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Business Planning and Finance (2. Financial statement analysis (Ratio…
Business Planning and Finance
Business Planning
: the stage in strategic planning where goals become projected revenue, against which the organization must allocate its financial resources.
Generally accepted accounting practices (GAAP)
International Financial Reporting Standards (IFRS)
1. Financial statements
General components of financial statements
Assets
Liabilities
Equity
Profit (=income)
Expense
Uses of financial statements
Income statement
a financial statement showing the net income for a business over a given period of time.
Income = revenues – expenses
Balance sheet
a financial statement showing the resources owned, the debt owned, and the owner’s share of a company at a given point in time.
Assets = liabilities + equity
Statement of cash flows/ funds flow statement
a financial statement showing the flow of cash and its timing into and out of an organization or report.
Operating activities
Investing activities
Financing activities
2. Financial statement analysis
Several important data
:
trends are important;
size is relative;
performance must be considered in context;
significance is relative.
Horizontal analysis
an analysis of the variance of each item in a statement from the previous year. (found in
income statements
and
balance sheets
)
Vertical analysis
each item in the statement is described as a percentage of the largest item in the statement.
Ratio analysis
Liquidity ratio
: an organization’s ability to liquidate or satisfy its short-term debt, such as wages, account payable, or interest payments on loans.
Current ratio = current assets / current liabilities
Quick asset ratio = (current assets – inventory) / current liabilities
Activity ratio
: the efficiency with which the organization has used its assets to produce value.
Inventory turnover ratio
: the amount of time an organization holds inventory before the inventory generates income.
inventory turnover ratio = average inventory level / annual cost of sales
Accounts receivable ratio
: the organization’s ability to collect payment from its customer.
accounts receivable ratio = average accounts receivable / net credit sales
Average collection period
: the amount of time on average that it takes the organization to receive payment.
Leverage ratios
: an organization’s solvency: its ability to satisfy its long-term debt.
debt ratio = total liabilities / total assets
time-interest-earned ratio = earnings before interest and taxes (EBIT) / interest expense
Market value ratio
: the attractiveness of an organization’s stock to its investors.
Earnings per share (EPS) = (net income – preferred dividends)/ holders of common stock
Price/earnings (P/E) ratio
: investor confidence as evidenced by the value of the stock.
P/E ratio = market price per share / earnings per share
Cash conversion cycle
: the length of time from the purchase of raw materials to the collection of accounts receivable from customers for the sale of product or service.
Cash-to-cash cycle time
: how long cash is tied up in inventory before it is sold and payment is collected from customers.
cash-to-cash cycle time = day’s inventory outstanding + day’s sales outstanding – day’s payable outstanding
day’s inventory outstanding = inventory / cost of sales
day’s sales outstanding = accounts receivable / net credit sales
day’s payable outstanding = accounts payable / costs of sales
Total factor productivity
: the weighted productivity ratios of different production inputs
3. Budgeting
Types of budgets
Master budget
: comprise many separate budgets with specialized purposes.
Steps in preparing a master budget
:
Prepare a sales forecast;
Determine expected production volume;
Estimate manufacturing costs and operating expense;
Determine cash flow and other financial effects;
Create pro forma financial statement.
Operating budgets
Sales
Production
Direct material
Direct labour
Factory overhead
Ending inventory
Selling and administrative expense
Pro forma income statement
Financial budgets
Cash
Pro forma balance sheet
Capital budgets
: the investment of resources (either cash on hand or financial debt) to improve an organization’s long-term competitive.
ROI = (gain from investment – cost of investment) / cost of investment
Residual income = operating income – (minimum required rate of return * operating assets)
Payback period = cost of investment / annual cash savings
Accounting rate of return = (annual cash flow – straight-line depreciation) / (0.5 * initial investment)
Net present value (NPV)
Internal rate of return (IRR) (= hurdle rate)
PV factor = initial investment / annual cash flows
Profitability index = present value of investment / initial value
4. Costing methods and tools
Cost classification
Manufacturing/ non-manufacturing costs
(purpose: external reporting)
Manufacturing costs
Material costs
Direct materials
: everything that becomes part of finished product, whether it is raw material or a component.
Indirect materials
: a relatively small part of a product, including small pieces of hardware and item difficult to quantify, such as solder or glue.
Labour costs
Direct labour
: the work that goes into creating a unit.
Indirect labour
: contributes to the entire shop floor production, but not to any specific product, including delivering inventory to multiple work stations or cleaning the shop.
Manufacturing or factory overhead
: everything but direct material and labour, including maintenance and repair, utilities and property costs.
Non-manufacturing costs
Marketing or selling costs
: advertising, shipping, sales compensation and expense, warehousing.
Administrative costs
: cost associated with individuals and activities involved in managing the operation as a whole, including accounting, HR, clerical support.
Product and period costs
(purpose: external reporting)
Product costs
: recognized or accrued in the same reporting period in which it’s sold.
Period costs
: accrued at the time the purchase is made. (not included in COGS, but includes selling and administrative expenses)
Variable/ fixed cost
(purpose: analysing cost behaviour under different conditions)
Variable costs
: an opening cost that varies directly with a change of one unit in the production volume.
Fixed costs
: an expenditure that does not vary with the production volume, including rent, property tax, salary.
Direct/ indirect cost
(product pricing and performance control)
Direct cost
: variable costs that can be directly attributed to a particular job or attention.
Indirect cost
: (=
overhead
) costs that are not directly incurred by a particular job or operation.
Differential, sunk, and opportunity costs
(purpose: analysing investment alternatives)
Costs of quality
(purpose: assessing value gained or lost through quality practices)
Tools
Absorption costing
the cost-per-unit calculation the all variable direct costs plus
a shared of fixed overhead costs for the period
.
United share of fixed overhead = (direct costs * fixed overhead rate) / product volume
Total unit cost = unit direct cost +
unit fixed overhead
Variable costing
the costs that could vary depending on the level of production – materials and labour, set up costs, or utilities.
Total unit cost = unit direct cost +
unit variable overhead
Job-order, process, and operation costing
Job-order costing
when products are produced in lots or batched or as an order manufactured to a customer’s specification.
(costs are assigned to specific jobs)
Overhead rate = budgeted annual overhead / budgeted annual activity units
Ps: budgeted annual activity represents the organization’s capacity in number of hours.
Job costing = direct cost + (required hours * overhead rate)
Process costing
when product is continuously mass-produced and has little variation, such as oiland chemical refineries or textile production.
(costs are collected by time period and average over all the units produced during the period)
Steps in determining process costs:
Determine how much has been produced in the period and in what stage of production;
Sum equivalent amounts;
Total costs and allocate them by work unit.
Ps:
process cost (unit)
= (material + labour + overhead costs) / equivalent amounts
Operation costing
when products produced have both common and distinguishing characteristics.
Activity-based cost accounting
the costs of
individual activities
that are required to produce a product or service.
Steps in activity-based costing:
Identify cost drivers;
Assign an overhead rate for each driver;
Estimate the number of occurrences for each driver;
Repeat for all drivers associated with the product.
Activity-based management (ABM)
: costs based on activities performed and then use cost drivers to allocate these costs to products or other bases.
Standard costs and variance analysis
Step 1: define standards costs.
standards costs
: the targeted costs of an operation, process, or product including direct material, direct labour, and overhead charges.
• Materials, based on cost at the time of purchase
• Labour at the point of production
• Variable manufacturing overhead.
Step 2: measure and analyse the variance.
• Materials variances
are measured by quantity used and price.
• Labour variances
are measured by rate of use and efficiency.
• Overhead variances
are measured by spending and by efficiency.
Step 3: determine changes that will produce improvement
Step 4: implement the changes
Step 5: re-measure variances
Cost-volume-profit (CVP) analysis tools
Contribution margin (CM) = sales – variable costs
• Unit CM = unit selling price – unit variable cost
• CM ratio = CM / sales
Break-even (BE) analysis
• B/E point (units) = fixed costs / unit CM
• B/E point (dollar) = fixed costs / CM ratio
Target income volume analysis
: translate sales targets into production requirements.
• Target income sales volume = (fixed costs + target income) / unit CM
Sales mix analysis
: the proportion of individual product-type sales volumes that make up the total sales volume.
