Saturday, 19 May 2012

What is Management Accounting?

While financial accounting seeks to account how a business used its financial resources, management accounting seeks to report how well the resources were used and indicate how to use them even better. Another major difference is that financial accounts are mainly meant for an external audience whereas management accounting reports are typically seen and used only by managers inside the business organization.

The information generated in the course of financial accounting might be used, but in a different way. For example, cost accounting (part of management accounting) accumulates the costs incurred by the business under "cost centres" instead of by the type of expense. For example, while financial accounting typically records all wage payments under a Wages Account, cost accounting analyses the wage payments by cost centres such as a particular project or department.

Managers are interested in how much cost a project incurred and under what categories, rather than in the total amount of wages paid across the whole organisation.

Management accounting also deals with non-financial data, such as output quantities. Actual performance is compared against standards that should have been achieved. Such comparisons can highlight variances from standards, which are then analysed by the factors that caused the variances. This kind of analysis tells the manager about specific problems that need his or her attention.

We will look at management accounting practices in more detail in forthcoming posts.

Thursday, 10 June 2010

Financial Accounting and Management Accounting

The posts so far have been concerned with the basics of accounting.

In the first post, we saw that "accounts" provide details of business transactions and show how legal obligations have been discharged. Later posts discussed the mechanics of keeping accounts, and significance of double entry bookkeeping that recorded the essence of business transactions, viz. giving and receiving of value.

We went on to look at the Income Statement that summarized the revenue and expenses during a period and showed how the business earned a profit or incurred a loss. We also looked at analyzing the Income Statement to glean meaningful insights about its performance.

Next came the Balance Sheet, or financial position statement that revealed the financial position of a business as on a particular date, such as the financial year ending date. We looked at analyzing the Balance Sheet to get an idea about the business' financial soundness.

Finally, we looked at cash flows; the critical role actual cash has on the continued survival of the business. We learnt how to compute the speed with which a business was turning over its cash through the inventory-> receivables-> cash cycle and how to prepare cash forecasts.

The Income Statement, Balance Sheet and Cash Flow Statement are intended mainly for an external audience - investors, lenders, suppliers, employees, customers, government and the public. For day to day management of business operations, these reports are practically useless. A special field of accounting, known as management accounting, has emerged to support business managers with decision-making information.

We will now start looking at management accounting.

Friday, 28 May 2010

Cash Budgeting Brings a Sense of Reality to the Business

Businesses can easily get overboard with their profitability projections and expansion plans. If orders are increased by offering too liberal terms of credit, for example, the high levels of sales might hide the problem that most of it are non-cash, and not available to meet day-to-day expenses. As mentioned in the last post on Cash Conversion Cycle, if receivables and inventories are too high, a business can have little cash to pay accruing liabilities and meet daily expenses.

A cash budget estimates in advance the lkely cash inflows and outflows of the business. Instead of sales, it will be collections from credit customers (and cash sales, if any) that will be shown on the receipts side. And the payments side will include not only operating expenses but also installment payments under long-term liabilities such as term loans and dividend payouts to owners. Such a cash budget will identify any likely cash shortages the business is likely to face.

Once a business becomes aware of cash shortages that are likely to occur, it can plan in advance and organize to raise needed funds to meet these. In the absence of cash budgeting, the business can suddenly find itself short of cash and unable to pay its creditors. And unpaid creditors can seriously disrupt business operations by going to a court.

So how do you prepare a cash budget? An example cash flow statement is illustrated below (click on it to get a larger, readable, view). We look at the process of cash budgeting below.

Estimate Cash Realizations

Look at the average credit that customers actually take advantage of. Then include this time lag while estimating the cash realizations from your sales. For example, suppose that your total sales for a month are 20,000 (of which 2,000 is cash sales) and the average time taken by customers is 2.5 months. You will then include the credit sale of 18,000 in the cash budget as a receipt only in the third month after the sale. The cash sale of 2,000 can of course be included in the month of sale.

Any receipts under bank or other loans, or capital brought in by owners, are also included under the month in which it is received. In fact, after preparing the first draft of the cash budget, you might find that you need to arrange funds under these categories to meet any shortfalls in cash foreseen.

Estimate Cash Payments

Established businesses might be able to obtain liberal credit terms from their suppliers. Small and new businesses might, however, get only short credit periods. Look at the actual credit that your suppliers allow you, and include payments that you have to make for the supplies you have purcahsed accordingly. For example, if you get only one month's credit, include payments for purchases in the month after the purchase.

Next, look at the various other kinds of payments you have to make. These typically include:

  • Operating expenses that you incur, such as travel expenses, petty purchases, employee salaries, tax payments, etc
  • Interest payments on any borrowings you have made
  • Repayments of borrowings that typically occur in installments at agreed intervals on specified dates
  • Any advance payments or deposits that you have committed to make
  • Dividend payments or owners' cash drawals from the business

Prepare a Monthly Cash Budget

Each month column of the cash budget will start with the opening balance of cash for that month, to which estimated cash receipts during that month will be added and from the resulting total will be deducted the estimated cash payments during that month. The month column will end with the resulting closing balance of cash, which will be carried over as the opening balance for the next month.

The first draft of cash budget might indicate that the closing balance is negative in one or more months. In such a case, you will have to think of how to arrange external funds to meet the cash shortage. With a realistic cash budget, you will even find it easier to get a bank advance needed funds to meet any temporary shortfalls.

Monday, 24 May 2010

Analyzing Cash Flows

Cash is the oxygen that keeps a business alive. Even a profitable business can die if its cash availability is inadequate to meet emerging commitments such as payments to creditors, interest payments on borrowings and loan repayments. The creditors can go to court and force a business to sell its facilities and pay their dues.

How can a profitable business become short of cash? The answer is that it can run out of cash in several ways. For example, it might be trying to expand its business too fast by extending liberal credit to attract more customers, and stocking up on materials and merchandise to ensure that orders, however small, are not lost on "out-of-stock" grounds.

Inventories need to be sold and then the credit period has to be waited out before actual cash is received. If this period is considerably more than the period of credit it receives from its own suppliers, a business can easily find itself out of cash to pay the suppliers.

It is this aspect of operations that the Cash Conversion Cycle (CCC) seeks to measure. CCC is computed by adding the number of days' sales (or better, Cost of Sales) in inventory (DIO) to the number of days' sales in receivables (DSO), and then deducting the number of days' sales (or Cost of Sales) in Payables (DPO) from the total.


Computing the Cash Conversion Cycle

We need the following five values to compute the CCC:

  • Revenue or Sales
  • Cost of Sales
  • Average Inventory during the period
  • Average Receivables during the period
  • Average Payables during the period

Of these, sales and cost of sales are obtained from the Income Statement while the remaining values are from the Balance Sheet. Average values of inventory, receivables and payables are computed by totaling the opening and closing values of each and dividing by two.

Let us do the computations using the following values extracted from a published annual report:

  • Revenues: 1395832
  • Cost of Sales: 1673403
  • Average Receivables - (closing + opening)/2, i.e. (501212 + 679378) / 2 = 590295
  • Average Inventory (552074 + 1958233) / 2 = 1255153.5
  • Average Payables (1641457 + 2255022) / 2 = 1848240

Dividing the yearly revenue by 365 we get a day's sales: 1395832 / 365 = 3824.20. Day's cost of sales is also computed similarly: 1673403 / 365 = 4584.67.

The receivables of 590295 represent 590295 / 3824.20 = 154.36 days' sales, i.e. 5 months' sales. Inventory of 1255153.5 represents 1255153.5 / 1673403 = 258.55 days' cost of sales, i.e. nearly 9 months' sales. In total, 412.91 days', i.e. more than a years' worth of sales are blocked in receivables and inventories (both of which have been brought down by the year end).

As against this, the company enjoyed 1848240 / 4854.67 = 380.71 days' cost of sales worth of credit, i.e. more than one year's credit.

The company's Cash Conversion Cycle thus works out to: 154.36 + 258.55 - 380.71 = 32.2 days. Even this was possible only because of the high credit given to the company by its creditors.

While the cash conversion cycle measures what happened in the past, it is the future-oriented cash budgeting exercise that helps a business control its cash position. Cash budgeting can forecast likely cash shortages so that the company can arrange funds to meet these.

We will look at cash budgeting in the next post.

Saturday, 24 April 2010

Financial Statements: The Cash Flow Statement

The Cash Flow Statement is the third of the main financial statements, coming after Income Statement and Balance Sheet. Basically, this statement shows how the changes in these earlier statements affected cash held by the business. For example, Cash Profits, i.e. income minus "cash" expenses will increase the cash holdings.

Any such increase as a result one change might be offset by the impact of other changes. For example, the increase resulting from cash profit might be nullified by a corresponding increase in working capital, i.e. increased inventories and receivables. An increase in receivables mean that revenue was not fully realized in cash while increase in inventories mean that part of the realized cash was spent on stocking more materials or merchandise. Both these developments reduce available cash balance.

Similarly, adding new production facilities, such as a new building or machinery, can reduce cash holdings. On the other hand, if money was borrowed from a bank for these additions, it can reduce the reduction in cash holdings.

The cash flow statement thus shows the complex interplay of several changes, viz. revenue, expenses, working capital, new plant and other facilities, dividend payments, borrowings and repayment of borrowings. All of these items involve cash inflows and outflows, and will affect cash holdings. According to current practice, cash flow items are classified under Operating, Investing and Financing activities. Let us now look at a typical cash flow statement.

The Cash Flow Statement example shown starts with identificatory data at the top, indicating the period to which the data in different columns relate to. The first column is for description of the items.

The first line of the statement proper is the Net Income from Income Statement. To this are added the non-cash items that had been included in the Income Statement. Depreciation, amortization, deferred taxes and other non-cash items had thus been adjusted against the Net Income to compute the "cash" profit.

The logic of non-cash items can be illustrated as follows.

An asset with a useful life of 10 years is purchased paying full value in a particular year. It will affect the cash flow in that year. However,  you cannot treat the whole cost as an "expense" in that year because the asset will be in productive use for ten years. So the asset cost is "expensed" over ten years by, say writing off 1/10th of the cost as "depreciation" each year. The depreciation charge does not affect the cash flow of the year, and is "added back" to the net income to arrive at the "cash income."

The next item in the cash flow is "Changes in working capital". As mentioned earlier, increase in inventories and receivables (which are the main items of working capital other than cash) reduce cash balances available. On the other hand, if there is a reduction in these items, cash balance is increased (as in the example cash flow statement).

Cash income plus changes in working capital constitute the "Operating" cash flows.

The next section is the "Investing" cash flows. These include purchases and sales of long-term facilities (capital expenditure) such as buildings, plant and equipment. Investment in stocks and bonds, if any, are also included here. The net total of such investments is the Investing cash flow.

Then comes the "Financing" cash flows, which represent the inflows and outflows related to financing of the business, such as issue or retirement of shares, receipts and repayments of loans, and interest and dividend payments.

The net effect of the above cash flows is a surplus or deficit of cash flows. If inflows exceed outflows, there is a surplus cash flow; otherwise there is a deficit. This surplus or deficit is adjusted against the cash balance that was there at the beginning of the period to arrive at the cash balance at the end of the period.

The Cash Flow Statement indicates the short-term financial position of the business, showing whether the business was in a position to meet all its obligations in a timely manner. For example, if the business had incurred losses, it might not have generated enough cash internally to meet any loan repayments. Such a situation will be clearly highlighted by the cash flow statement.

Wednesday, 21 April 2010

Balance Sheet Analysis: What Information Does it Reveal?

We mentioned in the last post that much information about the financial position of a company can be obtained by analyzing its balance sheet. Let us now look at the kind of information such analysis reveals.

Balance sheets are analyzed by comparing two items in that document. A simple example is the working capital computation we did in the last post. We deducted total current liabilities from total current assets and both these values were obtained from the Balance Sheet. Instead of deducting one item from another, the analysis often involves finding the ratio between two items.

Working Capital

If the working capital is negative, it can indicate that the company's short-term financial position is not safe. The business might not be able to meet its day-to-day payments comfortably. In practice, working capital adequacy also depends on the industry in which a company is engaged in.

A retail establishment that sells merchandise for cash can have a lower working capital and yet be able to meet its obligations without difficulty. It can accumulate the cash takings to meet any heavy cash outflows expected.

On the other hand, an aircraft manufacturing company will take years to complete an order, and even with part advance payments from customers, it will need substantial working capital to meet its day-to-day obligations such as payroll and other expenses, as well as paying its suppliers, during the period when the aircraft is being manufactured.

Two widely-used ratios related to working capital are the Current Ratio and Quick Ratio.

The Current Ratio is computed by dividing the total current assets by total current liabilities. In the example balance sheet, current ratio is 122078 / 78399 = 1.56 for 2009 and 109550 / 76134 = 1.44 in 2008. A ratio above one indicates a positive working capital. The computation also shows that the working capital position has improved during the latest year.

The Quick Ratio recognizes the fact that items like Inventories included in current assets might not be quickly convertible into cash and thus capable of being used for immediate payments. This ratio is computed by subtracting inventory from total current assets and dividing the net amount by total current liabilities. In the balance sheet above, the total current assets of 122078 for 2009 includes inventories of 45854 and when it is deducted, we get 76224 as "quick" assets. Dividing quick assets by total current liabilities of 78399 we get a quick ratio of 0.97. The ratio indicates that, provided the quick assets do not include significant amounts of "bad" items (such as unrecoverable debtors), the company can meet its current obligations without difficulty.

Long-Term Financial Soundness

While the working capital amount and related ratios give an insight into the company's short-term financial position, it is the Debt-Equity Ratio that reveals its longer-term financial strength. This ratio is computed by dividing long and short term debt by shareholders' equity. In the example balance sheet, long-term liabilities amount to 73945 and current portion of long-term debt amounts to 22337. By dividing the resultant total of 96282 by total shareholders' equity of 133783, we get a Debt-Equity Ratio of 0.72.

Generally, a debt-equity ratio of 1 or less is considered sound in the U.S. However, this can vary from industry to industry and the ratio is typically compared with other businesses in the same industry.

Inventory and Receivables Management

Managing inventories and receivables well is critical for good financial management. Inventories are managed by keeping it to as low as possible while ensuring that sales opportunities are not lost for want of materials. Receivables are managed by extending credit only to customers with good credit rating, and collecting the dues in a timely manner.

The effectiveness of managing inventories and receivables are sought to be assessed by computing two "turnover" ratios, inventory turnover and receivables turnover. The turnover ratios are computed by dividing inventories or receivables by total revenue (or cost of revenue) for the year. The ratios can then be used to work out the number of days' sales represented by inventories or receivables.

The total revenue amount will have to be obtained from the Income Statement. In the case of the company whose balance sheet has been illustrated, total revenue for the latest year was 713950 and cost of revenue was 432744. Corresponding amounts for the previous year were 739211 and 426916 respectively.

Inventory turnover: For inventory turnover, it is better to use cost of sales because inventory is valued at cost.  In the example above, we divide the cost of sales, 432744, with inventory, 48854  and get 8.86, representing 365 / 8.86 = 41 days worth of (cost of) sales.

Receivables turnover: 713950 / 11335 = 63, or 365 / 63 = 5.79 days worth of sales. This particular company did most of its sales on the Web against immediate payment, and hence the low receivables outstanding.

Turnover rates, and days of sales in inventory and receivables, differ from industry to industry. Hence, these values for a particular business become meaningful only when compared with those of other businesses in the same industry.

Tuesday, 20 April 2010

Financial Statements: The Balance Sheet - 2

In the first part of this post, we looked at most of the contents of a balance sheet, i.e. items listed under assets, and also at current liabilities and working capital. In this part, we look at the remaining items in a typical published balance sheet.

Long-Term Liabilities

Long-term liabilities represent obligations of the company that are payable only after more than one year from the date of the balance sheet. Typically, they will include loans taken to create the long-term assets such as buildings and plant. These loans will usually be repayable over a number of years in agreed installments.

Some companies might issue bonds to the public. Bonds are like shares except in that bondholders are not owners but lenders. They get an agreed rate of interest instead of variable rates of dividends that stockholders receive.

In the example balance sheet, there are items like Deferred tax liabilities under long-term liabilities. These are simply liabilities that are payable after one year or more.

Stockholders' Equity

we have been looking at the assets and liabilities a business so far. If you deduct the liabilities from the assets of a company, you get that company's net worth. This net worth is what we call stockholders' equity. (If the liabilities exceed assets, stockholders' equity is negative; this happens when the company has been incurring losses and the accumulated losses exceed the money contributed by shareholders.)

Stockholders' equity is not a single item in the balance shset. Instead, it is usually represented by several items, such as preferred stock, common stock and retained earnings. Preferred stock is something between bonds and common stock, typically receiving a fixed rate of dividend if profits to pay the dividend are available. Common stockholders are what we typically mean when we speak of company shareholders.

All stock typically have a "par" value which is simply a book value. Stockholders typically pay much more than this par value to acquire shares from the company, and the excess amount over par value is shown as Additional Paid In Capital.

Companies might also purchase their own shares in the market and either retire (eliminate) them, or keep them in reserve for later reissue. Thus companies might purchase shares when their market price is low, and reissue them when the price is high. If the shares are not retired, the balance sheet will disclose the repurchased shares as Treasury Stock, and show them as a deduction from the Stockholders equity.

The example balance sheet shows all the above cases, viz. preferred stock, common stock with par value, additional amounts paid in by shareholders and treasury stock.

The major item remaining under stockholders' equity is retained earnings. Retained earnings represent accumulated profits. Profits earned by the company can either be distributed as dividends to shareholders, or retained in the company to finance expansion or meet shortfalls in working capital.

The cumulative amount of such retained earnings is what we will see as Retained Earnings under stockholders' equity. Where the company has been incurring losses, the retained earnings figure will be Retained Deficit, a negative value that is deducted from stockholders' equity, as is the case in the example balance sheet.

Now that we have looked at the assets, liabilities and stockholders' equity, we will discuss balance sheet analysis in the next post. Balance sheet analysis can reveal very significant information about the company's financial position.