization is considered to be solvent when it can pay its debts as they fall due. In day-to-day terms,

this means that an organization has enough working capital to pay its suppliers.

Profitability

These ratios measure the organization’s use of its assets and control of its expenses to generate an

acceptable rate of return. You can see if an organization is profitable simply by looking at an income

statement, but you need to put that profit into perspective.

To do this you need to ask yourself:

Is the profit growth in proportion to the size of the organization?

Is the organization making as much profit on new sales as on existing sales?

Is the organization as profitable as others in the same sector?

Performance

Is the organization making the sort of profit that it has in the past or that others in the same sector are

making? By looking at individual parts of the organization you can gain more insight into their profitability

and efficiency.

Investment

These ratios measure investor response to owning an organization’s stock and also the cost of issuing

stock. They are concerned with the return on investment for shareholders, and with the relationship

between return and the value of an investment in an organization’s shares.





Solvency Ratios There are two key ratios that can help you to determine whether an organization is a solvent:

Current Ratio

The current ratio looks at the relationship between current assets and current liabilities. The word ‘current’

implies short-term assets or liabilities, which are payable or receivable within one year.

These figures are always shown on the balance sheet. To calculate this ratio you would divide current

assets by current liabilities.

Example:

This ratio of 2:1 would be considered a healthy result as it shows that the organization has sufficient

current assets to pay its current liabilities as soon as they are due.

Quick Ratio

The quick ratio, or acid test ratio, measures liquidity more precisely than the current ratio. It does not

include the value of stock within current assets because turning stock into cash takes time since payment

terms are usually anything between 30 and 90 days.

You can calculate the quick ratio by dividing current assets (excluding stock) by current liabilities. You can

find the stock or inventory figure on the balance sheet.





Example:

This example shows that an apparently healthy level of current assets might hide the fact that a large

proportion of the current assets is made up of stock. Whilst this can usually be turned into cash, it will take

time and to do it quickly might require heavy discounting.

When you need to review the liquidity of an organization, it is common practice to calculate both the

current ratio and quick ratio. This is so that you are aware of the extent to which stock held influences its

current assets. These calculations will quickly show you if the level of stock an organization holds is too

great and also whether it matches your expectations of the industry.

You must always be careful when drawing conclusions from these ratios. It is quite possible that an

organization may appear to be desperately short of working capital, but if it sells goods for cash and

purchases with a long credit line, then it may be that it is being very well managed.

It is vital that you understand what the organization actually does and the industry it operates in before you

draw any conclusions from these ratios.

Profitability Ratios You can see if an organization is profitable by looking at the income statement, but you need to put that

profit into perspective. This can be done by looking at various ratios that compare profit as a percentage of

sales or assets.

There are three ways this can be achieved:

Gross profit margin

Net profit margin

Return on assets

Gross Profit Margin

One of the most commonly used ratios is the gross profit margin, which looks at a gross profit as a

percentage of turnover (sales). You will find both of these figures in the income statement.

Example:

The formula used is gross profit divided

QUICK

RATIO





by turnover, multiplied by a hundred to turn it into a percentage.

Many people are often confused by the terms ‘gross profit margin’ and ‘mark-up.’ The definition of each

term shows how they differ and also shows that you use a different formula to arrive at a figure for each.

Gross profit margin: expresses gross profit as a percentage of total sales.

Mark-up: is the figure or percentage added by management to cover the cost of goods and the

required profit margin for a product or service.

From these definitions, you can see that the key difference is that management has control over and

define what they require as a mark-up, whereas gross profit is dependent on how many sales are made

and their value, which management can set targets for, but cannot control directly.

Industries often have what is considered an acceptable range for their mark-up, without which an

organization would not be able to operate. You should investigate whether the sector you are interested in

has such a range.

The formula for calculating mark-up is:

Mark-up = (total revenue - cost of sales) / cost of sales

This is then multiplied by 100 to give a percentage.

Net Profit Margin

This ratio is similar to the gross profit margin but looks at a net profit as a percentage of turnover. Net

profit is shown on the income statement and is defined as follows:

Net profit is the figure left after all operating and non-operating expenses have been deducted from total

revenue or income.

To calculate the net profit margin of an organization as a percentage you would divide net profit by total

revenue or income and multiply the answer by a hundred to turn it into a percentage.

Example:

You need to be mindful that your net profit is calculated after taking account of all costs and therefore can

be affected by a variety of things, such as:

Declining gross profit

Increased selling

Rising administration costs





If your net profit percentage is declining it is worth looking at your costs on an individual basis to see what

you can do about those that have increased the most as a proportion of sales.

It is important to look at the trend that emerges over several accounting periods, as opposed to individual

figures. The ratios can be used to measure periods other than a full year, as long as you have the relevant

income statements.

Return on Assets

You can also measure the level of profit compared to the value of net assets invested in an organization.

The assets are the major items that need to be in place for the organization to operate. These include such

items as:

Fixed assets ….. (Buildings, Vehicles, Computers, etc.)

Current assets ….. (Stock, Debtors, Cash)

The organization’s total net assets are calculated by taking total liabilities from the total assets. This

represents the amount of capital invested in the organization. Your net assets figure can be taken directly

from the balance sheet. You can, therefore, look at the net profit as a percentage of capital employed.

The return that an organization can expect depends on the industry sector and the economic cycle.

However, it remains a good measure of operational efficiency for an organization.

The ratio is calculated by dividing net assets by net profit and then multiplying it by a hundred to turn it

into a percentage, as this is the usual way it is expressed.

Capital employed is the net amount invested in the organization by its investors or owners and is taken

from the balance sheet. Many people consider this the most important ratio overall and it is useful to

compare the results with a return that can be obtained outside of the organization. The organization’s

return on assets can be improved either by increasing profitability or decreasing the capital employed.





Performing Ratios There are several ratios that you can use to measure how an organization is performing in terms of both

profitability and efficiency.

The ratios for measuring performance are:

Gearing

Number of days credit granted

Number of days credits taken

Stock turnover

Overheads as a percentage of turnover

Gearing

This ratio looks at total borrowings divided by net worth of the business. Ideally, the equity should be

significantly higher than debt.

If an organization’s net worth was $60,000 and the borrowings came to $20,000 (made up of a bank loan

and overdraft), then the borrowing ratio would be 1:3. In this example the equity is higher than its debt,

but to understand the implications of this you would need to look at the expected gearing figure within the

industry.

The purpose of this ratio is to compare the finance provided by lenders with the finance invested by

shareholders. Generally speaking, banks do not like to see the amount of debt exceed the amount of

equity. The ratio is usually expressed as a proportion (as in 1 to 1), although it can sometimes appear as a

percentage. Gearing is said to be high when borrowing is high in relation to equity.

Number of Days Credit Granted

This ratio is used to measure the effectiveness of an organization’s debt collection. It sets out the

relationship between debtors and the sales that have been made on credit and also shows how quickly

customers are paying their invoices.





The calculation for this ratio is trade debtors (this figure is taken from the balance sheet) divided by annual

sales and then multiplied by 365 days. This ratio gives a rather broad- brush calculation.

If you wanted to use a more detailed calculation you would look at how many days’ turnover it took to

make up the debtor total.

Example:

Current debtors = $50,000

Sales in current month = $30,000

Sales in previous month = $40,000

The current debtors ($50,000) therefore represent all of the current month’s sales ($30,000) and half of

the previous month’s sales ($20,000).

Therefore the number of debtor days in this example is calculated by adding debtor days from the current

month (31 days) and the previous month (30 days).

Current month has 31 days

Balance from previous month: $20k ÷ $40k x 30 days = 15 days

Total debtor days = 31 days + 15 days = 46 days

If this figure began to increase you would need to look carefully at the debt collection routines of the

organization. The sort of queries you would want to be answered are:

Are customers taking longer to pay?

Are a few customers building up a large debt?

Either of these factors may give cause for concern because the older a debt becomes, the more likely it is

to go bad.

Number of Days Credit Taken

This ratio sets out the number of days the organization takes to pay its suppliers. This is arguably less

important than the ‘debtor day’ figure, as in this case, the control over the payment of suppliers is in the

organization’s own hands.

When assessing another organization—for example, one that is asking you for increased credit—this ratio

can give a useful pointer as to whether the organization is operating within the accepted norms of the

industry and (using historic data) whether or not it is taking increasingly longer to pay people.

This ratio is calculated by dividing the figure for trade creditors by the annual purchases and then

multiplying this answer by 365 days. The figure for trade creditors normally comes from the closing balance

sheet and care should be taken that it is typical for the whole year.





These calculations give a profile of the organization to potential suppliers looking for details about how

efficiently the business is being run.

Stock Turnover

This ratio looks at how quickly the organization turns over stock into sales and is, therefore, another good

measure of efficiency. The higher the stock turned the more efficiently the business is being run. It is

important that the terms are completely understood and there are no abnormal factors. Normally the

definition of stock includes all of the following:

Finished goods

Work in process

Raw materials.

The stock value would usually be taken from the closing balance sheet but you need to consider if it is a

typical figure. For example, an organization involved in the retail industry may have a seasonal influence on

its operations so you may need to make allowance for this.

The stock turnover ratio is calculated by dividing the cost of goods sold by the stock value. For example:

A quick turnover suggests that the organization is efficient in holding the minimum stock used within its

operation. Again, this ratio is most informative when looked at over time. If the stock turn is slowing, this

may highlight a problem with slow-moving lines that require discounting to sell through.





Operating Expenses as a Percentage of Turnover

Examples of operating expenses are:

Rent

Utility bills

Wages, etc.

This is a useful tool in assessing whether or not this area of expense is growing more rapidly than the

turnover. This ratio is calculated by dividing operating expenses (overheads) by turnover and then

multiplying by a hundred to make the figure into a percentage.

The calculation has little meaning on its own, but when reviewed over several periods it can provide useful

information on the trend over that time span.

As an organization grows this percentage should fall. If it doesn’t, then the organization needs to review its

operating expenses carefully to understand why this is happening and see what management can do to

correct it.

Investment Ratios The accounting ratios that focus on the investment potential an organization offers include:

Price/earnings ratio

Price-to-book ratio (P/B)

PEG (price/earnings to growth) ratio

Dividend yield

These ratios are most useful when the data behind them is from regularly produced management

accounts. They are concerned with the return on investment for shareholders, and with the relationship

between return and the value of an investment in a company’s shares.

These figures are a constant focus of senior management’s attention, which is a good reason for

understanding how they are derived and what they mean.

Price/Earnings (P/E) Ratio

This is one of the most helpful of the investment ratios and is often abbreviated to P/E ratio. It can be used

to compare an organization to:

Other organizations

Industry sector

Overall market





This ability to make such comparisons is one of the reasons it is widely used by management. It also offers

the flexibility to use either quarterly or annual data.

In commercial organizations, a significant proportion of management personnel receive stock or options on

the stock as part of their benefits package and this drives their personal interest in the P/E ratio. The belief

is that by aligning the interests of management with the interests of other stockholders the former are

more committed to the organization.

A P/E ratio can be thought of as how long a stock will take to pay back the investment if there is no change

in the business. Whilst stock can go up in value without significant earnings increases, it is the P/E ratio

that decides if it can stay up. Without earnings to back up the price, a stock will eventually fall back in

value.

The P/E ratio can be calculated by dividing the current share (stock) price by the earnings per share (often

referred to as EPS) for the previous 12 months

There are key issues that must be acknowledged when using a P/E ratio and they are that this ratio:

Uses historic earnings. This is because of the nature of how EPS is calculated using the previous 12-

month earnings. (In most cases, the four most recent reported quarterly net earnings per share are

totaled.)

Only provides a snapshot based on the current share price. The very nature of stocks means that their

value is constantly fluctuating. (P/E ratio rises with share price and vice versa.)

The Price-to-Book (P/B) Ratio

The price-to-book (P/B) ratio represents the value of the company if it is broken up and sold. The book

value usually includes equipment, buildings, land, and anything else that can be sold, including stock

holdings and bonds.

To calculate this ratio the market price of an organization’s shares (share price) is divided by its book value

of equity. The latter is also known as the ‘price-equity ratio’ and is found on the balance sheet by

subtracting the book value of liabilities from the book value of assets.

Where an organization has a very high share price relative to its asset value it is likely that it has been

earning a very high return on its assets.

You may also find instances where an organization is trading for less than its book value (P/B <1) and this

tells an investor that either:

The asset value is overstated—meaning there is a chance that the asset value will face a downward

correction by the market, leaving investors with negative returns.





Return on assets is genuinely poor—indicating that new management or a new operating environment will

prompt a turnaround in prospects and give strong positive returns.

The P/B ratio is really only useful when you are looking at capital-intensive businesses or financial

businesses with plenty of assets on the books.

It is not meaningful for service-based organizations because due to accounting rules intangible assets such

as intellectual property (brand name, goodwill, patents, and trademarks) are ignored in calculating the

book value of equity.

The PEG (Price/Earnings to Growth) Ratio

This ratio illustrates the relationship between stock price, earning per share, and an organization’s

expected growth rate. This ratio is often used in management discussions, especially those where strategic

growth is being considered.

PEG is a widely used indicator of a stock’s potential value. Many people favor it over the price/earnings

ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG means that the stock is more

undervalued.

The PEG ratio is calculated by dividing the Price to Earnings (P/E) ratio by an organization’s annual EPS

(Earnings per Share) growth. The growth rate is expressed as a percentage and should use real growth

only, to correct for inflation.

It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for

comparing companies with different growth rates.

In general, the P/E ratio is higher for a company with a higher growth rate. Using just the P/E ratio would

make high-growth companies appear overvalued relative to others and this is why the PEG ratio is more

widely used.

A lower ratio is cheaper and a higher ratio is more expensive. For example, it is considered that an

organization with:

PEG < 1 is undervalued

PEG around 1 is fairly valued

PEG > 1 is overvalued.





Dividend Yield

The dividend yield is used to calculate the earnings on investment (shares) considering only the returns in

the form of total dividends declared by an organization during the year. By dividing the stock’s annual

dividend by the stock’s price and multiplying by a hundred, you get a percentage.

You can think of that percentage as the interest on your money, with the additional chance at growth

through the appreciation of the stock.





Chapter 2: Cash Flow Analysis

Introduction

Cash flow is simply the flow of cash through the organization over time. In the case of businesses that are

run for profit, cash is paid out in return for the labor and materials that are used to provide goods and

services that can be sold. The revenues received provide cash that can then be used to finance further

production and sales as well as increasing the organization’s economic value.

Cash flows are also essential for nonprofit organizations such as charities, schools, and hospitals that need

to meet the various ongoing expenses associated with providing their services.

As a manager, you need to understand how cash flows are generated and what factors impact those flows.

This knowledge is an integral part of making financial decisions that increase a firm’s economic value or the

capabilities of a nonprofit organization.

The management of cash flow is one part of a larger management responsibility known as the

management of working capital, which refers to the operating liquidity available to an organization.

An organization can have assets and profitability, but find itself short of liquidity if its assets cannot readily

be converted into cash.

Working capital is required to ensure that the organization is able to continue its operations and that it has

sufficient funds to satisfy operating expenses and any maturing short-term debt. The management of

working capital involves managing the four following aspects of an organization’s operations:

Inventories (stock, work-in-progress and finished goods)

Accounts receivable (debts that are owed to the organization)

Accounts payable (money the organization owes to its suppliers)

Cash

Effective management of working capital will increase the profitability of the organization. It also enables

managers to concentrate on their jobs without worrying too much about the potential for insolvency.

It can also reduce the amount of capital needed to run the enterprise, so even if you work in the nonprofit

sector it is still an important consideration.





Cash Flow Definition

Cash flow is a generic term that can be used differently depending on the context. It can refer to actual

past flows or projected future flows. It can refer to the total of all flows involved or a subset of them - for

example, net cash flow, operating cash flow, and free cash flow.

These terms will be defined later, but for now, we will concern ourselves only with actual cash flows for a

period of time in the past. It is important to define what is meant by ‘cash’:

Cash includes all of the money that the organization has in bank accounts and short-term investments that

can quickly be turned into available cash.

It is common for a balance sheet to show only a tiny amount for cash because businesses often operate

with an overdraft and only petty cash is included.

Importance of Managing working Capital

Many organizations that fail are profitable at the time, and

their demise often comes as a surprise to managers and staff

who can see that there are a full order book and plenty of

satisfied customers. In these circumstances, the reason for the

failure is usually down to a shortage of working capital.

This shortage of working capital can cause a company to not be able to pay its workers or suppliers even

though there are sufficient sales and profits. Even in cases where these short-term liabilities can be met,

the deterioration of cash flow critically undermines a company’s ability to reinvest in the business and,

ultimately, to survive.

The four factors that affect the amount of working capital available within an organization are:





WAYS TO MINIMIZE DEBT

NOTE: goods or service have

been received

Focus on largest debts first

Agree payment terms in advance

Ask for payment early & often

Give high priority to credit control

Prompt sending out of invoices

etc.

Resolve queries quickly

Have comprehensive credit policies

The management role that you perform may only influence one of these areas directly, but having a clear

understanding of them all will give you an insight into how well your organization controls its working

capital, and by extension how well it is managed financially.

Debtors

These are entities that owe your organization money. Many organizations have problems caused by the

slow payment of invoices and this, in turn, affects working capital and, in particular, and liquidity.

Chasing up unpaid invoices can be very time consuming and there is a fine line between maintaining a

good working relationship with your customers and upsetting them by demanding payment too

aggressively.

Whatever your organization’s policy is in the area of debt collection you will need to set expectations

appropriately with customers and be polite but assertive in following through with requests for payment.

This is a key area you need to monitor closely to ensure problem payers are identified as soon as possible.

There are some things you as a manager may be able to do to help:

Make sure that the payment terms are agreed in advance

Send out invoices and statements promptly

Deal with queries quickly and efficiently

Ask early and ask often, preferably by telephone

Remember you are only asking for something that has been previously agreed

Give credit control the highest status and priority

Have comprehensive credit policies

Concentrate on the biggest debts first





Inventory/Stock

Your aim should always be to keep stock as low as realistically possible and to achieve a high rate of stock

turnover. In this way, you are minimizing the impact on your organization’s working capital. In theory, this

is ideal to work towards, but in practice, it is more difficult to achieve because you have to meet the

commitments you have given to customers.

There are three components to what accountants refer to as inventory:

Raw materials—these are the materials required to produce goods.

Work in process (WIP)—includes partly finished goods and those raw materials and components

already committed to production.

Finished goods—are all those goods ready to be sold.

Many large and successful manufacturing companies use the just-in-time technique of arranging deliveries

from suppliers frequently and in small quantities. This is not easy to achieve and can cause problems if just

one vital component is missing when it is required.

Many organizations have sophisticated stock control systems, which keep track of stock levels. Once a pre-

determined level of stock is reached, an order is automatically generated so that items are never entirely

out of stock. In this way, minimum levels of stocks are held and supply is replenished often overnight.

Creditors

Many organizations adopt a policy of delaying the payment of suppliers as long as possible. There is an

obvious advantage in adopting such a policy as the purchaser is effectively getting an interest-free loan

from the supplier.

If your organization adopts this policy then your cash balance will be higher than would otherwise be the

case even though slow payments do not affect the net balance of working capital. However, there are also

some disadvantages in a policy of slow payment:

Suppliers will be reluctant to give discounts

They may treat you as a problem customer and make all of your requests the lowest priority

If you are always a slow payer there will be less scope for taking longer to pay in response to a crisis

Within your industry you will quickly gain a reputation as a poor payer and many suppliers may refuse

to work with you, making it hard to change suppliers if the need arises.

For these reasons, it is often unwise to adopt a consistent policy of slow payment, at least with important

suppliers. It is often better to take only a few days longer than the deadline stipulated in the contract and

to ensure that this is rewarded with keen prices, timely service, and prompt payment discounts.





If your organization is relatively small you may be able to obtain the same price as your larger competitors

by agreeing with an immediate payment plan with the supplier. This is because many large corporations

use their extensive purchasing power to justify paying suppliers after an unreasonably long time.

This sort of policy can leave many manufacturers and suppliers with serious cash flow problems. In these

circumstances, many suppliers are prepared to offer the maximum possible discount in exchange for

guaranteed quick payments, irrespective of the size of the order.

Cash

It is quite common for an organization to be profitable but short of cash. There are several reasons why

this can happen:

An expanding organization will have to spend money on materials (items for sale and salaries) before it

completes sales and gets paid. It is a fact of business life that purchases and expenses usually come

before sales and profits.

Capital expenditure, in the form of buying equipment, has an immediate impact on the cash available.

Even if the equipment is bought on credit, the monthly payments may exceed the monthly

depreciation figure.

Sales taxes and taxes on profit can both take cash out of an organization and cannot normally be

deferred without incurring a penalty of some sort.

Money may be collected from customers more slowly than expected. This often happens when

salespeople are motivated to bring in revenue but have no responsibility for, or interest in, enforcing

the payment terms.

To avoid your organization becoming ‘cash insolvent,’ it is essential that you and all the company’s

managers accurately forecast and monitor their area’s cash receipts and payments.

As a manager, you need to plan for the known costs and to allow some contingency for unanticipated

problems, e.g. late payment by a customer or a supplier withholding raw materials until payment has been

processed.

This type of planning is usually referred to as a cash flow forecast and should be part of your overall

budgeting management process.

As you plan and prepare your cash flow forecast it will highlight areas where improvements or savings can

be made. It also has the additional benefit of identifying potential problem areas.

For example, the figures for cash payments from trade debtors will be based on an estimate of the average

number of days’ credit that will be taken. This will pose the question of whether or not payments can be

speeded up





Cash Flow Forecast Includes

known costs

Plus an allocation for

unexpected costs

Your contingency plans could involve deferring an investment for a few weeks or negotiating an additional

overdraft with the bank. Either way, a well-planned cash flow forecast document helps you to be proactive

and to avoid the crises that usually result from running out of cash.

Cash Flow Forecast

There are two completely different

accounting documents that have the

words ‘cash flow’ in the title and it is

important to avoid confusing the two

of them. These documents are a ‘cash

flow forecast’ and a ‘cash flow

statement.’ A cash flow forecast,

which has already been mentioned, is

an internal document produced on an

ad hoc basis to help with budgeting. In contrast, a cash flow statement is one of the principal financial

reports that an organization publishes each year in accordance with international accounting standards.

As a manager, you may be asked to produce a cash flow forecast to show your known and anticipated cash

expenditure for some future period of time, usually the next budgetary period or the remainder of the

current one. You will usually be expected to add an element of contingency into your cash flow forecast to

cater for any unexpected costs that may arise.

This forecast is an important aspect of your planning and is an essential part of budgeting as it helps you to

identify potential areas where a lack of cash may become an issue. It also offers you the opportunity to

review and where necessary amend your planned expenditure.

Regular monitoring and reviewing of your cash flow forecast are essential because you never know when

your budget may be threatened or cut. You will be able to protect your original budget better if you

already have arguments for why your budget should not be affected and exactly what the consequences

will be if it is.

The better prepared you are, the more protected your budget will be in such circumstances. It also enables

you to communicate accurately and objectively to senior management of the consequences of any

budgetary changes.





Cash Flow Statement

In order for a set of financial statements to be complete, the accounting profession includes a cash flow

statement. Like all other financial statements, it has to adhere to accepted accounting principles.

The cash flow statement goes beyond what you include in your regular reports showing what cash has

come in and what cash went out.

A Cash Flow statement is a reconciliation of the differences between the:

Accrual basis balance sheet and

Income statement and

Cash flow.

This statement uses historic data and is usually dated at the end of an organization’s financial year. In

simple terms it shows how the final cash balance occurred, how much money flowed in and from where

and how much went out and why.

The cash flow statement reflects a firm’s liquidity. It includes only inflows and outflows of cash and

excludes transactions that do not directly affect cash receipts and payments. Being a cash basis report,

these financial statement details three types of financial activities: operating activities, investing activities,

and financing activities.





This statement is extremely valuable to management and investors because it is intended to:

Provide information on an organization’s liquidity and solvency and its ability to change cash flows in

future circumstances.

Provide additional information for evaluating changes in assets, liabilities, and equity.

Improve the comparability of different organizations’ operating performance by eliminating the effects

of different accounting methods.

Indicate the amount, timing, and probability of future cash flows.

The valuable information and data a cash flow statement provides ensure it plays a key role in an

organization’s decision making. This is why it is essential for managers to have an appreciation of how it is

compiled and how to interpret it.

The cash flow statement has been adopted as a standard financial report because it eliminates some of the

problems that occur when trying to compare accounts that have been prepared using different accounting

methods, such as various timeframes for depreciating fixed assets.

It is this compilation and integration of facts that draw savvy managers and investors to utilize this often

overlooked financial statement. It is important to remember that all the figures in a cash flow statement

can be found somewhere in the income statement, balance sheet, statement of shareholders equity, or

anyone of the financial statement notes provided.

If you looked at an income statement prepared using the accrual basis of accounting you could see a figure

for reported revenues, but you would not know if they have been collected yet. Similarly, the expenses

reported on the income statement might or might not have been paid.

Alternatively, you could review the balance sheet changes to determine the facts, but the cash flow

statement has already integrated all that information.

There are many ways you can utilize the information a cash flow statement presents. For example, if an

organization’s cash generated from operations is consistently above its net income or earnings they are

referred to as ‘high quality.’ In circumstances where the opposite is true then the organization’s earnings

have a ‘red flag’ raised against them. This informs anyone looking into the organization that they need to

investigate further why its reported earnings are not turning into cash.





Where an organization consistently generates cash in excess of what it needs on a day-to-day basis, it has

the ability to offer its investors a higher dividend or buy back some of its own shares. Such an organization

is considered to have ‘good stockholder value’ by investors. This is not the only option and they may

choose to use this excess cash to reduce debt or acquire another organization. In the case of nonprofit

organizations, a positive cash flow allows them to expand their operations and offer additional or

improved services.

Understanding the Changes in Cash

The way in which the ‘cash account’ is used in published accounts is to some extent counter-intuitive. To

help you understand it we will use an example for a fictitious company.

The following is a statement showing the balance of the cash account for Gary’s Garden Furniture business

in the first two months of trading.

From this table you can see that for a change in:

Assets (other than cash)—the change in the cash account is in the opposite direction.

Liabilities and owner’s equity—the change in the cash account is in the same direction.

The following table provided an explanation for each of the above items and reflects the change that

occurs in the column of each key financial area.





This can be summarized as follows:

When the owner’s equity increases, the cash account increases

When an asset (other than cash) increases, the cash account decreases

When a liability increases, the cash account increases

Conversely:

When the owner’s equity decreases, the cash account decreases.

When an asset (other than cash) decreases, the cash account increases.

When a liability decreases, the cash account decreases.

Direct Format Cash Flow Statement

It would be possible for you to create a report that listed all of the individual cash transactions as shown in

Gary’s cash account for January and February. But it does not really add to what you can already see on the

bank statement because it doesn’t show inflows and outflows in any meaningful way.





Grouping cash payments together and showing a total movement in cash over a particular period is much

more useful. The report below shows Gary’s Garden Furniture cash receipts and disbursements for July:

By applying the resulting net cash flow ($6,000) to the balance of cash at the beginning of the period

($8,000), it is possible to obtain the cash balance for the end of the month ($14,000).

Showing the flow of cash into and out of the organization in this way provides a summary of the cash

account. Unfortunately, it does not show net income or make any attempt to explain the difference

between any net income and net cash flow.

As well as these shortcomings, it is difficult to analyze these figures in any meaningful way. Consequently,

published accounts always use what is known as the indirect method of presentation.

This is the format that appears in all published financial reports of public companies and is the same

format as the report produced by most accounting software.





Indirect Format Cash Flow Statement

This statement begins with net income and adjusts for changes in account balances that affect available

cash. It is slightly more difficult to understand initially but has far more potential for analysis.

It also serves to answer the important question, what is the difference between net profit and net cash

flow? A statement prepared using this method has four distinct sections:

Operations

Investing

Financing

Supplemental information

Operations

When you look at the example below of Gary’s Garden Furniture you will see that the first entry is net

income. This figure has been taken from the Income Statement for the period. The idea is that net income

is presumed to be equal to net cash flow except for the adjustments that make up the details of this

statement.





Operations are the process of running the organization with all of the related cash flows such as buying

and selling goods, services, manufacturing, and paying employees. The entries under this title effectively

convert the items reported on the income statement from the accrual basis of accounting to cash.

Investing

This reports the purchase and sale of long-term investments and property, plant, and equipment.

Financing

This reports the issuance and repurchase of the organization’s own bonds and stock and the payment of

dividends.

Supplemental information

This reports the exchange of significant items that did

not involve cash and reports the amount of income

taxes paid and interest paid.

The report below is an indirect format cash flow

statement for Gary’s Garden Furniture.

To appreciate the information this indirect format

statement provides you with, you need to work through

the line descriptions, one line at a time. The

explanations below will help you to understand exactly

what the above cash flow statement tells you.

The first line under the Operations title is Net Income

because the prime objective of this report is to show

the differences between net income and net cash flow.

This Net Income figure should be the same as that

shown on the income statement for the same period.





Adjustments

Then you need to work through the meaning of each of the items listed under the heading ‘Adjustments.’

These are all the operating items that had an impact on cash that was not included in the income

statement.

Depreciation

Accounts Receivable

Prepaid Expenses

Inventory

Accounts Payable

Depreciation

Because the cash was all paid out when Gary’s bought the asset, the monthly charge for depreciation

expense must be removed from reported net income. In other words, it should be added back in to

increase the net income.

Remember, depreciation is the gradual charging of the cost to expense over the useful life of the item. It is

recorded each month after the asset is put into use yet no cash changes hands as a result of these

depreciation entries.

Accounts Receivable

At the beginning of the period, Gary’s Garden Furniture was owed money by customers who had bought

on credit. Some of this would have been collected during the month, which would increase the cash figure

but decrease the accounts receivable figure.

However, Gary’s would also make additional credit sales during the period, some of which would remain

unpaid. These must also be allowed for. This can be done using the following formula:





This calculation effectively converts sales to cash collections by comparing the balances of Accounts

Receivable from the beginning of the month and the end of the month. The following examples will help

ensure that you understand this aspect of the statement.

Prepaid Expenses

Prepaid Expenses represent an upfront cost for things like insurance. As with accounts receivable, the net

change in the balance of prepaid expenses on the balance sheet from the beginning to the end of the

period is a quick way to calculate the net effect of this adjustment on cash flow.

Basically, if the net figure of prepaid expenses has decreased over the month, there will be a corresponding

increase in the cash balance and vice versa.

Inventory

Most companies need some inventory on hand and the change in inventory balances works on the cash

account in the same way as Accounts Receivable.





Remember that the income statement includes the cost of all inventory sold in the month. The cash flow

statement must deduct the cash cost of any inventory added during the period. This can be done using the

following formula:

Conversely, the cash flow statement must add the cash cost of any inventory deducted during the period.

Accounts Payable

The Accounts Payable figure represents those amounts owed to creditors. The cash flow statement must

add the cash cost of any increase in accounts payable during the period as this represents money

effectively borrowed from creditors.

This can be done using the following formula:

Cash for Investing

This reports the purchase and sale of long-term investments and property, plant, and equipment. This

includes:

Capital expenditures

Short-term investments sold





Capital Expenditures

This describes the amount spent for all fixed assets that are not charged to expense when purchased but

are recorded on the organization’s balance sheet. That is, they are capitalized and then depreciated over

the amount of time they are used for.

The cash flow statement considers the purchasing of equipment and borrowing the money for the

purchase as two separate things.

Although the organization might have recovered the purchase cost by borrowing the money, the decision

to purchase the equipment represents a commitment of cash and appears as a deduction on the cash flow

statement. If the organization financed the purchase, an offsetting item would appear in the financing

section of the cash flow statement.

Short-Term Investments Sold

An organization can invest excess cash so that the money is gaining interest until it is needed for

operations. This type of investment is usually short term and uses vehicles like bank certificates or

securities, which the organization sells when it needs the cash.

When such an investment is purchased it appears as a cash expenditure that would be shown in this

section as a reduction in cash. When the investment is sold the net proceeds of the sale, except for the

gain or loss on sale (which appears in the income statement), become an additional source of cash.

Companies that have undergone a successful IPO (Initial Public Offering) often raise a lot of cash before

they are ready to use it. Short-term investments are a way to earn income from these otherwise idle cash

balances.





Cash from Financing

Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the

outflow of cash to shareholders as dividends as the organization generates income.

Other activities that impact the long-term liabilities and equity of the organization are also listed in this

section. These include:

Bank Debt: The net amount of any increases or decreases in monies borrowed from the bank.

Dividends: a profitable organization may elect to pay a distribution of profits to its owners. This is

usually done in the form of a dividend on the shares held by its stockholders.

These distributions are almost always in cash and the cash flow statement is the only place such payments

can appear.





Chapter 3: Lease vs. Buy Equipment Analysis

Introduction

Businesses have difficulty raising capital - that's no secret. This difficulty (among other reasons) has caused

many to look at leasing as an alternative financing arrangement for acquiring the use of assets. All types of

equipment leasing-from motor vehicles to computers, from manufacturing machinery to office furniture-

have become more and more attractive.

This guide describes various aspects of the lease/buy decision. It lists the advantages and disadvantages of

leasing and provides a format for comparing the costs of the options.

What Is a Lease?

A lease is a long term agreement to rent equipment, land, buildings, or any other asset. In return for most-

but not all-of the benefits of ownership, the user (lessee) makes periodic payments to the owner of the

asset (lessor). The lease payment covers the original cost of the equipment or other asset and provides the

lessor a profit.

Types of Leases

There are three major kinds of leases: the financial lease, the operating lease, and the sale and leaseback.

Financial leases are most common by far. A financial lease is usually written for a term not to exceed

the economic life of the equipment. You will find that a financial lease usually provides that: Periodic

payments are made, Ownership of the equipment reverts to the lessor at the end of the lease term, the

lease is noncancellable and the lessee has a legal obligation to continue payments to the end of the

term, and the lessee agrees to maintain the equipment.

The operating lease, or "maintenance lease," can usually be canceled under conditions spelled out in

the lease agreement. Maintenance of the asset is usually the responsibility of the owner (lessor).

Computer equipment is often leased under this kind of lease.

The sale and leaseback is similar to the financial lease. The owner of an asset sells it to another party

and simultaneously leases it back to use it for a specified term. This arrangement lets you free the

money tied up in an asset for use elsewhere. You'll find that buildings are often leased this way.

You may also hear leases described as net leases or gross leases. Under a net lease, the lessee is

responsible for expenses such as those for maintenance, taxes, and insurance.

The lessor pays these expenses under a gross lease. Financial leases are usually net leases.





Finally, you might run across the term full payout lease. Under a full payout lease the lessor recovers the

original cost of the asset during the term of the lease.

Kinds of Lessors

As the use of leasing has increased as a method for businesses to acquire the use of the equipment and

other assets, the number of companies in the leasing business has increased dramatically.

Commercial banks, insurance companies, and finance companies do most of the leasing. Many of these

organizations have formed subsidiaries primarily concerned with equipment leasing. These subsidiaries are

usually capable of making lease arrangements for almost anything.

In addition to financial organizations, there are companies that specialize in leasing. Some are engaged in

general leasing, dealing with just about any kind of equipment. Others specialize in particular equipment,

such as trucks or computers.

For example, Equipment manufacturers are also occasionally in the leasing business. Of course, they

usually lease only the equipment they manufacture.

Advantages of Leasing

The obvious advantage to leasing is acquiring the use of an asset without making a large initial cash outlay.

Compared to a loan arrangement to purchase the same equipment, a lease usually:

Requires no down payment, while a loan often requires 25 percent down.

Requires no restriction on a company's financial operations, while loans often do.

Spreads payments over a longer period (which means they'll be lower) than loans permit.

Provides protection against the risk of equipment obsolescence since the lessee can get rid of the

equipment at the end of the lease.

Leasing has the further advantage that the leasing firm has acquired considerable knowledge about the

kinds of equipment it leases. Thus, it can provide expert technical advice based on experience with the

leased equipment.

Finally, there is one further advantage of leasing that you probably hope won't ever be of use to you. In the

event of bankruptcy, claims of the lessor to the assets of a firm are more restricted than those of general

creditors.





Disadvantages of Leasing

In the first place, leasing usually costs more because you lose certain tax advantages that go with

ownership of an asset. Leasing may not, however, cost more if you couldn't take advantage of those

benefits because you don't have enough tax liability for them to come into play.

Obviously, you also lose the economic value of the asset at the end of the lease term, since you don't own

the asset. Lessees have been known to grossly underestimate the salvage value of an asset. If they had

known this value from the outset, they might have decided to buy instead of lease.

Further, you must never forget that a lease is a long-term legal obligation. Usually, you can't cancel a lease

agreement.

So, if you plan to end an operation that used leased equipment, you might find you'd still have to pay as

much as if you had used the equipment for the full term of the lease.

Accounting Treatment of Leases

Historically, financial leases were "off the balance sheet” financing. That is, lease obligations often were

not recorded directly on the balance sheet but listed in footnotes, instead.

Not explicitly accounting for leases frequently resulted in a failure to state operational assets and liabilities

fairly.

In 1977 the Financial Accounting Standards Board (FASB), the rule-making body of the accounting

profession, required that capital leases be recorded on the balance sheet as both an asset and a liability.

This was in recognition of the long-term nature of a lease obligation.

Cost Analysis of Lease v. Loan/Purchase

You can analyze the costs of the lease versus purchase problem through discounted cash flow analysis. This

analysis compares the cost of each alternative by considering: the timing of the payments, tax benefits,

and the interest rate on a loan, the lease rate, and other financial arrangements.

To make the analysis you must first make certain assumptions about the economic life of the equipment,

salvage value, and depreciation.

A straight cash purchase using a firm's existing funds will almost always be more expensive than the lease

or loan/buy options because of the loss of use of the funds. Besides, most small firms don't have large

amounts of cash needed for major capital asset acquisitions in the first place.





To evaluate a lease you must first find the net cash outlay (not cash flow) in each year of the lease term.

You find these amounts by subtracting the tax savings from the lease payment. This calculation gives you

the net cash outlay for each year of the leases.

Each year's net cash outlay must next be discounted to take into account the time value of money. This

discounting gives you the present value of each of the amounts.

The present value of an amount of money is the sum you would have to invest today at a stated rate of

interest to have that amount of money at a specified future date.

Say someone offered to give you $100 five years from now. How much could you take today and be as well

off?

Common sense tells you could take less than $100 because you'd have the use of the money for the five

year period.

Naturally, how much less you could take depends on the interest rate you thought you could get if you

invested the lesser amount. For example, to have $100 five years from now at six percent compounded

annually, you'd have to invest $74.70 today.

At 10 percent, you could take $62.10 now and have the $100 at the end of five years.

Fortunately, there are tables that provide the discount factors for present value calculations. There are

also relatively inexpensive special-purpose pocket calculators programmed to make these calculations.

Why bother with making these present value calculations? Well, you've got to make them compare the

actual cash flows over the time periods. You simply can't really compare methods of financing without

taking into account the time value of money. It may seem confusing and complex at first, but if you work

through an example, you'll begin to see that the technique isn't difficult-just sophisticated.

Evaluation of the borrow/buy option is a little more complicated because of the tax benefits that go with

ownership, loan interest deductions, and depreciation.

As noted earlier, the salvage value is one of the advantages of ownership. It must be considered in making

the comparison. Naturally, it is possible that salvage costs for real assets could be very high or be next to

nothing. Salvage value assumptions need to be made carefully.

Thus, while this sort of analysis is useful, you can't make a lease/buy decision solely on cost analysis

figures. The advantages and disadvantages discussed earlier, while tough to qualify, may outweigh

differences in cost-especially if costs are reasonably close.





Look Before You Lease

A lease agreement is a legal document. It carries a long term obligation. You must be thoroughly informed

of just what you're committing yourself to. Find out the lessor's financial condition and reputation. Be

reasonably sure that the lease arrangements are the best you can get, that the equipment is what you

need and that the term is what you want. Remember, once the agreement is struck, it's just about

impossible to change it.

The lease document will spell out the precise provisions of the agreement. Agreements may differ, but the

major items will include:

The specific nature of the financing agreement

Payment amount

Term of agreement

Disposition of the asset at the end of the term

Schedule of the value of the equipment for insurance and settlement purposes in case of damage or

destruction

Who is responsible for maintenance and taxes.

Renewal options

Cancellation penalties

Special provisions

Documents

Certified Financial Consultant - CFC® · Certified Financial Consultant - CFC® Part Financial Skills Chapter 1: Financial Ratios Chapter 2: Cash Flow Analysis Chapter 3: Lease vs