Your First Step to Financial Intelligence

Your First
Step to
Financial
Intelligence
9 practical
Finance tips
that you
must know

AUTHOR

Vipin Khandelwal is an
entrepreneur, a discoverer, a
voracious reader. He is
constantly evaluating ways to
enable learning in innovative
ways. Before entrepreneurship,
he was involved in doing
business and financial analysis
and headed a financial planning
services firm.
Follow him on Twitter @vipinkh

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YOUR FIRST STEP TO FINANCIAL INTELLIGENCE

TABLE OF CONTENTS:
Index

Page No.

Accounting vs Finance

7

The First Principles

8

The 3 Key Financial Statements

11

Income and Expenses

17

Assets and Liabilities

19

Is Profit = Cash?

21

Did you Budget for it?

26

Cost marginally –>Break Even

29

True Cost of Capital

33


INTRODUCTION
What happens when you go to a
different country, say China, and you
ask a local for directions?
You hear some mumbling in Chinese
which you don’t understand and you
are left all confused.
Now imagine you are in a meeting with the CEO and the CFO
who are discussing with your division or units performance with
you. How do you feel there?
Very similar to the China experience. Right?
To manage business profitably, you need to measure and
evaluate your business decisions effectively.
For this you need to know the language. And that
language is Finance.
Now you don’t need to be an accountant or possess a
famous finance degree to be smart and make sense of all
that your CFO talks to you.
You can know these secrets right now and take the first
step to build your Financial Intelligence.
So, ready. Here we go!

6


1

Accounting or Finance
In a business transaction,
there is a transfer of value
from one party to another in
return for another item of
value, money, product or
service.

Image credit: Wikimedia

The job of Accounting is to record these transactions using
rules of debits and credits. It is like scorekeeping in a cricket
match.

Finance is about using the information and reports
produced by accounting to evaluate and review business and
use them to make critical decisions.

7


2

The First Principles

Source: flickr

The first principles determine the way we treat our
business and financial transactions and resultantly,
how they can impact our decisions about business.
There are 2 important principles that you should know:



Materiality and
Matching

8


Principle 1: MATERIALITY
Materiality literally means
importance. A financial transaction
or data could be materially
Unit
important if it has the capability to
influence the decisions one way or
Example: One rupee in
the other.
Materiality changes from business to one million is not material
but one rupee per unit for
business.
Source- dreamstime

a million units is highly
material.

Principle 2: MATCHING
It almost sounds like match making and in some ways it is
so. Just that in business finance, matching refers to incomes
and expenses.
All expenses should be matched to the incomes or products
that cause them and also to the appropriate period (month,
year). This is important because we want to know
what was spent to earn that revenue.
Example: If a customer pays in March 2013 but the service
is going to be delivered in June 2013, then you should count
the sale /revenue only in the year pertaining to June 2013.

9


Accounting Period
It is usually a period of 12 months for which the accounts
are prepared and balanced. At the end of this period, the
financial statements are also prepared.
The accounting period is either from January to December or
from April to March.
In India, either can be followed but for taxation purposes,
the year is April to March.

“

If you cannot measure it,
you cannot manage it."

10


3

The 3 Key Financial Statements

So, what is the end result of all financial
transactions? How do we summarise the business
activities in order to make sense of what happened?
The end result for any business organisation are 3 Financial
Statements:

Balance
Sheet
Profit &
Loss
Statement

Cash Flow
Statement
3 Key
Financial
Statements

11


PROFIT AND LOSS STATEMENT
Any business exists to make a profit. And it is important to
measure it.
A profit and loss statement helps you know what is the
result of the business operations. Note, it is made for a
period of time, typically, quarterly, half yearly, yearly.
The two important items in this statement are Incomes and
Expenses.
The incomes for the period and all expenses for that same
period matched and the net result calculated.

Incomes – Expenses = Profit / (Loss)
If Revenues exceed expenses, there is a profit.
If Expenses exceed revenues, there is a loss.
Revenue in business parlance is also called “Topline” and
Profit/Loss the “Bottomline”.

12


SAMPLE P & L – Infoedge India

Topline

Operating Income

Bottomline
Source: Infoedge.co.in

13


BALANCE SHEET
If you have to look at your business and evaluate its
financial strength, how would you do it? How would you
know where the business stands today?
Through a Balance Sheet! Like its name it provides the
balances of your various accounts “as on a particular date or
point of time”. Read the emphasis.
Essentially, the balance sheet shows what the business
owes (liabilities) to others and what it owns (assets).
It is also called the Statement of Sources and
Application of Funds as it tells you from where all the
business obtained funds/capital, the sources and how did it
use those funds or the application.
The balance sheet helps you understand and analyse
important financial information about a business. (More
about that in the next guide)

14


Infoedge India

External
liabilities

Net worth = Total Assets – All External Liabilities
What is the other way you could calculate Net Worth?

15


CASH FLOW STATEMENT
Cash is the lifeblood of business.
Ultimately, in any business activity, we sell a product or
service and receive cash payment against it or we hire or
buy a product or service and pay cash for its use.
The Cash Flow statement therefore is a summary of how
cash was received and in what ways it was sent out.
It is an important statement as it shows how and when cash
resources will be available to carry out business operations.

A Cash Flow statement typically shows cash flow changes
from 3 types of activities.

Cash from
Operation

Cash from
Investment

Cash from
Financing

The day to day
operations of the
business incl
buying of raw
material, sales,
salaries, etc.

Buying or selling of
assets, Loans,
investment in stock
markets, etc.

Raising fresh
money through
stock markets or
loans, payment
of dividends, etc.

16


4

Income and Expenses

So, we now know that a Profit and Loss Account summarises
the Incomes and Expenses so that we can figure out if the
business made a profit or a loss. But how do we know which
item would fall under income or expense and how should it
be treated?

Count incomes against
which value has been
delivered within the
period, not advances.

An income is also
called revenue,
sales, turnover and
is a result of the
normal business
activity wherein
products or services
are provided in
return for income.
Count expenses which
contribute to their
economic usefulness within
the period of measurement
(typically a year).
17

An expense is an
outflow of money
in return for a
product or
service. It is also
known as “cost”.


The Concept of Accrual
If you recall the matching principle, it says that we should
match incomes and expenses to each other as also the
period to which they actually belong.
This results in what we are discussing here, Accrual.
Put simply, Accrual is “an act or process of
accumulating” (thefreedictionary.com).
In the world of finance, accrual reflects a recognition of an
income or expense even before actual cash has been
received or paid out. In other words, they are non-cash.

World over, accounting is mostly done on the basis of
accrual.
So, your vendor might send
you a bill which has to be
paid after 30 days. In that
case, cash will leave the
business only after 30 days
and hence it is an accrued
expense. It has become
due but not paid.

Similarly, you might make a
sale for which the cash will
actually come in after 60
days. You record the
transaction and it becomes
an accrued income. It
has become due but not
received.

18


5

Assets and Liabilities

In the Balance sheet section, you read that Assets are “what
the business owns “ and Liabilities are “what the business
owes”. So, how do we know what is an asset or a liability?

Asset

An Asset is an outlay, like a computer
equipment, which has economic
usefulness in business operations over
several years.

Important points about Assets
 Assets can be Fixed assets (Plant & machinery,
Computers, Land) and Current assets (Inventory, Stocks,
Cash, Goods sold on credit or accounts receivables)
 Current Assets are those the value of which is
exhausted within 12 months
 Assets can also be tangible (Owned Office space) or
intangible (patents); movable (Cash) and immovable
(Land)

19


Important points about Liabilities
 Liabilities can be long term (like bank loans, long
term deposits) and short term (working capital
borrowings, accrued expenses, creditors who sold
goods to us on credit, advance income).
Current Liabilities are those which have to be repaid
within 12 months (creditors, expenses due but not paid)
 Shareholders money (share capital, owners equity) is
also shown on the liabilities side since it is the amount
that the business has to pay back to the
owners/shareholders.

Liability

A Liability is an obligation which
provides economic resources for
running the business operations like
buying of equipment.

Note:

Working
Capital

Required to run day to day business
operations.
= Current Assets – Current
Liabilities
20


6

Is Profit = Cash?

PROFIT

So, you might wonder that for all the sales that you have
brought into the company, when it is time for the bonus, you
are told that there is no cash to pay. Why?
Because you got the sale, not the cash! You sold the products
on 60 days credit. Means, your customer needs to pay only
after 60 days. So the real cash arrives after 60 days. And
that’s when you get your share of bonus.

Note:

Now as per the accrual rule, the sale is done and recorded
so it increases topline and bottomline, but not CASH.

21


There are several
companies who
show huge profits
but there is no cash
with them.
The shareholders might feel cheated thinking that though the
company has made record profits, why it is not declaring any
dividends?
Can you figure out why would that be the case?
Let us see some of the reasons
 Sales happening on credit - Income up, not cash
 Advance payments made for equipment / software
 ________________________________(fill in a reason)

22


Similarly, there are companies who may have lot of cash
with them but they are not profitable?
 Depreciation or amortisation of assets charged to
income, a non cash expense. Hence cash is available but
there would be low or no profit.
 A company which has raised capital (equity or debt)
and hence has cash, but revenues are lower than
expenses and hence no profit
 ________________________________(fill in a reason)

23


The Concept of Depreciation
Depreciation literally means by which something
reduces in value.

“

As per wikipedia,

depreciation refers to

The allocation of the cost of the assets to periods
in which the assets are used (depreciation with
the matching principle)”

Typically assets offer useful value over a period of time. To
ensure that we match these uses of value with the right
period, we depreciate assets. Which means that for every
period the value of the usage is deducted.
For example,
if you have bought a computer for 45,000 and it is going
to be useful for 3 years, then you would depreciate it by
15,000 (45,000 / 3 yrs) every year.
Remember, depreciation is a non cash expense, means there
is no outflow of cash. This treatment is carried out in
the Profit and Loss statement under the expenses
side. The balance value of the asset (post depreciation)
is shown under Assets in the Balance Sheet.

24


Depreciation vs Amortisation
While depreciation is
used in reference to
physical or tangible
assets, amortisation is
used for intangible ones
like patents.

EBITDA
Also, Operating profit or profit from core

operations or operational profitability

EBITDA = Income (minus) all expenses
except Interest, Tax, Depreciation
/Amortisation

25


7

Did you budget for it?

You are the head of the department. And you finally come
across this fabulous technology that will help the company
achieve its objective.
You rush to the CFO and talk to her about getting it.
She listens to you patiently and asks, “Did you budget for it?”
All your hopes suddenly fall flat on the ground. You had not
provided for this new technology in the budget.

26


A budget is a very important document for you and for
your organisation.
 It helps to put quantitative estimates to a set of
intentions
 It helps in channelising the resources available to the
organisation in the right direction towards achievement of
desired objectives
 When compared with actual results, it helps to evaluate
and analyse the performance of the
division/unit/organisation
 When you perform better than the budgets, you get
rewarded.

Typically budgets are prepared on a yearly basis.
Budgets are a bottom up exercise, where every
department (marketing, production, sales, IT HR)
makes its budget and sends it to the central business
planning department which collates all of them to
create a company wide budget.

27


Important points to keep in mind while
making a budget to save pain in the future
 Ensure that you understand the business
objectives to be achieved with respect to your
department or business unit. You will be able to defend
your budget only in relation to the business objectives
and strategy.
Start to prepare in advance. Generously use inputs
from the team.
 Ensure that you plan for all possible expenses,
fixed and variable. And after that, include a
contingency reserve to provide for unexpected
expenses that might come up including new
initiatives.
Be realistic in estimating income.
Be actively involved in making your budget. If
someone else makes your budget, it will be their
budget and not yours.

Review your budget periodically. If there are
significant changes in the assumptions or market
conditions from the time you made your budget, you
should adjust it to reflect the current realities.
28


8

Cost Marginally - Break Even

“

The Cost of doing nothing
is everything.”

It is a given that there is a cost to produce and deliver a
product or service.
The way we structure our costs can significantly impact our
business results.
Let’s look briefly at the role of various costs.

29


Costs are primarily of two types

Fixed Costs
These costs are incurred
irrespective of whether
the business has any
running operations or
not.

Variable Costs
Costs incurred as a result
of business operations.
As business operations
vary in size and scale,
these costs vary too. You
got the word, vary.
Right! Examples: Raw
materials, sales
commission and contract
employees.

Examples: Rent of office,
permanent employees
and related costs.

Fixed costs also do not
change with the change in
the output and hence put
pressure on the business to
perform specially in not so
good market scenarios.

Variable costs change with
the change in output. They
allow for suitable
adjustments based on
business climate and market
demand.

Manufacturing businesses
tend to have a high fixed
cost structure. Think power
plants.

Service businesses are lot
more flexible with respect to
cost. Think Consultancy.

30


Break
Even
Margin
The point of business operations at which
incomes are equal to costs is known as
the break even point. It is useful in
evaluating whether a new project makes
sense or not.
B E Point is = Fixed Costs / Contribution Margin

Contribution
Margin
Also, Marginal profit per unit of sale
= Sales Price - Variable Cost
If this is positive, it makes sense to take
that bulk order at a discounted price.

31


“

As Henry Ford once put it,

If you need a machine and don't
buy it, then you will ultimately
find that you have paid for it and
don't have it.' Thinking on a
marginal basis can be very, very
dangerous."
- Clayton Christensen

32


9

True Cost of Capital

When you take a business loan from the bank at 15%, you
know the cost of the loan, that is, 15% per year.
Now to be profitable, you have to deploy this money so as to
be able to earn more than 15%.
For example, if you earn 20%, then you make a profit of 5%
or a margin of 33% (5% / 15%).
Remember: A business exists to make a profit.

33


Businesses raise money in the form of
equity and debt.

Equity

Debt

also known as the owner’s money,
represents of the ownership in the
business. It is a risk capital in the sense
that there is no fixed return and shares
profit and/or losses in the business.
is money borrowed from third parties like
banks, individuals and other financing
institutions. The returns are fixed and
assured to the one who provides
debt/loans.

There are various forms and structure of equity and debt but for
the purpose of this ebook, we will stick to the simpler definition.

On the previous page, we went over an example where you
borrowed debt at a defined fixed rate of interest.
The question now is “What is the cost of owner’s capital
or equity”?
Now if you are thinking there is no cost to equity (since there
are no fixed returns), I am sorry to break the bad news. You
are mistaken !

34


Equity has a cost, definitely.
It is important to ascertain this for it will help us understand
what returns do we need to target to have a profitable
business.
How do we do it? Now think for a while, that the owner has
a choice to lend her money at a fixed rate of interest than give
it to the business.
Assuming that the owner is able to give away a loan at 15%
(same as our debt example).
To this we would have to add a premium for the fact that the
owner is taking a risk. Why? She is not going to get fixed
returns and so she needs to be compensated for this
uncertainty.

For example sake again, the cost of equity capital would be,
say 20% (a 5% additional return for the risk premium).
Now assuming 50% of the money comes through debt and
50% through owner’s equity, the true cost of capital would
be (50% x 15%) + (50% x 20%) = 17.5% (weighted cost)
The business will have to earn more than 17.5% to be
truly profitable. Else the owner is better off giving a loan for
a fixed return.

35


Can you relate the concept of “true cost of
capital” to “Return on Investment
(ROI)” concept?

ROI is used as one of the tools (along with payback period
and Internal Rate of Return) to evaluate investment
opportunities.
Scarce organisational resources are directed towards
opportunities which have the potential to provide the
maximum return on investment.
So, next time when you are proposing an investment to
the company, read CFO, ensure that the ROI calculation is
in place.

36


“

If you really want to
impress your CFO,
start talking metrics.”

37

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