How business works

HOW
FINANCE

WORKS

Financial reporting ❯ Financial accounting
Management accounting ❯ Measuring
performance ❯ Raising financing

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Financial
reporting

Financial reports are everywhere: a bill at a restaurant is a financial report, as
are sales receipts and bank statements. In business, however, financial reporting
refers to the financial statements that make up a company’s annual report and
accounts. Compiled by accountants, they provide investors and lenders with
information to assess a company’s profitability, and enable company managers,
government, tax authorities, and other stakeholders to evaluate the business.

Types of financial reports The annual report

Financial reports take many forms and can Financial statements usually appear in a company’s
contain a vast amount of information about a annual report and sum up its financial activities in a
company’s finances, work, core business values, standardized way for different audiences to interpret
performance, employees, and its compliance quickly and clearly. These statements take diverse forms,
with local, logistical, domestic, and international and being able to deconstruct them is a vital skill for
laws. The most important financial report, accountants and businesspeople, making it simple
or statement, is usually the annual report— to see how well a business is performing and why.
essentially a collection of many other, smaller
reports—which sums up how the business has $50
performed in the last year. There is a multitude billion
of laws, regulations, and guidelines governing
what should be put into this report. the amount hidden via
loans diguised as sales by
THE ACCOUNTING CYCLE Lehman Brothers in 2008

The eight steps of the accounting cycle are $ $$
used by nearly all accountants. The cycle
helps by standardizing processes and makes
sure that accounting jobs are
performed correctly and in
the same way and order
for every activity.
See pp.102–103.

100 101HOW FINANCE WORKS
Financial reporting

TYPES OF ACCOUNTING ❯ Forensic Engages in disputes and
litigation, and in criminal investigations
There are seven widely recognized types of accounting: of fraud. See pp.152–153.

$ ❯ Financial Drawn up by accountants; ❯ Project Deals with a particular project;
used by investors, creditors, and
management. See pp.110–129. $ a useful aid for project management.

❯ Management Used by managers ❯ Social and environmental Shows how
to control cash flow and budgets, and a company makes a positive difference
forecast sales. See pp.130–143. to the community and environment.

❯ Governmental Also called public
finance accounting; used by public
sector for noncommercial accounting.

❯ Tax Dictates exact rules that companies
$ and individuals must follow when

preparing and submitting tax returns.

Fin ancial statements

❯ What’s in an annual report? A full record
of company performance according to various
criteria, as well as accounts. See pp.104–105.

❯ What are the statements? The main one is
financial; others include sustainability, directors’
pay, and charitable donations. See pp.106–107.

❯ Who reads which statements? Sections are
relevant to banks, shareholders, government,
auditors, staff, and media. See pp.108–109.

❯ What do the notes mean? Main statements
are annotated in detail. See pp.104–109.

❯ What are the rules? Accounting principles
regulate financial reports. See pp.112–113.

❯ Which are the most important financial
statements? Profit-and-loss statements,
balance sheets, and cash-flow statements
contain key facts. See pp.114–121.

The accounting cycle

The accounting cycle is a step-by-step process bookkeepers use to
record, organize, and classify a company’s financial transactions.
It helps to keep all accounting uniform and eliminate mistakes.

How it works any length of time—this is known as an accounting
period—and usually lasts a month, a quarter, or a year.
The cycle works as an aid to organize workflow into a Accounts which deal with revenues and expenses
cyclical chain of steps that are designed to reflect the return to zero at the end of each financial year, while
way assets, money, and debts have moved in and out accounts showing assets, liabilities, and capital carry
of a business. It progresses through eight different over from year to year.
steps, in the same order each time, and restarts as
soon as it has finished. The cycle can be based on

The eight-step cycle Transactions  

The processes shown here are Any type of financial transaction,
repeated in the same way for every from buying or selling an asset to
accounting period. All businesses paying off a debt, can start the
go through different phases, and the accounting cycle.
accounting cycle works by reflecting
that. The financial statement, which new cycle
is prepared toward the end of each
cycle, is helpful in showing how Closing the books 6,000
strongly the business has performed 15,000
during each period of time. A closing entry based on adjusted
journal entries is taken, the books 21,000
BOOKKEEPING AND are closed, and the cycle restarts.
ACCOUNTING Financial statements  

❯ Internal controls A method The corrected balances are then
of deploying, measuring, and used to prepare the company’s
monitoring a business’s resources. financial statements.
This helps prevent fraud and keep
track of the value of assets.

❯ Double-entry bookkeeping
The process of recording all
transactions twice—as a debit
and as a credit. If a company buys
a chair for $100, its debit account
increases by $100 and its credit
account decreases by $100.

❯ Bad debts Debts that cannot be
or are unlikely to be recovered, so
are useless to the creditor (lender),
who writes them off as an expense.

102 103HOW FINANCE WORKS
Financial reporting

Journal entries Posting   NEED TO KNOW

Accountants then analyze the Journal entries are then ❯ Debits Expenses—dividends,
transaction and note it in the transferred to the general assets, and losses. In double-entry
relevant journal—a book or an ledger—a large book or accounting, debits appear on the
electronic record. electronic record logging left-hand side of the account
all the company’s accounts.
❯ Credits Gains—income, revenue,
owners’ equity, and liabilities. In
double-entry accounting, credits
appear on the right-hand side

❯ Chart of accounts List giving
the names of all of a company’s
accounts, used to organize records

❯ Audit trail Full history of a
transaction, allowing auditors to
trace it from its source, through
the general ledger, and note any
adjustments made

13% $ $ Trial balance  
$
more accountants A list of all the company’s accounts
will be required is prepared at the end of the
in the US by 2022 accounting period, usually a year,
quarter, or month.

10,000 55 230
21,000

Adjusting journal entries   Worksheet  

Once the accounts are balanced, any Often, trial balance calculations
adjustments are noted in journals at don’t accurately balance the
the end of the accounting period. books (see pp.116–117). In such
cases, changes are made on
a worksheet.

Financial statements

The formal records of a business’s financial activities are presented as
financial statements. Most jurisdictions require accurate information
by law, and financial directors and auditors are liable for its contents.

How it works so they need to be detailed but also comprehensible
to the general public. The statements are usually
Financial statements summarize a company’s presented together in the form of an annual report,
commercial activities clearly and succinctly, with with in-depth accounts and footnotes to give detail.
details of the business’s performance and changes to Legal requirements vary, but accounts must be exact.
its financial position. They are aimed at several parties,

What’s in an annual report

The contents page shows where to find the big three statements—the balance sheet, cash-flow
statement, and profit-and-loss statement—and softer information such as stories about staff and
opinions of other stakeholders. The annual report provides an opportunity to impress shareholders
and lenders as well as fulfill legal reporting obligations. It will contain all, or most, of the following.

r’s introduction It is common for the chairman r environm These pages contain much of
Chai to write an introduction Ou Ou ent es the company’s information on
focusing on the positives and its environmental protocols,
explaining any negative parts most of which are industry-
of an annual report for the specific. See also pp.122–123.
benefit of shareholders.

mers and c ommunity This section underlines a r employe A section on employees
company’s social ethos, in details areas such as staff
Our custo particular its community development and training,
involvement. Different types health and safety, and key
of companies may focus on statistics on staff satisfaction.
different values.

O ur finance A brief overview summarizes infrastruc The infrastructure pages of
$ s the key areas of finance Our ture an annual report are a good
for the company, including place to supply more detail
overall performance, about the company’s fixed
turnover, operating assets and explain why the
costs, capital investment, company is an attractive
depreciation, interest charges, investment for investors
taxation, and dividends.
(See also pp.114–121.)

104 105HOW FINANCE WORKS
Financial reporting

CONSOLIDATED FINANCIAL STATEMENTS NEED TO KNOW

In an era of globalization, large corporations are now commonly made up of ❯ Subsidiary One company that
multiple companies. Companies owned by a parent company are known as is controlled by another, usually
subsidiaries, and continue to maintain their own accounting records, but the a holding company
parent company produces a consolidated financial statement, which shows
the financial operations of both companies. Depending on the jurisdiction’s ❯ Holding company A company
reporting requirements, however, if a company owns a minority stake in a set up to buy shares of other
second company, then the latter will not be included in the former’s companies, then control them
consolidated financial statement.
❯ Globalization The process of
businesses developing such large
multinational presences that they
transcend international borders

Our performance indicators Performance indicators are Dir ectors’ rep In the directors’ report,
common across all industries. ort members of the board
They measure areas such as of directors give their
customer satisfaction and the professional opinions
quality of goods or services on how the business
provided by the company. has performed over
the last year.

Environ mental acc ounting The environmental Independ ent auditor’s report Auditors are independent
CO2 accounting section contains and check the accuracy of
figures that pertain to the $ companies’ accounts. This
environment, often those helps to eliminate mistakes
stipulated by law—for and track fraud.
example, greenhouse
gas emissions.

Boa rd of direc The board of directors, s to the accounts Notes to the accounts
tors governance report, and Note are a key part of financial
statement of directors’ statements. They provide
responsibilities sections extra detail, insight, and
indicate who is leading the explanation of the bare-
company, showcases their bones figures supplied in
credentials and roles, and earlier pages of the report.
reveals their pay.

FINANCIAL STATEMENTS

Deconstructing a TAXES
financial statement
The percentage of business taxes taken by governments varies from country
The profit and loss account shows to country but the generic types remain similar:
revenues, costs, and expenses—
how much money the business ❯ Direct taxes are levied directly on profits or income and
makes—over an accounting period. include income taxes, inheritance taxes, and taxes relating
The balance sheet shows what to sales or purchase of property and other capital assets.
a business is worth at the time
it is published, and is relevant ❯ Indirect taxes are paid on goods or services, such as sales
to investors as it reveals assets, taxes. Indirect taxes are often targeted to reduce consumption
liabilities, and shareholders’ of harmful goods, a factor relevant to companies working in
equity—all useful for gauging the alcohol and tobacco industries.
business health. The cash-flow
statement shows the movement ❯ Green taxes are increasingly common and are often indirect.
of cash within a business—its They are generally used as a way of prohibitively increasing
liquidity. However, along with the the price of goods or services harmful to the environment,
big three financial statements, an such as air travel, landfill sites, or fuel, to diminish their use.
annual review contains a wealth
of information about a company’s ❯ Corporation tax is only paid by companies, not by sole
performance, of interest to its proprietors or partnerships. It is levied as a percentage of the
stakeholder groups. It is often the company’s total profit.
notes that bring statements to life.

Case study: the details Sustainable investment

Financial statements are presented as part of the Wessex Water’s investment in sustainability includes
annual report, which also publishes case studies, mandatory expenditure and extra discretionary
quotations, statistics, and profiles of customers, expenditure (at the time of the review, £1 = $1.58).
suppliers, employees, and directors. The notes,
often running to 20 pages or so, contain tables 2013 2012
and text that flesh out the financial information. £m £m
The following examples are taken from the 2013
annual review of UK utility company Wessex Water. CUSTOMERS AND 55 38
COMMUNITIES
Our finance
ENVIRONMENT 30 25
$ This section contains the
headline financial figures of EMPLOYEES 49 46
the business, such as profits,
taxes paid, assets owned, INFRASTRUCTURE 139 116
liabilities, and dividends TOTAL 273 225
paid out, as well as some
more detailed explanation
of the figures.

106 107HOW FINANCE WORKS
Financial reporting

NEED TO KNOW BOARD OF DIRECTORS

❯ Monopoly Situation in which Much of what might be considered personal information about directors of public
there is just one supplier of a companies is in the public domain. It is usually a legal obligation to disclose:
particular product or service;
without government control, ❯ Names of executive directors ❯ Dates of directors’ terms of office
a company with a monopoly ❯ Remuneration, including bonus, share
could make prices high and ❯ Names of non-executive directors,
quality low, as consumers and whether they are independent options, pension plans, and benefits
would have no alternative or shareholders ❯ Notice period
❯ Termination payment
❯ Oligopoly Industries that have ❯ Shareholding ❯ Potential conflicts of interest
a small number of suppliers. The
competition is not as intense as in ❯ Board attendance record
the free market, so governments
often impose regulations on
companies to ensure quality
and fair prices

❯ Remuneration Money paid
for work or a service provided—
the financial term for pay; may
include bonuses or share options

Charitable donations $

Companies vaunt their
philanthropy in the annual report,
detailing how much they have
given away and how it has helped.
They may support charities
relevant to the nature of their
business or let employees vote
on recipients.

96% Customer satisfaction

Wessex Water Overall, this section shows how the
utility’s customer company works with customers to
satisfaction score improve service and support. In
monopoly and oligopoly industries,
customer satisfaction is particularly
important, as governments often set
high targets. Wessex Water’s annual
review shows a customer satisfaction
rating of 96 percent.

FINANCIAL STATEMENTS

Financial statements for users operations and policies. For this reason, financial
statements are useful to a wide range of stakeholders,
The many financial statements included in the annual from the company’s employees, customers, and
report are a gold mine of information for those who shareholders to potential investors, governments,
know how to read them. They provide headline profit tax authorities, journalists, credit-rating agencies,
figures, explanations of issues from directors, detailed banks, and the general public.
financial data, and information about companies’

Who reads what

Different stakeholders are interested in different parts of the
annual review. Customers of a service provider, for instance,
may look at the section on customers and community while
potential lenders go to the financial statements..

SStakeholderS Important parts Why?

HAREHOLDER ❯ Profit-and-loss ❯ To see how much money the
account company is making
EMPLOYEES
❯ Balance sheet ❯ To assess the long-term strength
AUDITORS ❯ Dividends of the company

$ ❯ To see how much will be paid
out to them

❯ Our employees ❯ To see any training programs or
❯ Governance report employee benefits being praised
❯ Performance that may be available to them

indicators ❯ To see how much executive and
non-executive directors are paid
❯ The whole
statement ❯ To see how well the company is
performing, and if it can improve
❯ Independent
auditor’s report ❯ To assess whether or not the
(written by the accounts are error-free
auditor)
❯ To ensure that the company has
complied with Generally Accepted
Accounting Principles (GAAP).
See pp.112–113.

108 109HOW FINANCE WORKS
Financial reporting

STATISTICS MADE EASY

Impressive statistics are often scattered through an annual report. These examples are from UK utility Wessex Water:

6% post-tax ❯ This percentage is estimated by dividing income after tax by the amount of investment. It is

return on capital useful for showing shareholders the kind of returns they can expect on their investments.

64% ❯ For most industries, gearing is a company’s debt compared to its equity. In the water industry,
gearing it compares a company’s net debt to its regulatory capital value (the value of the business that
earns a return on investment). Gearing is expressed as a percentage. See pp.174–175.

A3/A-/BBB+ ❯ Credit ratings assess the likelihood that loans will be repaid. A3 and A- fall at the bottom of
credit rating “strong capacity to meet financial commitments,” while BBB+ is at the top of the adequate
range. The major ratings companies in the US are Moody’s, Standard and Poor’s, and Fitch.

GOVERN Stakeholder HORITIES Important parts Why important?

MENT/TAX AUT ❯ Taxation ❯ To check that the figures are
❯ Independent correct and the correct amount
L INSTITUTION of tax has been paid
auditor’s report
$ ❯ Environment section ❯ To check the audit, and that they
are satisfied with the accounts
JOURNALISTS and environment-
related notes ❯ To check that environmental
laws have been adhered to
❯ Balance sheet
❯ To see the company’s assets
FINANCIA S/BANKS and liabilities, and assess its
strength

❯ To decide whether or not it is
wise to lend to the company

❯ Chairman’s ❯ To find elements to quote
introduction
❯ To see how strongly the
❯ Accounts and notes company has performed

❯ To analyze why a company
has been performing well or
poorly, and investigate if
they suspect fraud

Financial
accounting

A company’s financial accounts classify, quantify, and record its transactions.
They are extremely useful for people outside the business, such as creditors and
potential investors, as well as those currently involved with making investment
decisions. For this reason, the accounts should be concise and clearly present the
timing and certainty of future cash flows, so that people looking at the company
can decide whether or not to invest in, lend money to, or do business with it.

Key elements Accounting Profit-and-loss Balance sheet
standards statement
The profit-and-loss account, Gives a snapshot of
balance sheet, and cash- Generally accepted Shows how much how much a business
flow statements are the principles standardize money a company is worth at a certain
most important financial practice worldwide is making and is time and is a good
statements in an annual to ensure accuracy especially useful for indication of its
review, supplemented and prevent fraud. potential investors long-term health.
by the report’s notes. See pp.112–113. and stakeholders. See pp.116–119.
To understand these See pp.114–115.
statements, a knowledge ❯ International ❯ Balances company’s
of accounting principles, standards simplify ❯ Outlines revenues assets against its
depreciation, amortization, account reporting. and gains minus equity and liabilities.
and depletion is vital. expenses and losses
Accountants also need ❯ Companies must or operating costs. ❯ Lists different types
to understand the legal meet environmental of assets, including
requirements that the accounting rules ❯ Informs a company tangible fixed assets
statements must satisfy and regulations. if a profit warning and current assets.
and how environmental See pp.122–123. is needed.
laws can affect a business
and its accounts.

$
$

110 111HOW FINANCE WORKS
Financial accounting

$74 AUDITING
billion
The accounts of public companies are
the total value lost by given unbiased scrutiny by external
shareholders in the 2001 accountants to check that they are
Enron accounting scandal accurate and clear. This is a legal
requirement in most countries,
designed to ensure market
confidence in the business
world and transparency
in corporate finance. A
company may also have
an internal audit process,
which means that its
accounts are checked
before being submitted
to an external auditor.

Cash-flow Environmental Depreciation Amortization
statement accounting and depletion
Accounts for the
Reveals a company’s Accounts for myriad decrease in value Account for the
liquidity by tracking environmental rules over time of tangible decrease in value
the flow of cash— and regulations that fixed assets in order over time of a range
money or short-term oblige companies to to spread the cost of intangible assets,
investments—in and mitigate the impact of assets over their loans, and natural
out of the company. of business activities. economic life. resources.
See pp.120–121. See pp.122–123. See pp.124–127. See pp.128–129.

❯ Shows if a company ❯ Showcases green ❯ Can be calculated ❯ Intangible assets
can sustain itself, credentials in using a number of include patents,
grow, and pay debts. financial statements. different methods. trademarks, logos
and copyright.
❯ Details cash flow ❯ Reveals compliance ❯ Tangible fixed
from operating, with environmental, assets include ❯ Natural resources
investing, and social, and buildings, plant, include minerals
financing activities. governance criteria. and machinery. and forests.

International
accounting standards

With increasing globalization, international accounting standards,
assumptions, and principles that help to make accounting easier across
borders are essential for preparing financial statements.

Accounting standards

ECONOMIC MONETARY UNIT GOING CONCERN TIME PERIOD FULL DISCLOSURE
ENTITY ASSUMPTION ASSUMPTION ASSUMPTION PRINCIPLE
ASSUMPTION
Standard International economic The financial activities Different operations All information, past,
Transactions by activity is expressed in of a business will carry of a business can be present, or future,
businesses owned monetary terms, with on indefinitely. divided into arbitrary which could affect
by one group or all units assumed to be time periods. financial performance
individual are kept quantifiable, constant must be disclosed,
separate from and not affected by usually in the notes of
transactions made inflation or deflation. financial statements.
by other companies
owned by that group
or individual.

Example If a group owns Current manufacture Oil reserves will never Sales of toothbrushes If a coconut importer
two companies, of baseball bats is run out; gold in a gold can be measured daily, knows that a hurricane
one manufacturing compared financially mine will last forever; a monthly, quarterly, and has damaged next year’s
televisions and the to manufacture that manufacturer will not so on (when in reality coconut crop, it must
other retailing cell was carried out 30 years go out of business. they are constant, or mention this in its
phones, the financial ago, without taking subject to variations that financial statement.
statements for each inflation into account. are not predictable).
company are separate.

Helps the group Shows as much of the Offers a model for Makes financial Provides full information
of companies and company as possible in businesses to look at reporting easier. for shareholders and
investors compare financial statements, the long-term future potential investors.
Purpose financial statements as everything a business of their operations.
of each company owns can be quantified.
with its competitors.

Pros and cons Largely beneficial It is hard to measure It is not applicable The more often Companies may try
monetary value of, to companies economic activity to “bury” information
Companies that for example, the fastest approaching liquidation, is measured, the easier likely to put off investors
operate in the worker at the baseball- as it assumes that any it is to identify trends. or lower the share price
same group but in bat production plant. assets are worth their in the notes.
different countries original value. Measuring activity
must prove standard It is hard to compare often means more Not all countries
market rates used for across time because work, and such data are equipped to root
intra-company trading. of inflation/deflation. may multiply errors. out transgressors.

112 113HOW FINANCE WORKS
Financial accounting

How it works confused with International Accounting Standards
(IAS), which were in use from 1973 to 2001. Generally
International Financial Reporting Standards Accepted Accounting Principles (GAAP), which
(IFRS) are the most widely accepted standards are known colloquially as accounting standards or
for accounting, and they are used in more than standard accounting practice, are country-specific
110 countries. Originally introduced to harmonize guidelines for recording and reporting accounts.
accounting across Europe, they have with time They differ from one jurisdiction to another.
spread around the world. IFRS are not to be

HISTORICAL COST MATCHING REVENUE CONSERVATISM PRINCIPLE OF
PRINCIPLE PRINCIPLE RECOGNITION MATERIALITY
PRINCIPLE
Assets and liabilities are The time period in If there are alternatives Accountants may
valued at their buying which a business’s Revenue should for reporting on an make a professional
price (in countries expenses and revenue be recorded at the item, accountants decision to go against
with high inflation or figures are collected moment when: should choose to report any one of the other
hyperinflation, other always concurs. a) goods or services the lower amount of principles.
principles, such as are exchanged; income or asset gain.
fair value, are used). b) assets can be
converted to cash;
c) it is earned—not
when it is received.

If a company bought a A grocery store A toy-maker takes an If a company is An oil refinery buys
factory 50 years ago for measures costs incurred order for 500 toys in involved in a lawsuit, a $100 whiteboard,
$100,000, that will be its and revenues gained July, delivers it in it must report the which could last
stated value today, even over the same time September, and is paid potential losses rather 10 years. Under the
though its market value period, because when for it in December. The than the potential gains, matching principle,
now is far higher. sales are high, costs revenue is recorded in in the notes of the it should be billed for
are also likely to be September, when the financial statement. $10 each year, but the
high, due to the need goods were exchanged. accountant enters it
to buy more stock. as a one-time cost.

Ensures uniformity Avoids different time Matches the time Prevents companies Saves time for small,
and prevents the scales, which could period that work was from overestimating almost insignificant
overvaluation of present a distorted undertaken to when money they will make in transactions when
assets, which was a picture and erratic the payment was the future, then running there is no risk of
feature of the 1929 financial results—for received, as with the into debt if it does not it being applied
Wall Street Crash. example, with high matching principle. materialize. misleadingly.
revenues from one
period and high costs
in another.

Assets, especially Helps to present Revenue may not Requires a degree Saves time on
property, acquired accounts in a always be received. of objectivity from accountancy.
a long time ago are representative manner. accountants: if this
invariably represented If there are doubts objectivity is absent, Makes information
as being worth less than about a recipient’s financial reports can easier to read—for
their current real value. ability to pay, the be misleading. example, figures can be
company can make rounded to the nearest
an allowance for dollar, thousand, or
doubtful accounts. even million dollars.

Profit-and-loss
statement

A profit-and-loss statement is a financial statement that shows all
revenues, costs, and expenses during an accounting period. It is also
known as an income statement, or an income and expense statement.

How it works profitable the company is. The statement usually
works by showing revenues and gains, less expenses
The purpose of the profit-and-loss statement is to show and losses from business activities, as well as the
the profitability of a business during a given period. sale and purchase of assets. Businesses that are sole
Along with the cash-flow statement and the balance proprietorships or partnerships are generally not
sheet, it is the most important financial statement a required to submit profit-and-loss statements.
business produces, as it shows investors how

How to read a profit-and-loss statement

Profit-and-loss statements commonly illustrate the financial performance of a business
over a particular month, quarter, or year. The key pieces of information are the figures for
turnover (or revenue) and operating profit. If profits are going to be lower than expected,
the company may put out a profit warning in advance of releasing the statement.

Case study: profit-and-loss statement

$

This statement taken from the 2013 annual review of Wessex Water, a UK utility company,
shows it was making a healthy profit (at the time, the exchange rate was £1 = $1.58).

Amount of money taken by the Year 2013 Year 2012
business over a certain time; in this £m £m
case, there was a 5.3 percent increase
in turnover from the previous year Turnover 492.1 467.5
Operating costs (268.1) (248.5)

Profit earned from the business’s core Operating profit 224.0 219.0
operations after expenses have been Interest payable and similar charges (86.9) (81.7)
taken off, but before taxes have been Interest receivable
deducted; it does not include money Other finance costs 2.9 1.2
made on investments (1.5) (1.0)

Profit before tax after all Profit on ordinary activities before taxation 138.5 137.5
income and expenses have been Taxation on profit on ordinary activities (30.6) (44.3)
taken into account, excluding
extraordinary payments Profit attributable to shareholders 107.9 93.2

Level of profit that can
be paid out in dividends to the
company’s shareholders.

Figures in parentheses represent negative numbers.

114 115HOW FINANCE WORKS
Financial accounting

TYPICAL EXPENSES % Office supplies

Payroll $ Stationery such as pens, paper, and filing
systems, office printers, furniture, lighting
$ Legal fees and professional services

Salaries and wages paid to staff, temporary Accounting and legal fees, payable to
contractors, and indirect labor accountants, auditors, and legal advisers
Utilities Interest on loans

Water, electricity, and gas; postage and Interest paid on money borrowed, which
shipping; transportation counts as a business expense
Insurance Tax

Insurance on fixed assets and personal Varying among jurisdictions, this may
liability insurance for employees include payroll tax and corporation tax
Phone/internet bills Entertainment

Cost of telephone, broadband internet, Legitimate costs of business entertaining,
and mobile devices used by employees subject to certain criteria being met
Advertising

Sales and marketing of the company and
its products

Case study: operating costs

$

This table breaks down the company’s operating costs in more detail. It is important to

read any notes regarding depreciation and ordinary and extraordinary costs and gains.

Manpower costs including basic pay Year 2013 Year 2012
and pensions, overtime payments, £m £m
staff training, and maternity leave
Manpower costs 51.7 45.3
Term given to the gradual decline in an Materials and consumables 29.1 26.7
asset’s value, caused by factors such as Other operational costs 67.6 63.8
wear and tear and market conditions. Depreciation 120.3 114.0
Amortization of grants and contributions (0.8) (0.8)
Decrease in value over time of Loss/(gain) on disposals of fixed assets 0.2 (0.5)
intangible assets or loans 268.1 248.5
Operating leases for plant and machinery
Profit or loss on the sale of fixed assets Research and development 1.5 1.2
Directors’ remuneration 0.1 0.1
Leasing costs for buildings Fees paid to the auditor 2.1 1.8
and equipment 0.2 0.2

Research and development carried
out to improve the reliability and
effectiveness of services

Directors’ remuneration including Figures in parentheses represent negative numbers.
base salaries and benefits, pensions,
car and health benefits, share options,
and bonuses

Balance sheet

A balance sheet is a financial statement that shows what a business is
worth at a specific point in time. Its primary purpose is to show assets,
liabilities, and equity (capital), rather than financial results.

How it works relationship between assets, NEED TO KNOW
liabilities, and owners’ capital—
The balance sheet essentially what the company owns (assets) ❯ Deferred income Income a
shows what the company owns, is purchased either through debt company receives for goods
what it owes, and how much is (liability) or investment (capital). or services that have not yet
invested in it. It is based on the The equation always balances, as been delivered or provided. Until
accounting formula, sometimes everything a company owns has to income is received it is recorded
called the balance-sheet equation, have been bought with its owner’s on a balance sheet as a liability.
which is the basis of double-entry funds or through borrowing.
bookkeeping. This shows the

The balance-sheet equation

As the name suggests, the balance sheet must always balance. This is
because everything the business owns (its assets) must be offset against
the equivalent capital (or equity) and liabilities (debt).

Company has no liabilities ASSETS LIABILITY CAPITAL
$1,000 $0 $1,000
For example, a young business may
have assets of $1,000. It currently has
no liabilities so its capital is equal to
its assets—that is, it is the amount of
equity the owners or shareholders
have invested in the business. Using
the accounting formula, the equation
would look like this:

Company incurs $400 ASSETS LIABILITY CAPITAL
in liabilities $1,000 $400 $600

After spending $400 on, for example,
an illuminated sign for the storefront,
the owner incurs $400 in liabilities and
so the formula changes. However, since
the sign is worth $400, and the owner
has $600 remaining, the equation
remains balanced—as it always does.

116 117HOW FINANCE WORKS
Financial accounting

Case study: balance sheet

$

This example from Wessex Water, a UK public utility company, shows how a balance

sheet works in practice (at the time, the exchange rate was £1 = $1.58).

Fixed assets (or non-current assets) ASSETS, LIABILITIES, AND CAPITAL Year 2013 Year 2012
are not easily converted into cash £m £m
and usually last longer than one Fixed assets
year. They are either tangible, such Tangible assets 2,167.1 2,069.2
as land, or intangible, such as a logo Investments – –

Current assets are assets that last Current assets 7.0 6.3
one year or less, and can be easily Stock and work in progress 162.6 153.9
converted into cash. Cash, cash Debtors 181.0 211.0
equivalents, and inventory are Cash in the bank and in hand
the most common current assets 350.6 371.2
Creditors—amounts falling due within one year (198.8) (171.7)
Creditors are the individuals or Net current assets
organizations to which the company 151.8 199.5
owes money. Here, the money must
be repaid in the current financial year

Net current assets equals current
assets after money due to creditors
has been deducted

Total assets less current liabilities Total assets less current liabilities 2,318.9 2,268.7
is the sum of fixed and net current (1,891.5) (1,811.9)
assets minus liabilities due within the Creditors—amounts falling due after more
current financial year than one year (114.9) (115.3)
Provisions for liabilities and charges (93.1) (83.0)
Liabilities due in more than one Retirement benefit obligations (17.2) (17.9)
year are amounts due to creditors, Deferred income
which are deducted from total fixed 202.2 240.6
and net current assets Net assets
81.3 81.3
Net assets are what is left once Capital and reserves 120.9 159.3
liabilities have been deducted from Called-up equity share capital
the company’s fixed and net current Profit-and-loss account 202.2 240.6
assets to give the overall net assets
Shareholders’ funds
Shareholders’ funds, or owner’s
equity, is the remaining capital;
this money can be reinvested
into the business or paid out as
an annual dividend

SYMBOLS FOR DEBITS AND CREDITS
Accountants use a number of different terms and symbols to indicate debits and credits.
Some use “Dr” for debits and “Cr” for credits, others use “+” for debits and “–” for credits.
On this balance sheet, parentheses are used to show credits (negative numbers).

BALANCE SHEET

Understanding the notes after the summary, the detailed section of the balance
sheet explains the specific financial workings of the
The balance sheet is a useful indication of the health business in a number of notes. It shows exactly where
of a business, and it is important that investors know money has been gained or lost, in figures, and it
how to analyze it. It can be read in two ways—“at often includes a written commentary about potential
a glance,” as on the previous page, where general developments that may affect the company, such as
information is summarized, or in depth, with more court cases, staffing, or availability of resources.
detailed information about each element. Provided

Balance-sheet notes

Investors may want to know more about the figures in the summary section, so additional notes and
tables give detailed breakdowns of the figures (at the time, the exchange rate was £1 = $1.58).

Case study: tangible fixed assets

$

This table presents details of Wessex Water’s tangible fixed assets (long-term assets
that cannot easily be converted into cash).

Tangible fixed assets LAND AND INFRASTRUCTURE PLANT, OTHER
include land and machinery BUILDINGS ASSETS MACHINERY, ASSETS

Additions are new tangible £m AND £m
fixed assets the business VEHICLES 105.0
has acquired this year
£m £m 2.3
Disposals are any tangible
fixed assets the business has Cost 676.3 1,229.7 1,204.6 2.8
disposed of or sold this year As of April 1, 2012 9.5 67.8 49.1 (0.5)
Additions
Total value of the company’s Transfers on 13.7 11.2 42.2 –
fixed assets is listed by commissioning (0.2) - (13.1) 109.6
category and in total Disposals
Grants and contributions – (5.0) – 34.0
Depreciation is the decrease As of March 31, 2013 699.3 1,303.7 1,282.8 6.6
in value of assets over time
Depreciation 211.3 435.5 558.8 (0.5)
Value of depreciation As of April 1, 2012 13.7 43.2 56.8 40.1
of assets is listed by Charge for the period (0.1) (11.5)
category and in total Disposals 224.9 – 604.1 69.5
As of March 31, 2013 478.7
Net book value of an asset 71.0
is its initial cost minus all its Net book value 474.4 825.0 678.7
depreciation to date As of March 31, 2013

Combined value of the As of April 1, 2012 465.0 794.2 645.8
company’s tangible fixed
assets in each category,
and also in total, is listed

118 119HOW FINANCE WORKS
Financial accounting

Case study: debtors

$ Debtors are individuals or entities that owe the business money.
Wessex Water has four categories of debtor.

Individuals or entities that Trade debtors 2013 2012
sell assets to third parties on Owed by group companies £m £m
credit, receiving payment at Prepayments and 48.9 48.1
a later date accrued income 31.8 35.0
Other debtors 70.3 62.1
Prepayments for services
that will be received in the 11.6 8.7
future, which the business 162.6 153.9
has already been paid for,
and accrued income that
is expected in the future

PAYMENTS = Case study: creditors
ON ACCOUNT AND TOTAL
ASSETS IN COURSE $ Creditors are individuals or entities that the business
OF CONSTRUCTION £m owes money to. They are in credit of Wessex Water.
3,308.8
£m 2013 2012
224.9 £m £m
93.2
96.2 – Money owed to the bank Bank overdraft 21.8 18.6
(13.8) Inter-company loan - 1.3
(69.9) (5.0) Individuals or entities Obligations under
– 3,514.9 that are owed money for finance leases 7.0 6.3
– supplying raw materials Trade creditors
or components Amounts owed to subsidiary 4.3 3.1
119.5 company 18.9 14.2
Money owed to Amounts owed to other group
related companies companies 0.6 0.6
that are owned by Amounts owed to associate
the same group company 0.7 0.2
Payment to shareholders Dividend
– 1,239.6 Other creditors 23.3 21.7
– 120.3 Tax and employee Corporation tax 2.4 2.0
– (12.1) benefit payments Taxation and social security 16.7 9.2
– 1,347.8 Accruals and deferred income 1.9 1.7
Any notes relating 92.8
119.5 2,167.1 to creditors 101.2 171.7
93.2 2,069.2 198.8

The inter company loan was due to a fellow subsidiary
company SC Technology GmbH and has been repaid.

Cash-flow statement

The cash-flow statement shows the movement of cash during the last
accounting period. It is important because it reveals a company’s
liquidity—whether or not it has more money coming in than going out.

How to read a cash-flow statement

The statement of cash flows, to give it its official title, answers the key question of whether a
business is making enough money to sustain itself and provide surplus capital to grow in the
future, pay any debts, and give out dividends. Figures in parentheses are negative numbers.

Case study: cash-flow statement

$

By analyzing this water utility’s statement, which includes a comparison to the previous year, decision-

makers can base future plans on past cash flows (at the time, the exchange rate was £1 = $1.58).

Using profit before tax as a starting Year to Year to
point, non-cash income and expenses March 31, March 31,
are deducted to reach net cash inflow
from operating activities 2013 2012
£m £m
Returns on investment in this case
is total interest received minus total Net cash inflow from operating activities 334.6 303.2
interest paid, as well as interest paid Returns on investments and servicing of finance
on finance lease rentals (80.0) (79.2)

Taxation is the sum of all taxes paid Taxation (21.8) (31.5)
and tax credits received

Capital expenditure and financial Capital expenditure and financial investment (215.4) (149.7)
investment is, here, the sum of the Dividends paid (129.6) (129.4)
sale of tangible assets plus connection
charges, grants, and deferred income

Dividends are sums of money paid Cash outflow before financial investment (112.2) (86.6)
to shareholders, typically each year Financing 79.0 222.2

This is the sum of all the figures above (Decrease)/increase in cash (33.2) 135.6

Financing describes how much money Reconciliation of cash movement to the movement in net debt
the company has made or lost from
loans, finance leases, and bonds (Decrease)/increase in cash—above (33.2) 135.6
(222.2)
This is the change from last year’s Movement in loans and leases (79.0)
figures to this year’s, and the total
of the two figures above Movement in net debt (112.2) (86.6)
Opening net debt (1,626.1) (1,539.5)
A utility company can afford
to operate with more debt than Closing net debt (1,738.3) (1,626.1)
companies with a less stable base

120 121HOW FINANCE WORKS
Financial accounting

How it works are performing. The profit-and-loss statement, for
example, obscures this by adding in non-cash factors
The cash-flow statement is often more useful for such as depreciation. Similarly, the balance sheet is
investors assessing a business’s health than other key more concerned with assets than liquidity.
statements, because it shows how the core activities

Three types of cash flow

Cash refers to actual money as well as cash equivalents including cash in the bank; bank lines
of credit, and short-term, highly liquid investments for which there is little risk of a change in
value. Cash does not include interest, depreciation, or bad debts (debts written off).

Cash flow from operating activities

The bulk of cash flow usually comes from operations, and is worked out with a
formula. The change in working capital (current assets minus current liabilities)
can be a negative figure.

REVENUE – – TAXES + DEPRECIATION + ANY CHANGE CASH FLOW
COST OF SALES IN WORKING = FROM OPERATING

CAPITAL ACTIVITIES

Cash flow from operating activities in practice expense of $20 over the period (a positive adjustment on the
orginal outlay for the machine). There is no change in working
In this example, a juice company sells $100 worth of orange capital (short-term assets to cover short-term debt).
juice after spending $20 on oranges. It pays 25 percent of its
$80 earnings in tax. Its juicing machine incurs a depreciation

A JUICE - OFIITITPNSATEYAASXRNINGS25% ITS JUICING + = $80NOCHANGE
COMPANY SELLS MACHINE INCURS IN WORKING
CAPITAL
$100 + $20A DEPRECIATION CASH FLOW
EXPENSE OF $0 FROM
WORTH OF
ORANGE JUICE OVER THE OPERATING
PERIOD
-
ACTIVITIES
AND SPENDS

$20

ON ORANGES

Cash flow from Cash flow from = Total cash flow
investing activities financing activities Adding all three cash flows
gives the total. Separating
Buying or selling assets This includes buying or out the three types shows decision-
or investments is in this category. selling stock or debt and paying makers the health of core activities
This figure is usually a cash outflow out dividends. Money made from as opposed to financing and
(negative figure) due to buying more selling something is called cash investing, which bear little relation
than selling, but can be positive if inflow; money lost through paying to day-to-day operations.
there are significant sales. out is cash outflow.

Environmental
accounting

Environmental regulations force companies to consider the impact of
their activities and to adopt corporate social responsibility (CSR) as
they grapple with legislation, climate change, and public opinion.

How it works Environmental credentials

Globally, there are reams of different environment Most companies include a section on environmental
acts spread across multiple jurisdictions that affect accounting in their financial statement. Some details are
the companies operating within their borders in required by law, but the statement also gives an opportunity
different ways. Areas protected by environment acts to showcase environmental credentials to stakeholders.
include the atmosphere, fresh water, the marine
environment, nature conservation, nuclear safety, and Society
noise pollution. International acts are usually ratified
by each country individually before taking effect ❯ Programs and practices
there. An example of a common global means of that assess and manage
reducing greenhouse gas emissions is emissions the impact of operations
trading (“cap and trade”), by which companies must on communities
buy a permit for each ton of CO they emit over a
❯ Fines and sanctions for
2 noncompliance with
regulations
certain level. Those emitting under the agreed level
can sell their permits to other companies. Product
responsibility
CASE STUDY
❯ Life-cycle stages in which the
Cleaning up rivers health-and-safety impact

Wessex Water’s impressive record on pollution is of products and services are
mentioned several times in its statement, including in assessed for improvement
the chairman’s introduction. This prominence shows ❯ Adherence to laws,
that the company believes acting in an environmentally standards, and voluntary
conscious manner is important to its investors. The codes relating to marketing
company illustrates several areas where it has acted
with others to positively affect the environment: communications
❯ Work with the charity Surfers Against Sewage,

which campaigns for clean seawater
❯ Its river strategy: collaborating with pressure groups

and organizations to reduce pollutants and the impact
of habitat alteration, and so increase the numbers
of aquatic plants, invertebrates, and fish in local rivers
❯ Improving water quality at swimming beaches in the
region, in compliance with mandatory standards

122 123HOW FINANCE WORKS
Financial accounting

GREENHOUSE GAS EMISSIONS

In some countries, companies are Appointed Direct fuel Grid Third Total Total
required by law to provide details business parties 2012–13 2011–12
of their greenhouse gas emissions. use electricity
This is usually presented as a table 4 10 8
in the environmental accounting Gas, diesel, 6 0
section of the annual report. It other fuels 0 115 0 115 107
includes direct and indirect 1 11 11
emissions—by the company itself and Grid electricity 2 20 20
by third parties—of gas, diesel, and 7 17 19
other fuels; sulfur oxides and nitrous Transportation 9 0 0 (3) (4)
oxides; methane; and other ozone- Methane 17 0
depleting substances. In this table, Nitrous oxide 10 0 14 169 161
from the Wessex Water utility
company, emissions are shown Exported 0 (3)
as ktCO2 equivalents. renewable

TOTAL (net 42 112
emissions)

$

Economic Human rights Labor practices

❯ Financial implications, risks, ❯ Investment agreements ❯ Workforce by employment
and opportunities for the that include human rights type, contract, and region
organization’s activities
due to climate change clauses or that have undergone ❯ Average hours of training
human rights screening per year, per employee by
❯ Financial assistance received employee category
from the government ❯ Suppliers and contractors
that have undergone screening ❯ Ratio of basic salary
on human rights; actions taken of men to women by
employment category
to address any issues

Environmental

❯ Direct and indirect energy
consumption

❯ Waste by type and disposal method

❯ Water withdrawal by source;
discharge by destination and quality

❯ Fines and sanctions for
noncompliance with regulations

Depreciation

When a company buys an asset, its cost can be deducted from income
for accounting and tax purposes. Depreciation allows the company to
spread the cost, by calculating the asset’s decline in value over time.

How it works typically a year. Secondly, they NEED TO KNOW
match that loss in value to the
If a business buys a long-lived amount of income earned in that ❯ Fixed/tangible assets Items that
asset, such as a building, factory period, so depreciation becomes enable a business to operate but are
equipment, or computer, to help it a deduction from taxable income. not a part of trade; assets lasting a
earn income, this expenditure can year or more qualify for depreciation
be offset as a cost against income There are several different
earned. However, not all this ways to calculate depreciation. ❯ Useful/economic life Length of
income will be generated in the The method a company uses may time an asset is fit for its purpose
year of purchase and, over time, depend on the kind of business, the and has monetary value
the asset will age and become less type of asset, tax rules, or personal
beneficial to the business, until preference. In the United States, ❯ Salvage/scrap/residual value
it becomes outdated or unusable. per IRS guidelines, companies Worth of an asset once it has
must use MACRS (Modified outlived its useful life—often set
Accountants do two things to Accelerated Cost Recovery System), by the tax authority
turn the declining value into a a combination of straight-line and
tax advantage. Firstly, they work double declining balance methods ❯ Book value An asset’s worth on
out how much the asset’s value (see below and p.126). paper at any point between its
decreases over a period of time— initial purchase and salvage

Calculating depreciation VALUE ($) $21,000
$25,000 1
The straight-line method is the simplest way of working out
depreciation and can be applied to most assets. Depreciation is $20,000
calculated along a timeline, with value loss spread evenly over
the asset’s economic life. Scrap value is deducted from purchase $15,000
value and the remainder is split into equal portions over time.

$10,000

PURCHASE – SCRAP ANNUAL
VALUE VALUE
DEPRECIATION ($) $5,000
=
USEFUL ECONOMIC $
LIFE (YEARS)
$

0

Example $25,000 – $5,000 = $4,000 Year 1 After a year, the van’s
5 value has depreciated by $4,000
A landscaping business buys a (its purchase value minus its scrap
new van for $25,000. The IRS value, divided by its useful economic
sets its scrap value at $5,000 life). Its value is now $21,000.
after five years of use.

124 125HOW FINANCE WORKS
Financial accounting

TYPICAL LIFE OF FIXED ASSETS 60%

Tax authorities often specify the typical useful (economic) life of a particular asset. the value the
This helps to standardize depreciation, and to eliminate uncertainty about value average car
and the number of years over which an asset can be depreciated. loses after
three years
OFFICE

RACEHORSES FURNITURE ROADS
15 years
2 years 6 years 10 20 Time
(years)

5 15

COMPUTERS FRUIT- BOATS
3 years BEARING TREES 20 years

10 years

$17,000

$13,000 $9,000

$5,000

23 4 5
TIME (YEARS)
Year 2 After the second year, the Year 3 At the end of the third Year 4 The van
value has depreciated by another year, the van has depreciated has depreciated by Year 5 By the
$4,000. The van will lose an equal by another $4,000, and its book $4,000, to $9,000, end of year five,
amount of value each year for the next value is $13,000, although its at the end of four the van is valued
three years of its useful economic life. actual value may be more or less. years of life. at only $5,000—
its scrap value.

DEPRECIATION

Applying depreciation categories of assets. For example, WARNING
the “accelerated” methods that
When calculating depreciation, chart rapid depreciation at the Misusing depreciation
there are a number of different beginning of an asset’s life are
factors to consider. For instance, more suitable for technology, ❯ The wrong method A company
a business needs to be able to while the “activity” methods that must choose a method that is
predict the number of years an link depreciation to actual hours permissible for an asset type
asset will last. Helpfully, tax of use or number of units produced
authorities in most countries issue are best suited to transport and ❯ Frontloading Opting for an
guidelines to accountants and production lines. accelerated method can result in a
businesses with estimates of taxable gain if an asset is sold early,
the useful economic life of many Again, tax authorities in most for more than its book value
common business assets. countries offer guidelines on which
method to use. Although it is ❯ Claiming beyond useful life
Companies may also wonder technically possible for a company Depreciation cannot be claimed
which of the many methods of to use two different methods for after an asset’s useful life
calculating depreciation to use their own accounting and for tax
for a given asset. Each method purposes, this is best avoided. ❯ Ignoring depreciation If a
reflects a different pattern of company fails to claim depreciation,
depreciation, with some being it has to report a gain from the sale,
more suitable for particular despite the loss on deduction

Other depreciation methods

There are many different methods of calculating depreciation. Some are favored
by particular tax codes, while others are specifically applicable to certain industries
and types of assets, and their patterns of value loss.

Double declining balance method

A method used to claim more depreciation in ( )PURCHASE VALUE – SCRAP VALUE ANNUAL
the first years after purchase, which is useful for
assets that lose most of their value early on. It reduces a USEFUL ECONOMIC X 2 = DEPRECIATION
company’s net income in the early years of an asset’s life,
but generates initial tax savings. LIFE (YEARS) (%)

When to use it This accelerated method can be used for any asset
that loses value early on, such as computers or a delivery truck.

Sum of the years’ digits (PURCHASE VALUE – SCRAP VALUE)
method (SYD) ANNUAL
( )X = DEPRECIATION
Depreciation is calculated by dividing each REMAINING USEFUL LIFE
year of the asset’s life by the sum of the total years to SUM OF THE YEARS’ DIGITS (%)
give a percentage of the depreciable value. If the asset’s
useful life is 5 years, then the sum of the years as digits When to use it This is another accelerated method that can also
is 15 (5 + 4 + 3 + 2 + 1). In year 1, it loses 33 percent be used for vehicles that lose most of their value early on.
(5 ÷ 15), in year 2, 27 percent (4 ÷ 15), and so on.

126 127HOW FINANCE WORKS
Financial accounting

DEPRECIATION ON THE BALANCE SHEET

A company’s accounts have to list all assets held by the COMPANY NAME BALANCE SHEET
company, including all fixed assets such as property and
equipment. The accumulated depreciation of these fixed Assets 2013 2014
assets over the year is deducted from their value at the Current assets: 17,467.00 8,023.00
start of the year to give the year-end total. Without a Cash 4,853.00 3,367.00
depreciation figure, the accounts would give a false Investments 1,056.00 2,138.00
reflection of the finances of the business. The assets Inventories 2,165.00 3,600.00
would appear as their original cost value and that might Accounts receivable 3,000.00 3,000.00
well exceed their current value. Prepaid expenses
Other 860.00 976.00
Fixed assets are shown Total current assets 29,401.00 21,104.00
distinct from current assets
Fixed assets: 2013 2014
Depreciation of fixed Property and equipment 64,553.00 58,219.00
assets is deducted Building/site improvements 2,679.00
Equity and other investments 4,780.00 4,587.00
Total assets are calculated Less accumulated depreciation 3,789.00
after depreciation has been Total fixed assets 5,625.00 4,171.00
deducted 67,497.00 61,314.00

Previous year’s total Other assets: 2013 2014
assets can be compared Goodwill 1,577.00 1,650.00
Total other assets 1,577.00 1,650.00

Total assets 98,475.00 84,068.00

Units of production method (PURCHASE VALUE – SCRAP VALUE)

When a company uses an asset to produce ( )X = DEPRECIATION
quantifiable units, such as pages printed UNITS PRODUCED PER YEAR (PER UNIT)
by a photocopier, it can claim depreciation with this
method, which calculates depreciation according to the LIFETIME PRODUCTION
number of units an asset produces in a year.

When to use it This method is typically used by factories to
calculate depreciation on machines that produce units of goods.

Hours of service method (PURCHASE VALUE – SCRAP VALUE)

The asset’s decline in value is measured ( )X = DEPRECIATION
according to the number of actual hours it is HOURS USED PER YEAR (PER HOUR)
in use. To calculate depreciation using this method, LIFETIME HOURS
the company measures the hours of use per year as a
percentage of the estimated total lifetime hours. It is When to use it This method may be used to match an airplane’s
particularly useful for transportation industries. flying hours with the revenue generated from those hours.

Amortization
and depletion

Similar concepts to depreciation, amortization and depletion are used
by accountants to show how intangible assets and natural resources
respectively are used up.

How it works asset on the balance sheet and an expense on the
income statement. In lending, amortization can also
Amortization is how the cost of purchasing an mean the paying off of debts over time. Depletion
intangible asset, such as copyright of an artwork, is shows the exhaustion of natural resources such as
spread over a period of time, usually its useful lifetime. coal mines, forests, or natural gas.
It is shown as a reduction in the value of the intangible

Amortization in practice

There are two types of amortization, one for spreading the cost of an
intangible asset, the other for loan repayment. Both are calculated in
similar ways, but loan repayments are worked out as a percentage.

Intangible assets INITIAL COST = YEARLY
USEFUL LIFE AMORTIZATION
In this example, a VALUE ($)
$20,000 = $2,000
company buys an $20,000 10 YEARS
intangible asset—

a patent for a new,

revolutionary type $16,000

of tennis racket—for

$20,000. The patent $12,000
will be useful for 10

years, so its cost is
recorded as a $2,000 $8,000

amortization (expense)

each year rather than as $4,000

a one-time cost. Unlike

tangible assets, a patent

does not have a salvage 0 1 2 3 4 5 6 7 8 9 10
value (see p.124). TIME (YEARS)

Loan percentage COST OF LOAN YEARS TO REPAY =%
= 100 = 2%
If a company has an outstanding loan worth
$150,000, and pays off $3,000 of this loan YEARLY REPAYMENT 50
each year, then $3,000 of the loan has been 100
amortized. It can also be said that 2 percent 150,000 =
of the loan has been amortized, as it will 3,000
take 50 years to repay the loan at this rate.

128 129HOW FINANCE WORKS
Financial accounting

GOODWILL NEED TO KNOW

In business, goodwill describes total sum of its assets and liabilities is ❯ Intangible assets Non-
an intangible asset based on a $9 million, the goodwill is worth $1 physical assets, such as patents,
company’s reputation, including million. According to International trademarks, brand recognition,
loyal customers and suppliers, brand Financial Reporting Standards since and copyright; their valuation is
name, and public profile. Goodwill 2001, goodwill does not amortize, sometimes subjective
arises when one company buys so it does not appear as amortization
another for more than its book value in financial statements. However, if ❯ Patent A license granted by a
(total assets minus total liabilities). the value of goodwill falls (through government or authority giving
For example, if Company A buys negative publicity, for example) it the owner exclusive rights for
Company B for $10 million but the can be recorded as an impairment. making or owning an invention

How to calculate depletion

Like amortization, depletion is calculated using the straight-line
method (see pp.124–125) unless there is a particular reason to use
another method.

In this example, a logging company buys COST – SALVAGE VALUE X UNITS = DEPLETION
a forest with an estimated 60,000 trees for TOTAL UNITS EXTRACTED EXPENSE
$10 million. The original salvage value is
$1.5 million, but the company spends $500,000 10,000,000 - 1,000,000 6,000 = $900,000
on road building in the forest, bringing it down X
to $1 million. The company cuts down 6,000 60,000
trees during each accounting period.

NUMBER MILLI$1O0N
OF TREES MILL$I9.O1N
MILL$I8.O2N
60,000 MILL$I7.O3N
50,000 MILL$I6.O4N
40,000 MILL$I5.O5N
30,000 MILL$I4.O6N
20,000 MILL$I3.O7N
10,000 MILL$I2.O8N
MILL$I1.O9N
0 MILLI$1ON

1 2 3 4 5 6 7 8 9 10
TIME (YEARS)

Management
accounting

For a company’s management to anticipate profit and loss, plan cash flow, and set
effective goals for the business, the coming year’s incomings and outgoings need
to be set out in detail. Unlike financial accounting, which is primarily for external
users such as investors, lenders, or regulators, management or cost accounting
takes place within a business to project expected sales revenue and expenses,
so that the business can decide how to best use its available resources.

Department budgets Management accounting
Managers estimate what funds will be needed process
for expected outgoings. See pp.136–137.
Planning is done for the financial (fiscal)
Purchase orders (POs) year that lies ahead—this is also called
POs tell the finance department exactly how the accounting year and is made up of
much money to reserve for payment. 12 consecutive months. Start and end
dates differ from country to country.

Timesheets

Staff employed on an hourly or daily basis fill in timesheets;
these help managers to calculate overall staff costs. See pp.140–141.

Invoices

Invoices submitted by contractors and suppliers have to be
matched against purchase orders and paid out. See pp.134–135.

Goods received

Employees log receipt of merchandise, describing
what the goods or services are and the quantity received.

Management Information
is passed to
Managers create budgets and document business costs
to monitor business performance, and plan for the short finance
and medium term. The information they collate sheds department
light on the financial implications of ongoing projects.

130 131HOW FINANCE WORKS
Management accounting

80% COST ACCOUNTING PRINCIPLES

of accountants and The Chartered Institute of Management Accounting (CIMA)
financial professionals in the UK and the American Institute of Certified Public
in the US are employed Accountants (AICPA), with members in 177 countries, have
within a business or established Global Management Accounting Principles.
organization ❯ Communication provides insight that is influential

Facilitate good decision-making through discussion.
❯ Information is relevant Source best material.
❯ Stewardship builds trust Protect financial and non-

financial assets, reputation, and value of organization.
❯ Impact on value is analyzed Develop models to

demonstrate outcomes in different scenarios.

Cost of production report (CPR) $

CPR shows all of the costs that can be charged
to a particular department. See pp.140–143.

Budget reports

Reports help management to determine the accuracy of
budgets and analyze business performance. See pp.136–137.

Cash-flow statement $

This shows how well the business will be able to meet its financial
obligations and generate cash in the future. See pp.120–121.

Financial $Balance sheet $
analysis is
passed to The balance sheet estimates the value of assets and inventory held,
managers so that management can reduce it if necessary. See pp.116–117.

Profit-and-loss statement $
$
Also called an income statement, the P&L statement tells
management how much money the business made or
lost over a particular time period. See pp.114–115.

Finance department

Accountants in the finance department (or contracted
from outside the business) receive information about
the costs from managers. They then use these to generate
reports and statements for the managers, who use this
information to make decisions for the next financial year.

Cash flow

The money coming in and going out of a business is its cash flow; the
balance of inflow and outflow is key to survival. Inflows arise from
financing, operations, and investment, while outflows are expenses.

Sales revenue Capital CASH
IN
Cash for goods and Investment and lump sums
services sold ❯ Main source of cash inflow for $CASH
❯ Revenue generated by core IN
start-ups
operations ❯ Additional cash injection after $$
❯ Basis of profit—does not have to
initial start-up or at key stages Cash in hand
be repaid, unlike loans or capital in a company’s growth
❯ Company must be able to turn ❯ Revenue from flotation of private Loan repayments
companies (going public) and
revenue into cash (get paid) to shares issued by public companies Debt servicing and
maintain cash flow ❯ Also known as cash flow from shareholder profit
❯ Also known as cash flow from investing activities ❯ Interest on long-term loans for
operating activities
CASH OUT asset purchases and on short-
“Cash comes in, term loans for working capital
cash goes out, Overheads ❯ Repayments on capital loans
but the tank ❯ Commission paid to factoring
should never Payment of bills companies
be empty.” ❯ Day-to-day running costs ❯ Cash distribution to shareholders
❯ Rental cost of commercial via share repurchases and
Salaries and wages dividend payments
property; utility bills—water,
Payments to employees electricity, gas, telephone, and
❯ Money paid to employees who internet; office supplies and
stationery
are directly involved in the ❯ Salaries and wages of employees
creation of goods or provision not directly involved in creating
of services goods and services (known as
❯ Salaries paid to staff as a fixed indirect labor)
amount monthly or weekly
(based on an annual rate)
❯ Wages paid to contractors for
hours, days, or weeks worked

132 133HOW FINANCE WORKS
Management accounting

How it works and other sources. Cash flows out to pay employees,
rent and utilities, suppliers, and interest on loans.
Cash flow is the movement of cash in and out of a Timing is key—having enough cash coming in to
business over a set period of time. Cash flows in from pay bills on time keeps the company solvent.
sales of goods and services, loans, capital investment,

CASH Loans Other revenue
IN
Bank loans and overdrafts Grants, donations,
$ CASH and windfalls
IN ❯ Working capital loans to meet
shortfalls, with anticipated inflows ❯ Grants from government or other
$$ as collateral institutions, usually one-time sums
for research and development
❯ Advances on sales invoices
from factoring companies ❯ Donations and gifts (applicable to
nonprofit organizations)
❯ Short-term overdrafts
❯ Also known as cash flow from ❯ Sales of assets and investments
❯ Repayment of loans made to
financing activities
other organizations
❯ Tax refunds

CASH OUT

or stock Tax Equipment

Suppliers Payments to tax authorities Purchase of fixed assets

Payments for materials ❯ Corporation tax based on annual ❯ Cost of buildings and equipment,
and services financial statements such as computers and phones,
❯ Cost of raw materials needed office furniture, vehicles, plant,
❯ Payroll tax paid by employers on and machinery
to manufacture goods for sale behalf of employees
❯ Cost of stock, imported or local ❯ Offset by depreciation (see
❯ Fees for services such as ❯ Sales tax on goods or services pp.124–127)
❯ Varies from country to country,
consulting or advertising
to generate revenue depending on tax law
❯ Payments to contractors involved
in goods and services creation

CASH FLOW

Cash-flow management manage cash flow, it is essential for WARNING
companies to forecast cash inflows
The handling of cash flow and outflows. Sales predictions and Top five cash-flow problems
determines the survival of any cash conversion rates are important.
business. Equally important is A schedule of when payments are ❯ Slow payment of invoices
a company’s ability to convert due from customers, and when a ❯ Credit terms on sales invoices
its earnings into cash, which is business has to pay its own wages,
known as liquidity. No matter how bills, suppliers, debts, and other set at 60 or 120 days, while credit
profitable a business is, it may costs, can help to predict shortfalls. terms on outgoings are 30 days
become insolvent if it cannot pay If cash flow is mismanaged, a
its bills on time. New businesses business may have to pay out before ❯ Decline in sales due to change in
may become victims of their receiving payment, leading to cash economic climate or competition,
own success and fail through shortages. Some businesses, such or product becoming outmoded
“insolvency by overtrading” if, for as supermarkets, receive stock
example, they spend too much on on credit but are paid in cash, ❯ Underpriced product, especially
expansion before payments start generating a cash surplus. in start-ups trying to compete
coming in and run out of cash to
pay debts and liabilities. In order to ❯ Excessive outlay on payroll and
overheads; buying rather than
renting assets

Positive and negative cash flow

CASH CASH
IN IN

$ $

CASH IN HAND INCREASES CASH IN HAND STABLE

CASH
OUT

Positive cash flow Stable cash flow CASH
OUT
Cash flowing into the business is Cash flows into the business at
greater than cash flowing out. Cash the same rate as it flows out. Cash $
in the tank—stock—increases. A stock remains stable—a sign that a
business in this position is thriving. business is healthy.

134 135HOW FINANCE WORKS
Management accounting

NEED TO KNOW 80%

❯ Factoring Transaction in which a Cash conversion of small business
business passes its invoices a third start-ups across
party (factor), which collects payment Successful businesses convert their the world fail
from the customer for a commission product or service into cash inflows because of
before their bills are due. To make the poor cash-flow
❯ Accounts payable Payments a conversion process more efficient, a management
business has to make to others business may speed up:

❯ Accounts receivable Payments ❯ Customer purchase ordering
a business is due to receive
❯ Order fulfillment and shipping
❯ Aging schedule A table charting
accounts payable and accounts ❯ Customer invoicing
receivable according to their dates
❯ Accounts receivable collection
❯ Cash-flow gap Interval between period
payments made and received
❯ Payment and deposit

CASH NO CASH HANDLING THE FLOW
IN IN/OUT
Managing a surplus
CASH IN HAND DECREASES
❯ Move excess cash into a bank
CASH CASH DRIES UP account where it will earn interest,
OUT or make profitable investments.
NO CASH
IN/OUT ❯ Use cash to upgrade equipment
to improve production efficiency.
Negative cash flow $ Bankruptcy
❯ Expand the business by taking
Less cash is flowing into the If cash flowing out continues on new staff, developing products,
business than is flowing out. Over to exceed cash flowing in, cash or buying other companies.
time, the stock of cash will decrease stock levels will drop so low that
and the business will face difficulties. the business becomes insolvent—it ❯ Pay creditors early to improve
has no assets left to continue trading. credit credentials, or pay down
debt before it is due.

Managing a shortage

❯ Increase sales by lowering prices,
or profit margins by raising them.

❯ Issue invoices promptly and
pursue overdue payments.

❯ Ask suppliers to extend credit.

❯ Offer discounts on sales invoices
in return for faster payment.

❯ Use an overdraft or short-term
loan to pay off pressing expenses.

❯ Continue to forecast cash flow
and plan to avert future problems.

Budgets

Setting the budget for a business involves planning the income and
expenditure for the accounting year. This is usually broken down into
months so that planned budget and actual figures can be compared.

How it works each manager in the business, along with expected
cash-flow projections for the business, to create a
Every business needs to budget for anticipated master budget. The master budget can also include
revenue and operating costs within the financial year. figures for any financing that the company is expected
Unlike capital budgeting, in which senior management to need over the coming year. As the year progresses,
allocates what will be spent on specific projects or the projected budget and the actual money coming in
assets, revenue budgeting focuses on the overall and going out are monitored on a daily, weekly, or
projections for money coming in and money going out monthly basis, so that any deviations from the original
for each month of the coming financial, or accounting, budget can be identified, and, if necessary, remedied.
year. Accountants compile operating budgets from

Setting and Consultation $
controlling budgets
Senior management sets out Prepare the budget
Budget-setting is a process that the company’s objectives to the
takes place between the department departmental managers. Each The budget is usually based on the
managers, senior management, and manager is then responsible for accounting year, but broken down
finance department in a company to working out the budget required into shorter periods. Departmental
establish and control the cost of each by their individual department, managers submit their budgets to
department or project. in order to meet those objectives senior management for approval.
for the coming year. These may cover areas such as
1% operating costs (salaries and supplies)
and administration (office expenses).
of companies
worldwide made
accurate budget
forecasts, from
2004 to 2007

136 137HOW FINANCE WORKS
Management accounting

INCREMENTAL AND ZERO-BASED NEED TO KNOW

There are two main approaches to setting budgets: ❯ Planning, Programming, and Budgeting
Systems (PPBS) A budgeting system used
Incremental budget The Zero-base budget The coming in public service organizations such as city
budget for the year ahead is year’s budget starts afresh, with councils and hospitals
based on the previous year’s no reference to previous years.
budget. This budget takes This means that each item ❯ Virement An amount saved under one cost
into account any changes, entered into the budget is heading in a budget is transferred to another
such as inflation, which could carefully scrutinized and has to cost heading to compensate for overspend
have an impact on the new be justified by the department
calculations. The downside managers. This method makes ❯ Budget slack Deliberately underestimating
is that previous inaccuracies it easier to see the full cost of all sales or overestimating expenses in a budget
may be carried forward. planned changes.

$
$$

Master budget Measure performance Take action

Once approved, the budgets from After each month (or equivalent time If necessary, the budget is revised
each department are combined into period set in the budget), the actual to take into account any unforeseen
a master budget for the year, which figures realized by the company are and continued expenditure, or any
includes: a budgeted profit-and-loss compared with the original budget savings that were not anticipated. If
account, a projected balance sheet, projections. Variations are examined income is less than expected, action
and a budgeted cash-flow statement closely to work out whether they are may be taken to alter departmental
that typically shows a month-by- significantly different from the figure processes or campaigns in order to
month breakdown. in the original budget. reach the targets set in the budget.

Assets and inventory

A company’s possessions, or assets, are divided into two categories:
fixed (or long-term) assets and current (or short-term) assets. Current
assets consist of cash in the bank and inventory.

How it works Current assets are held for the NEED TO KNOW
short term and used mainly for
Fixed assets are items that enable trading. The most important ❯ Asset valuation A method of
a business to operate. They tend category in terms of generating assessing the value of a company’s
to be long-term holdings and revenue is current assets. The key holdings. Asset valuations may
cannot be easily converted component of these is inventory. take place prior to a merger or
into cash. Fixed assets can be Inventory can be finished goods the sale of the business, or for
categorized as either tangible or ready for sale, but it can also be insurance purposes
intangible: tangible assets are the raw materials that will be
material objects, while intangible used for producing the goods.
assets have no physical form.

Assets and inventory in practice

The partial balance sheets below show the current assets of a branch of Super Sports Inc.,
a sportswear and sports accessories company. These assets include cash in the bank and
inventory held by the company. The inventory in this case consists of all the items in the
shop that are ready for sale.

Super Sports Inc. $ Super Sports Inc. $

May 31 12,000 June 15 54,000
22,000 0
Assets 34,000 Assets 54,000

Cash at bank Cash at bank
Inventories Inventories
Total assets Total assets

Balance sheet as of May 31 Balance sheet as of June 15

The “Assets” section of the balance sheet shows that the Two weeks later, the company sells all of its inventory for
company holds $22,000 worth of inventory (or goods) at $42,000 and receives payment for this sale on the same day.
this point in time, as well as $12,000 cash in the bank. This means that total assets have risen by $20,000—the
profit made on the sale of the inventory—and increases
the amount of cash in the bank by $42,000.

138 139HOW FINANCE WORKS
Management accounting

TYPES OF INVENTORY

Inventory can include three types of stock, depending on the kind of business being
carried out: raw materials, unfinished goods, and finished goods. See pp.316–317.

Raw materials Work in progress Finished goods

Materials and components scheduled Materials and components that have The stock of completed products, or
for use in making a product. For begun their transformation into goods ready for sale to customers.
example, a chocolate factory will have: finished goods; these may be referred A bookstore, for example, will have:
to as “unfinished goods.” For instance,
❯ Ingredients in the form of sugar, a graphic designer will have: ❯ Hardback and paperback books
cocoa mass, cocoa butter, additives, of various genres and formats
flavorings, and perhaps milk or nuts. ❯ Layouts and designs that are supplied by publishing houses
being developed and are awaiting
❯ Foil, plastic, and paper for the client approval ❯ Gift items such as greeting cards
wrappers and packaging and notebooks

Types of fixed assets

Super Sports Inc. owns a range of tangible and intangible fixed
assets. Compared to tangible fixed assets, the worth of
intangible fixed assets can sometimes be harder to evaluate.

Tangible fixed assets

ND AND PROPE FURNITURE PUTER EQUIPM VEHICLES LS AND MACHI

COM
TOO
INTE LA RTY ERTY NERY
ENT

Retail outlets plus Store displays and Computers for Trucks and branded Warehouse and
company headquarters back office furniture administrative work company cars distribution equipment

Intangible fixed assets

LLECTUAL PROP TRADEMARKS BRANDS MPUTER SOFTW RIGHT AND ROY

©
ALTIES
ARE
CO
COPY

Brands and designs, Legally protected words Own brands, including Internet portal for Licensing revenue
creative innovation online sales streams
and symbols value and luxury ranges

Costs

Costs are the direct or indirect expenses that a business incurs
in order to carry out activities that earn revenue, such as
manufacturing goods or providing a service.

How it works Variable costs

There are two main ways of classifying costs: The head chef orders LARGE
direct, or variable, costs, which increase as more the ingredients that will FOOD ORDER
goods and services are sold, and indirect costs, which be required each day.
contribute to the overall running of the business and For peak evenings the
can either vary with the level of production or stay cost of the food order
fixed. There are three main costs that businesses is higher; for quieter
need to account for. The first is labor—wages paid to nights, the food order
people employed to carry out a particular task. Labor is lower.
can be regarded as direct or variable, or as a fixed
cost or overhead. The second is the raw materials
used in production and other materials used in
service industries—these costs are variable. The
third is expenses, which are other costs incurred in
the course of the business’s activities.

Fixed and Fixed costs

variable costs RENT AND
INSURANCE
One way of looking at costs is to split them
into two categories: fixed costs, which do not COSTS
change with the level of business activity, and
variable costs, which do change with the level
of business activity. This helps accountants
to determine how changes in business
activity (for example, cutting or increasing
production) will affect costs. In reality, some
fixed costs will increase once business activity
reaches a certain level—these are called
stepped fixed costs.

LAUNDRY
SERVICES

STAFF SALARIES CLEANING BILL

A restaurant rents premises to cater for 40 diners. The
fixed costs are the same whether the restaurant serves
30 or 40 diners a night.

140 141HOW FINANCE WORKS
Management accounting

PEAK QUIETER NEED TO KNOW
EVENINGS EVENINGS
❯ Break-even point (BEP) The
SMALL point at which total sales revenue
FOOD ORDER is equal to total costs

Stepped fixed costs ❯ Questionable costs Costs that
can be treated as fixed or variable
HIGHER
RENT AND ❯ Sunk costs Costs incurred in the
INSURANCE past that cannot be recovered

COSTS ❯ Prospective costs Costs that
may be incurred in the future
depending on which business
decisions are made

40%

of business
owners say that
payroll is their
greatest expense

EXTRA
LAUNDRY
SERVICES

HIGHER STAFF COSTS HIGHER CLEANING BILL

The restaurant becomes popular, so the owner rents the
premises next door to serve an additional 40 diners a night.
The costs that were fixed at a certain level have now doubled.

Product costing
and pricing

Knowing the full cost of creating each product that a business
sells is vital because it helps a company price its products
appropriately and assess the performance of the business.

How it works calculate the cost of a product, it NEED TO KNOW
is treated as one unit of production.
Both direct and indirect costs The direct and indirect costs ❯ Absorption costing Allocation
contribute to the production cost involved in creating that single of all production costs to product
of a product, whether it is a unit are then assessed and added
manufactured good or a service together to create the full cost. ❯ Differential costing Difference
being provided. In order to between the cost of two options

38% ❯ Incremental (marginal) costing
the average total of US The change in total costs incurred
business costs that can be when one additional unit is made
accounted for by indirect costs
❯ Throughput costing An analysis
of the impact that one extra unit
of production will have on sales

❯ Cost-plus pricing Product price
is based on direct and indirect
costs, plus markup percentage

Full cost pricing Direct costs Share of indirect costs

Direct costs can be measured in terms ❯ Materials ❯ Production and service
of how materials and labor are used overheads
to produce each unit. Indirect costs ❯ Direct labor
(overheads) are harder to assess but also ❯ Administrative
need to be factored in so that the full cost of ❯ Direct expenses and management
each product can be calculated. Managers overheads
and accountants must apportion indirect ❯ All used exclusively to
costs to reflect their contribution to the cost create a product or ❯ Sales and distribution
of creating a single product. Once this is service for sale overheads
ascertained, the full cost of that product can
be determined. In general terms, the price is
worked out by adding the direct and indirect
costs of production with a
profit margin that gives an
appropriate selling price.

142 143HOW FINANCE WORKS
Management accounting

OTHER COSTING METHODS $

There are several different approaches to costing and pricing depending on the
industry, the type and size of the business, and the method of production.

JOB COSTING BATCH COSTING $ CONTRACT COSTING
Used for a Used when a batch of identical Used for a large one-time job, often
customized order products is made—for example, the result of a tender process (when
made to a client’s an electrical goods company a company bids for work) and
specifications—for manufacturing television sets carried out at the client’s site—for
example, a printing example, a construction company
company that building homes in a new residential
prints brochures development
for a client

PROCESS COSTING $SERVICE COSTING
Used for an ongoing job that often Used when the product being sold
involves several manufacturing $ is a standard service offered to
processes, making it difficult to isolate$ customers—for example, a nail salon
individual unit costs—for example, offering an express manicure and
an oil refinery which processes pedicure within a set period of time
crude oil into diesel oil and for a fixed price

$

Profit margin Selling price

❯ Must be able to generate profit ❯ Low: in order to gain market
for the company share, or to match competitors

❯ Must be in line with how the ❯ Cost-based: recover
direct and indirect
product has been costs and profit
margin that the
marketed LUXUFORYR HSAOLME E market will accept

❯ Must be ❯ Service-based:
pitched flexible since no
realistically so manufacturing or
that customers distribution cost

will buy

Measuring
performance

There are two main ways of measuring a company’s performance: financial
and non-financial. To assess financial performance, a company calculates
financial ratios. To assess other areas of the business, a company examines its
key performance indicators (KPIs), which help management and staff evaluate
performance and how it can improve. KPIs also enable interested outsiders, such
as investors, lenders, or analysts, to decide whether to invest in the business.

Financial and non-
financial categories

Any company that publishes a financial report

will be required to set out key figures on the

revenue generated and the expenses incurred

during the course of its activities. These figures

can be compared using mathematical

calculations called financial ratios.

However, financial ratios alone may

not give an accurate vision of the

company’s future prospects.

Non-financial ratios, or key

performance indicators,

do not measure financial

performance, but they do Tracking and forecasting Company

reveal other important Financial and non-financial measures can be
characteristics of a company used to forecast company performance and
that will ultimately affect its track fraud. See pp.152–153.
profitability, such as customer

loyalty and research and

development (R and D)

productivity.

144 145HOW FINANCE WORKS
Measuring performance

TREND ANALYSIS USING PERFORMANCE MEASUREMENTS

A comparison of CURRENT RATIO COMPARISON OVER TIME
Fast-food chain A is shown to be a consistently better performer over
either financial time, and so has the most solid financial standing of the three companies.
braettiowseoernKcPoIms panieCsURRRAETNIOT
FAST FOOD CHAIN A
in the same industry 0.9
FAST FOOD CHAIN C
and across time 0.8 FAST FOOD CHAIN B

is often used to 0.7 2 34 56 7
track a company’s 0.6 YEAR
performance.

Current ratios 0.5

are calculated by 0.4
dividing current 0.3
assets by current 0.2
liabilities: the

higher the ratio, 0.1

the more liquidity

a company has. 1

Finmaenacsiaulres $ $Nofinnm-aenacsiaulres THE BIGGER PICTURE

Financial ratios Key performance Some professional services
indicators companies, such as multinational
❯ Used by investors and ❯ Used internally and by PwC, undertake quarterly surveys,
lenders to gauge financial interviewing senior executives to
health of an organization: if investors, as they appear find out how optimistic they are
it’s likely to survive economic in financial statement about their sector and the wider
slump, and what prospects ❯ May be calculated daily or economy. Such surveys help
it has for future growth even more frequently for companies measure their own
internal use performance objectively.
❯ Standard set of ratios used ❯ Companies can set diverse
by the financial industry KPIs to reflect future goals 69%
❯ Unique to each company
❯ Calculated based on figures See pp.146–147. of multinationals
provided in financial reports link performance
measures to
See pp.148–149. future financial
results

Key performance
indicators (KPIs)

Key performance indicators (KPIs), or key success indicators (KSIs),
are based on a company’s goals and vary depending on the company
and industry. KPIs are usually stated in a company’s annual report.

How it works determine the department’s efficiency. This is an
example of a lagging indicator—it is an outcome and
KPIs are the non-financial measures of a company’s therefore easy to measure, but not straightforward to
performance—they do not have a monetary value influence. Companies also look for leading indicators,
but they do contribute to the company’s profitability. which are focused on inputs and easier to change. A
Any company department can adopt KPIs to gauge its leading KPI for the accounts department might be the
performance. A KPI for an accounts department might percentage of purchase orders raised in advance.
be the percentage of overdue invoices, as this will help

Corporate KPIs Accounts

KPIs can be set up as dashboards on computers $
so that they can be checked frequently. These
dashboards show examples of KPIs specific
to departments in a company. Having
set their KPIs, the departments are
subject to managerial review,
which could result in
action if KPIs are
sub-standard.

Sales and marketing Number of retrospectively raised Customer service
purchase orders; finance report
error rate (measures the quality
of report); average cycle time

of workflow; number of
duplicate payments

Net promoter score (NPS—how many Number of customer complaints;
customers would recommend company); customer satisfaction (measured over

customer retention rate; customer time); average email response
lifetime value (total amount of time; number of products
money generated by sold compared to total
one customer) sales calls made

146 147HOW FINANCE WORKS
Measuring performance

31% BALANCED SCORECARD SYSTEM

of companies This strategic system offers a different ❯ Learning and growth
use a computer way of monitoring a company’s Employee training and
dashboard performance. It was proposed by corporate culture
to monitor KPI Robert Kaplan and David Norton at
measurements the Harvard Business School in the ❯ Business
1990s, and Harvard Business Review has processes
cited it as one of the most influential Includes specific
business ideas of the last 75 years; it measurements for
is estimated that over 50 percent of monitoring daily performance
large companies in the US, Europe, and
Asia use the approach. The Balanced ❯ Customer perspective
Scorecard consists of four ways to view Customer satisfaction
an organization’s performance:
❯ Financial perspective
Traditional financial data

Operations

Human resources Project cost (difference between budgeted vironment and sustainabili
cost and actual cost of work); time taken
to get a product to market; optimally
running operations

En ty

Economic value of an employee’s Waste recycling rate; size of carbon
skill set; employee satisfaction levels; footprint; size of water footprint
(amount of water usage);
revenue per employee; rate of energy consumption
employee turnover

Financial ratios

Lenders, investors, analysts, internal management, and other
interested parties calculate financial ratios to decipher what
financial statements are really saying about the state of a business.

How it works purpose—for example, whether the purpose is to
measure the company’s ability to provide a good
Financial ratios are used to assess the financial return to shareholders, its capacity to handle debt,
standing of a business and identify any problem areas or the efficiency with which it operates. The ratios
that might affect its future prospects. The process can also be used to compare a business with its
involves comparing two related items in the financial competitors or in comparison to specific benchmarks
statement, such as net sales to net worth or net income within the company to determine how consistent its
to net sales, and using those ratios to measure the financial results are.
relative performance of the company. There are many
different ratios to choose from, depending on the

Top financial ratios Profitability ratios Efficiency ratios

These are some of the ratios most These are used to see how These show how efficiently
commonly used by people involved effective a company is at the company uses its assets
with assessing businesses. They are generating profit. Profitability ratios and resources to maximize profits. An
best considered comparatively and may mirror investment valuation example is the sales revenue to capital
in the context of the economic ratios. One example is the operating employed ratio, which indicates a
climate. The ratios are for analyzing profit margin ratio. A high ratio is good, company’s ability to generate sales
established companies, usually public as it indicates that a high proportion of revenue by utilizing its assets. Similar
ones with shares traded on the stock revenue (gross income) converted into ratios can examine how quickly the
exchange—start-ups and small-to- operating income (profit minus costs). company settles its bills and invoices.
medium enterprises generally do not
have a full enough range of figures to OPERATING OPERATING SALES NET SALES
provide any kind of reliable guide. PROFIT = INCOME REVENUE TO
CAPITAL
MARGIN REVENUE CAPITAL = EMPLOYED
EMPLOYED

RATIO

$$$ Other profitability ratios Other efficiency ratios

6x ❯ Return on equity (ROE) is measured ❯ Accounts receivable turnover ratio
as net income after tax / shareholders’ is measured as net credit sales /
1 2 3+ equity. The higher the ratio, the greater average accounts receivable. It shows
0 . =– the profitability, but not if a company how efficiently a company turns sales
is relying too heavily on borrowing. into cash. The higher the ratio, the
more frequently money is collected.
❯ EBITDA to sales ratio is measured
as EBITDA (earnings before interest, ❯ Inventory turnover ratio is measured
taxes, depreciation, and amortization) / as the cost of goods sold / average
revenue. It gauges the profitability of inventory. It shows how efficiently a
core business operations. The higher company manages its inventory level. A
the margin, the greater the profits. low ratio usually equates to poor sales.