Accounting is the process of systematically collecting, an­alyzing, and reporting financial information. The basic prod­uct that an accounting firm sells is information needed for the cli­ents.

Many people confuse accounting with bookkeeping. Book­keeping is a necessary part of accounting. Bookkeepers are re­sponsible for recording (or keeping) the financial data that the ac­counting system processes.

The primary users of accounting information are managers. The firm’s accounting system provides the information dealing with revenues, costs, accounts receivables, amounts borrowed and owed, profits, return on investment, and the like. This infor­mation can be compiled for the entire firm; for each product; for each sales territory, store, or individual salesperson; for each divi­sion or department; and generally in any way that will help those who manage the organization. Accounting information helps managers plan and set goals, organize, motivate, and control. Lenders and suppliers need this accounting information to evaluate credit risks. Stockholders and potential investors need the information to evaluate soundness of investments, and government agencies need it to confirm tax liabilities, confirm payroll deductions, and approve new issues of stocks and bonds. The firm’s accounting system must be able to provide all this information, in the required form.

THE BASIS FOR THE ACCOUNTING PROCESS

The basis for the accounting process is the accounting equation. It shows the relationship among the firm’s assets, liabil­ities, and owner’s equity.

Assets are the items of value that a firm owns — cash, inven­tories, land, equipment, buildings, patents, and the like.

Liabilities are the firm’s debts and obligations — what it owes to others.

Owner’s equity is the difference between a firm’s assets and its liabilities — what would be left over for the firm’s owners if its assets were used to pay off its liabilities.

The relationship among these three terms is the following:

Owners’ equity = assets – liabilities

(The owners’ equity is equal to the assets minus the liabilities)

For a sole proprietorship or partnership, the owners’ equity is shown as the difference between assets and liabilities. In a part­nership, each partner’s share of the ownership is reported sepa­rately by each owner’s name. For a corporation, the owners’ eq­uity is usually referred to as stockholders ‘ equity or sharehold­ers ‘ equity. It is shown as the total value of its stock, plus retained earnings that have accumulated to date.

By moving the above three terms algebraically, we obtain the standard form of the accounting equation:

Assets = liabilities + owners’ equity

(The assets are equal to the liabilities plus the owners’ equity)

A BALANCE SHEET

A balance sheet (or statement of financial position), is a summary of a firm’s assets, liabilities, and owners’ equity ac­counts at a particular time, showing the various money amounts that enter into the accounting equation. The balance sheet must demonstrate that the accounting equation does indeed balance. That is, it must show that the firm’s assets are equal to its liabilities plus its owners’ equity. The balance sheet is prepared at least once a year. Most firms also have balance sheets prepared semi-annually, quarterly, or monthly.

AN INCOME STATEMENT

An income statement is a summary of a firm’s revenues and expenses during a specified accounting period. The in­come statement is sometimes called the statement of income and expenses. It may be prepared monthly, quarterly, semiannually, or annually. An income statement covering the previous year must be included in a corporation’s annual report to its stockholders.

THE IMPORTANCE OF THE ABOVE TWO STATEMENTS

The information contained in these two financial statements becomes more important when it is compared with corresponding information for previous years, for competitors, and for the indus­try in which the firm operates. A number of financial ratios can also be computed from this information. These ratios provide a picture of the firm’s profitability, its short-term financial position, its activity in the area of accounts receivables and inventory, and its long-term debt financing. Like the information on the firm’s fi­nancial statements, the ratios can and should be compared with those of past accounting periods, those of competitors, and those representing the average of the industry as a whole.

- Determination of the rational composition of the product portfolio;

- Analysis of customers demand for individual products;

- Consideration of limits on production capacity, working capital, and customer demand;

- Choice of optimal prices and production volumes with regard to market demand;

- Cash flow forecast to develop optimal product mix.

Optimal product mix

Often a company may improve its financial condition by changing the composition of its manufactured product mix, even if the current output levels are above the Break-Even Point. This becomes especially critical when a company has limited production capacity and resources. The optimization can be achieved by an increase in sales of products that are most profitable. At the same time, the profitability of one product can not be the only criteria for output increases, since it only reflects the existing structure of production.

The first step in PPO is the determination of the Contribution Margin for each product. An increase in production output must be adjusted to market demand. Contribution Margin provides reliable information for decisions regarding production output increases. The Contribution Margin Ratio (Contribution Margin to Sales) indicates what share of revenue can be used to cover Fixed Costs and Profit. The higher the ratio is, the more preferable it is to produce them.

The second step in PPO is considering the limitation and constrains of the business in respect of Production Capacities, Working Capital, and of market demand for the enterprises products. The importance of the optimization becomes crucial when the company encounters these limitations and it can be attained through the enlargement of the share of more profitable products and reducing the share of the less profitable or even unprofitable ones or even by a total exclusion of those.

The comparison of the product profitability ratio and contribution margin ratio for a company’s products is illustrated. The rating the attractiveness of the particular product based on Product Profitability is different from the one based on the Contribution Margin approach. The first option is the commonly applied one in Moldovan companies, which is not the appropriate one, due to the distortions in the Indirect Costs area, which will be explained further in this section. The calculation of the Product Profitability by products is based on the accounting information which is available in the accounting department, while the calculation of the Contribution Margin Ratio could be performed only by re-categorization of costs in Variable and Fixed, which is a managerial approach. As a conclusion, in order to improve the production plan, products having the highest Contribution Margin Ratio should be favored. This procedure is applicable when the products are produced using different production lines or they are not competitors among them and the market demand has no restrictions in respect of each item produced.

The comparison of the contribution margin ratio and contribution margin ratio per machine hour for a company’s products is illustrated. This is the second step of analysis which is applicable when the products are being produced using the same machines or are competitors among them. As it is seen on the chart, the rating of attractiveness is different for the two ratios presented. In this case the most attractive products are those having the highest Contribution Margin per Machine Hour used. The same comparison is required when analyzing the limitation of Working Capital or Limited Marketing Demand for a particular product.

The process of determining the costs of all units that can be sold, and then allocating these costs between the units sold during the period (cost of goods sold) and the units unsold at the end of the period (inventory) is referred to as Product Costing. Only product costs are use in product costing, not period costs.

Product Costs are costs that are closely associated with units produced by the enterprise or purchased for resale by a retailer or wholesaler. Examples: Cost of materials and labour used in production. Thus, Product Costs are inventory costs when incurred and these costs are assets until the units are sold. At the moment of sale, several things happen:

- The economic benefit, sales revenue, is realized;

- The asset expires;

- No longer recognizing the product cost as an asset, it is now recognized as an expense, cost of goods sold;

- The Cost of Goods Sold is matched with the sales revenue on the Income Statement.

Period Costs are costs that are recognized as expenses as soon as they are incurred. They are not assigned to the product; instead, they are immediately assigned to the Income Statement as an expense of that period. The benefits provided by period costs are realized fully when the costs are incurred and are recognized in the current period. Examples: Administrative salaries, Marketing expenses.

It is important to classify product costs and period costs correctly. If these costs are classified incorrectly, they will be expensed at the wrong time, and the financial statements for the period will be inexact.

There is a third group into which costs can be classified when they occur: Non inventoriable unexpired costs. These costs represent assets when they are incurred, but they are not costs that can be assigned to inventory. Example of such costs: Expenditures for prepaid insurance, prepaid rent, machinery, buildings. Each of these costs is an asset, other than inventory. Many of these assets are used up or consumed as time passes. As they expire over time, the amount expired can then be classified as a product cost or a period cost.

Manufacturers must maintain three different inventory accounts:

- Raw materials inventory. Materials purchased from a supplier;

- Work in progress. The unfinished goods in production – the units that are being worked on;

- Finished goods inventory. The completed product awaiting sale.

Categories of Product Cost used in Moldovan National Accounting System:

- Direct materials. Raw materials that become an integral part of the completed product;

- Direct labour. It is the work that directly converts the raw materials into finished goods;

- Manufacturing overhead. The total costs of production department minus direct costs. Examples: indirect materials, indirect labour, rent, property tax, maintenance and repair, utilities, depreciation, idle time.

The Cost Flow of a retailer goes directly from purchase of goods to sale. The Cost Flow for a manufacturer is much longer:

- Purchase and use of raw materials;

- Use of labour;

- Use of manufacturing overhead;

- Transfer of manufacturing overhead to Work in Progress;

- Completion of production;

- Sale of finished goods.

Overhead Allocation between Product Types

Cost allocation is a process of assigning cost to specific products. It rises the issue of what share of costs need to be assigned to a particular product. The answer to this question has the effect on the viability of the business.

Cost allocation is needed in order to determine product costs, which in turn are needed for (1) reporting to external authorities (Statutory Accounting) and for (2) analyzing product line profitability (Managerial Accounting).

In the process of cost allocation, Direct and Indirect Costs must be assigned to specific products. Direct Costs are easy to allocate because they are linked to particular products, based on the internal standards supported by a normative base. The common Direct Costs are:

- Raw materials;

- Energy;

- Production Labour;

- Subcontracted services.

In order to allocate Direct Costs it is enough to match products made and direct expenses incurred, however, even direct cost allocation sometimes causes difficulties if there are many products made in one place and they use the same machinery an the same materials. In this case direct costs are assigned proportionally to standard norms which are developed by the technological and planning departments. Periodically, standard norms must be compared with actual consumption patterns to make adjustments.

Indirect Costs, often called Overheads, are the hardest to allocate because they are not directly traceable to products. The common Indirect Costs are:

- Top management expenses;

- Social assets;

- Depreciation of buildings;

- Repair and maintenance;

- Interest expenses;

- Rent;

- Security;

- Heating and ventilation.

The Overhead Expenses are allocated in a Two-Stage Process. At the first stage the factory overheads (G&A, Marketing, and other overheads) are assigned to Cost Centers (product line A, product line B) and only then they are assigned to particular products, using specific allocation bases. Identifying Cost Centers is important for accurate cost allocation. A Cost Center is a responsibility center where managers are accountable for the expenses which fall under their control. Normally, cost centers are represented by workshops.

Overhead allocation is a very complex calculation process. All allocation methods are subjective and therefore disputable. The more indirect the cost is, the more subjective its allocation is likely to be. The purpose of the allocation is not to be fully accurate, but simply to spread costs in a fair and efficiency-improving manner.

Allocation bases should be chosen according to the following criteria:

- They should be related to the cost considered, i.e. of the resources effectively used;

- They should be representative of the normal operating conditions;

- If possible, they should be a factor of which decision-makers can have an impact;

- In some cases, they can take the special objectives of cost management into account.

The following are commonly used simple allocation bases:

1. Direct Labour. It is acceptable when manufacturing processes are highly Labour-intensive, overhead a small percentage of total costs and low product diversity. It’s not relevant when Labour costs are low (e.g. 10%) and overhead high (e.g. 30%);

2. Depreciation of machines. It is justified in highly capital-intensive industries. It is also relevant for some types of overhead which are often linked to production facilities (interest expenses, chief engineer. It is not relevant in non capital-intensive industries and for overhead caused by the number of staff;

Sales. This method will be “painless”, as only best-selling products will be penalized. It is not representative in terms of cost generation and it removes part of the incentives to increase sales;

Energy. Only relevant if other bases related to production processes do not apply (e.g. if some departments are grossly overstaffed, or if machines for different products vary widely), as it then becomes the only possible way to assess resources used.

Management should be aware of the consequences to their business when choosing an allocation base. For example, the common Moldovan practice of splitting overhead by a proportion of direct Labour tends to distort the costs of hand-produced products versus those machine-produced products. Choosing “Sales” as an allocation base often penalizes products that are high revenue generators. A good basis on which to allocate overhead in a Moldovan manufacturing company is often a mix of direct Labour and machines.

Changing the itemization and overhead allocation base usually yields different profitability estimates for individual production lines or individual products. The higher the share of overhead costs, the greater the expected changes in profitability estimates for individual products as a result of overhead reallocation. There is no ideal base for overhead allocation but there are more appropriate bases of allocation for each company. Potential benefits from a more detailed allocation of overhead must exceed the related costs.

Incorrect overhead allocation between product types and production divisions can result in (1) inconsistency between the price ratio for individual products and market demand, (2) unjustified reduction of output for some products, (3) incorrect assessment of divisions operations.

The choice of overhead allocation base is determined by company specifics, industry characteristics, as well as by the relative value of certain costs within the overall structure of company costs.

Cost Drivers

The Cost Driver is a factor which affects the level of a particular cost dramatically: it can have a positive or a negative impact. A cost driver is the element of a cost that exerts great influence over its account, such that a change in the cost driver necessarily results in a change in the cost. Knowing the cost driver of products is vital to understand the elements of cost and to make decisions accordingly. Mastering cost drivers allows enterprises to make operational decisions with some degree of certainty as to their cost impact.

Examples of Cost Drivers:

- Labour – Location, efficiency of work;

- Raw materials – Purchasing sale, wastage, delivery costs;

- Financing costs – Interest rates, inflation, location;

- Repairs cost – Number of machines to be repaired, age of machines;

- Energy cost – Volume of buildings to be heated, efficiency of heating system, waste;

- Sales department – Number of invoices issued, number of customers;

- Accounting department – Number of transactions, average transaction processing time;

- Warehousing costs – Average length of storage, number of pallets handled;

- Distribution costs – Complexity of route structure, number of owned vehicles.

Product engineering has a significant effect on the cost of each product. Beyond the basic product engineering, the detailed product specification such as purity, quality, and finish could add further costs. Design specification can often add significant additional cost that customers may not be prepared to pay or may simply not want. The company must analyze whether what is produced is really expected by the customer at the proposed price.

The areas where cost gains can be obtained:

- Input costs can be reduced;

- Switching from one technology to another;

- Labour productivity improvement;

- Efficient organization of the business process;

- Economy of scale;

- Change of location;

- Distribution costs.

The CVP relationships suggest that a useful way of studying the basic profit characteristics of a business is to focus on the Profit per Unit (which is different at every volume), but rather on the Total Fixed Costs and the Contribution Margin.

There are four basic ways in which the profit of a business can be increased:

- Increase in selling price per unit;

- Decrease variable cost per unit;

- Decrease fixed costs;

- Increase volume.

There are 2 approaches to the Cost Accounting in respect of profit analysis:

- Traditional method (cost-plus approach);

- Contribution margin method.

The Contribution Margin is the difference between Sales and Variable Costs and serves to cover Fixed Costs and to bring a certain Profit. In order to maximize Profit volume, it is necessary to maximize the Contribution Margin. Each additional unit of production sold at a given price will directly contribute to the Profit. The Unit Price should not exceed the Variable Unit Costs, otherwise a revision of the Selling Price or discontinuing the manufacturing of the product is required. The uppermost advantage of the Contribution Margin per Unit is that unlike the Profit per Unit it does not varies with the change of the output.

The Cost-Volume-Profit Analysis is based on the following basic assumptions, which are valid only within a certain range of production and sales:

Fixed Costs remain constant within a certain range of output;

Variable Costs per Unit of production do not change with volume of output;

The Sales Price per Unit of production remains fixed for set volume of sales.

The Cost-Volume-Profit Analysis gives answers to the following questions:

At what level of sales is the product profitable?

What will income be at a given sales level?

What could income be if the company operates at maximum capacity?

What will the impact of changes in price, fixed costs, variable costs, and volume be on income?

The basic formula of the Cost-Volume-Profit analysis is:

Another useful indicator of the Cost-Volume-Profit analysis is the Financial Safety Margin (Safety Threshold), which evaluates the sales volume above the Break-Even Point:

It shows how much the actual volume of sales exceeds the Break-Even point in percentage. The higher the margin the larger the profitability corridor of the company.

The Cost Structure effect on Profit is best characterized by the Operating Leverage, which shows the relationship between the change in Profit and change in Sales volume:

The Operating Leverage shows the percent change in Profit with a 1% change in Sales. It is related to the level of company risk. The greater the Operating Leverage, the higher the company risk. The greater the risk, the higher the potential reward. A high Operating Leverage means that there is a high level of fixed costs and a low level of variable costs per unit of production. Operating Leverage becomes higher the closer the sales volume is to the Break-Even point.

The concept of the Contribution Margin is most useful when analyzing one product company. For a company that makes several types of products it is more convenient to use the Contribution Margin Ratio for individual product types, divisions and for the company as a whole. The calculation formula is:

The significance of Contribution Margin is supported by the following:

It is the most important and useful tool of the product profitability analysis or for groups of products measuring changes in monetary terms;

The higher the Contribution Margin Ratio for a particular product the more attractive the manufacturing and selling of this product, from the manufacturer’s point of view, is;

It is the most qualitative and appropriate principle of product portfolio optimization, especially when there is a production capacity limitation.

The Cost-Volume-Profit analysis can also be used to analyze multi-product companies, which is a common situation for most of the businesses. In addition to answering questions covered by the single-product analysis, the modified model also covers the following topics:

Identifying which products are most profitable and vice-versa;

Comparative profitability of products;

How to utilize limited resources more efficiently;

In which product line to invest;

Identifying the optimum product portfolio;

Support for pricing decisions.

- Fixed or Variable – depending on whether the costs change with variations in production volume;

- Direct or Indirect – depending on whether costs are directly related to a certain product.

The purpose of these classifications is:

- Fixed/Variable Costs are used for the Cost-Volume-Profit Analysis and for the optimization of the structure of production;

- Direct/Indirect Costs are used in assessing the allocation of a cost to a particular product or company division.

Fixed Costs do not vary with the quantity produced, no matter what the output is, the amount of fixed costs will be the same. (rent, interest, G&A expenses); Variable Costs vary with the quantity produced. A variation in output will cause a variation in the cost by the same proportion. (raw materials, wages, power energy); Semi-Fixed Costs depend on the quantity produced, but will not vary in direct proportion to the quantity produced. They increase in steps, i.e., they are fixed until a certain level of output is reached at which point they become variable. (shipment for bulk).

Direct Costs are incurred exclusively for one product. They can easily be traced to a specific product. They are generally incurred in the production/marketing process. Dropping the product would eliminate this cost. (raw materials, power energy, wages);

Indirect Costs are incurred for more than one product. They can not be traced for a specific product. Dropping the product would not eliminate this cost. (energy to heat, production supervision Labour).

Classification of costs as Fixed or Variable is necessary for making decisions that affect the volume of output. Managers want to know how such decisions will effect Cost and Revenues, and most importantly – Income.

Cost Management consists of:

- Having a systematic approach to determining what your real costs are;

- Understanding why costs are incurred;

- Taking action based on your analysis and understanding, in order to improve the company’s cost structure (cost reduction, strategic choices);

- Always looking for opportunities to save money.

Advantages of effective Cost Management:

- More cost competitive products, and thus increased sales opportunities;

- Appropriately priced products and flexibility in pricing;

- Availability of qualitative and real information about the cost of certain types of products and their position in the market in comparison with the other competitors’ products;

- Better resources allocation and a better managed business;

- Providing objective data for generating company budgets;

- Capability of evaluating performance of each division in the enterprise from the financial point of view;

While understanding the true costs the company has the opportunity to take better management decisions. The appropriate management of costs will lead to a more competitive enterprise.

The consequences of inefficient Cost Management are:

- Cash is wasted;

- Product prices are set incorrectly;

- Resources are dedicated to “wrong” products, activities or customers;

- Management does not know how the company can reduce its costs;

- Costs rise without being noticed because they are not managed;

- Profitability drops for unknown reasons.

The answer to the question: “How could the production strategy from a cost point of view be optimized in such a way that it would contribute to an appropriate pricing of products and to selling them in a profitable way” could be found through the comparison of the Costing Models.

Full Absorption Costing Model – is based on the calculation of the product cost by applying the total cost incurred for the company or for a particular production line to the total range of products. This model was widely used in countries with controlled economy. It does not provide an accurate or sensitive measurement framework for price computation in competitive markets, and does not provide a basis for determining which products are making profits and which are causing losses. In competitive markets, those companies that can cut their Per Unit Production Costs to a minimum are going to be able to sell their products at a lower price. Those companies that cannot cut their costs will lose market share or suffer losses.

Avoidable Costing Model. It is used by some western companies. It involves selecting of some of the overhead costs and attributing them to a particular product. Avoidable Costs are those overhead costs that would be eliminated if a particular product was completely withdrawn from the production. This method provide a more accurate assessment of the cost of producing a product than the Full Absorption Method, but still does not accurately measures the costs involved for that product.

Variable Costing Model. It is also called the “Marginal Costing Model’, that provides an accurate measure of the costs involved in producing a unit of a particular product. It is the model used most widely in the West, nevertheless in the last years this model is getting more popularity among former SU countries.

Variable Costing Model identifies the costs of producing each additional unit for a given product and focuses on how product costs change when the volume of production changes. It entails identifying which costs are directly attributable to a product (variable costs), e.g., the raw material costs and energy costs. Once these variable per unit costs are known, by subtracting them from the price of the product, one can determine how much of the price is available to cover overhead costs. This amount that contributes to covering fixed costs is called Contribution.

The Accounts Receivable Turnover Ratio indicates how many times, on average, the receivables revolve, that is, are generated and collected during the year. The receivables turnover ratio is computed as follows:

* – the sales figure used in computing the ratio should be that of credit sales only, because cash sales obviously do not generate receivables.

While the turnover figure furnishes a sense of the speed of collections and is valuable for comparison purposes, it is not directly comparable to the terms of trade that the enterprise normally extends. Such comparison is best made by converting the turnover into days of sales tied up in inventories. This measure, also known as Days Sales in Accounts Receivable, measures the number of days it takes, on average, to collect accounts receivable, which is calculated as follows:

These indicators are analyzed:

- In dynamics;

- Are compared to industry averages;

- Are compared to the credit terms granted by the enterprise.

If the company provides a 30 days period of sales on credit, then an average collection period of 60 days reflects either some or all of the following conditions:

A poor collection job (Marketing Department);

Customers in financial difficulty, or an excessive delinquency of 2 – 3 clients;

Introduction of new products (promotion phase);

A desire to make more sales in order to utilize available excess capacity;

Special competitive conditions in the industry.

The further analysis is directed towards the ageing schedule of accounts receivable for each customer.

Inventory Turnover Ratio

In most businesses, a certain level of inventory must be kept in order to generate an adequate level of sales. Inventories are normally considered the least liquid and at the same time the most risky component of the current assets group.

The Inventory Turnover Ratio measures the average rate of speed with which inventories move through and out of the enterprise. The computation of the Average Inventory Turnover is as follows:

Another measure of Inventory Turnover is also useful in assessing purchasing policy is te required number of Days to Sell Inventory. The computation of it is:

These indicators are analyzed:

- In dynamics;

- Are compared to industry averages;

- The further in-depth analysis is directed to the groups of inventories (raw materials, perishable tools, work in progress, finished goods).

A rate of return that is slower than that experienced historically, or that is below that normal in the industry, would lead to the preliminary conclusion that:

Inventories include items that are slow moving because they are obsolete, in weak demand, or otherwise unsalable;

A build-up of inventory in accordance wit a future contractual commitment, or for any number of other reasons that must be probed further;

Anticipation of a price rise;

One should never lose sight of the fact that the total inventory turnover ratio is an aggregate of widely varying turnover rates of individual components. Departmental or divisional turnover rates can similarly lead to more useful conclusions regarding inventory quality.

Accounts Payable Ratio

Not all liabilities represent equally urgent and forceful calls for payment. The nature of current liabilities must be judged in the light of the degree of urgency of payment that attaches to them.

The Accounts Payable Ratio indicates how many times the current liabilities are renewed within a certain period of time and it is expressed through the following formula:

A measure of the degree to which accounts payable represent current rather than overdue obligations can be obtained by calculating the Days Purchases in Accounts Payable Ratio:

The amount of Purchases is calculated based on the following relation:

* – Adjusting of Cost of Goods Sold figure for depreciation and other noncash-requiring charges, as well as for charges in inventories.

The formula of Working Capital is:

This excess is sometimes referred to as Net Working Capital because some businessmen consider current assets as Working Capital. A working capital deficiency exists when current liabilities exceed current assets.

The absolute amount of working capital has significance only when related to other variables such as Sales, Total Assets, and so forth.

The most common categories of current assets are:

Inventories;

Accounts and notes receivable;

Temporary investments;

Cash and cash equivalents;

Prepaid expenses.

The following are current liabilities most commonly found in practice:

Current portion of long-term debt;

Short-term bank and other loans;

Accounts and notes payable;

Tax and other expense accruals.

The analyst must undertake the “restructuring” measures of the Balance Sheet items in order to get an appropriate amount of the Working Capital, as described in Section 1.4 “Adjustments to the Financial Statements”. Additionally, a range of rearrangements of the Balance Sheet components have to be undertaken:

1. Inventories have to be added up to Accounts Receivable, being termed as Realizable Assets;

2. Short-Term Investments have to be added up to Cash (cash on hand + bank accounts), being termed as Positive Treasury;

3. Owners’ Equity has to be added up to Long-Term Liabilities, being termed as Permanent Resources;

4. Short-Term Payables have to be added up to Short-Term Accruals, being termed as Current Liabilities;

5. Short-Term Financial Debt is moved downwards, being termed as Negative Treasury.

This is being done for several reasons: (1) different levels of decision making, (2) different participants and specific interests of the business participants, (3) the stability of items from each group and the particularities of transactions.

The Working Capital Equation is:

This equation is the basis for several important relationships, used in the Short-Term Analysis:

Negative Amount of Working Capital – represents an unfavorable financial situation, which is characterized by reduced ability of debt repayment. It is a result of absorption of a part of temporary sources by permanent needs (fixed assets), which is a violation of the financing principles.

Need of Working Capital is the difference between the financing needs for operations cycle (realizable assets) and the current liabilities:

Positive Amount of the Need of Working Capital means a surplus of realizable assets over current liabilities. It is positively appreciated only when it is a result of a thoughtful strategy directed to inventories build-up;

Negative Amount of the Need of Working Capital means a surplus of temporary resources over the need in working capital. It is positively rated only when it derives from the acceleration of realizable assets turnover financed by patient debts.

The Net Treasury (Net Credit Position) is the difference between the Positive Treasury and the Negative Treasury, i.e. between the available cash and the short-term financial debts:

The Positive Amount of the Net Treasury is characterized by a monetary surplus at the end of operations cycle, which is a material expression of the net income in the company’s bank accounts at the end of it;

The Negative Amount of Treasury reveals a financial unbalance at the end of operations cycle. The monetary deficit is off-set by newly attracted loans and other forms of short-term debt.

Definition and significance of cash flow

Cash flow is normally described as “profits plus non-cash charges”. The cash flow shows the amount of money that is effectively at the disposal of the company. It is one of the most important financial figures from the banker’s point of view, because of the following reasons:

-          The cash flow helps to identify the company’s sustainable core earnings.

-          It displays the amount of cash that is used (released from the company’s current operations) to sustain or to grow the business.

-          It reveals the cash which is available to service debt. This helps to calculate whether a company can “afford” a certain loan at certain terms.

-          Finally, the cash flow indicates how much cash is available from internal sources to finance long term growth.

The following table gives an overview of the sources and uses of cash as they are reflected on the balance sheet. An increase of liabilities, e.g. by enlarging debt, provides cash, just as an increase of assets, e.g. by stocking up the inventory, uses cash.

Sources and uses of cash

Cash flow forecasts

It is important to see how long it would take a company to repay its current debt, if it continuously earned the same cash flow:

So, if a firm had net debt of DM 10 m. and a gross cash flow of DM 2 m., it would take five years to repay all debt, provided the company would sustain a cash flow of at least DM 2 m. for the next five years.

A more complex calculation of debt capacity is required if one wants to know how much debt a company could service (principal and interest payments) at a given cash flow over a given period of time at a given interest rate. The Present Value (PV) of future cash flow (discounted) has to be calculated. Given continuous cash flows of DM 500,000 per annum available to service debt for the next five years, and interest rates of 10%, how much debt could this company service?

PV       =          Cash flow        +Cash flow      +Cash flow      +Cash flow      +Cash flow

1+Int.Rate       (1+R)2           (1+R)3           (1+R)4           (1+R)5

PV       =          500,000           +500,000        +500,000        +500,000        +500,000

1.1000             1.2100             1.3310            1.4641            1.6105

=          DM 1,895,395.

The company has a capacity to service debt of DM 1,895,395 over five years at an interest rate of 10 %. If the company had debts outstanding of, e.g., DM 4 m., the bank would face a refinancing risk of DM 2,104,605, that is 52.6 %.

In reality, no company has the same continuous cash flow for a number of years. Thus, it is necessary to try to forecast the future evolution of a company’s business and its impact on the balance sheet and the profit and loss account. Management must provide the bank with its assumptions of how sales, profit margins, net trading assets, asset turnover, depreciation, operating profit and so on will look in the coming years. The credit analyst must ask why the company thinks that things should go this way. In most cases, the outcome will be different from what has been planned in the previous year. Thus, it is important to examine the reasons that have led to these differences, and to adjust the business planning for the next years. Such elaborate planning can supply data about future cash flows which have to find their way into the above mentioned formula. But reality will always be different from the forecast!

Chapter E features a very detailed case study on financial planning and forecasting.

3. Worksheet: Key ratios

The financial statements reflect ability of a company’s management to manage:

-          business risk: Generate maximum profit from the minimum level of assets

-          finance risk: Finance the assets in such a way as to minimize risks to creditors

-          performance risk: Operate the company in a way as to minimize costs and maximize profits.

When a credit analyst has to make a credit decision, the first thing he or she will have to analyse is a firm’s balance sheet. The balance sheet analysis alone may often not be sufficient to assess a firm’s creditworthiness, and other factors have to be taken into consideration. These factors, like the qualification of management, may finally be considered more important than the financial figures. But, without looking into the balance sheet, no credit decision must ever be made! This would amount to a violation of the law.

The balance sheet is a statement that shows a firm’s assets and liabilities. So, the banker can see what a company owns and what it owes to its creditors. The structure in which the balance sheet has to be drawn up is regulated in the respective Commercial Laws. Large corporations must present balance sheets that have been audited by an independent auditor. Since the balance sheet is drawn up at the close of the company’s fiscal year, it only represents a true and fair view of the financial situation at this very day. It may not be representative for the firm’s financial position at another time of the year.

The corporate banker’s favourite method of analysing balance sheets is to spread them. Spreading is a standardized method of presenting financial statements in a systematic and consistent manner. As financial statements come in many different formats, it is important that banks organize such data into a standard pattern. This allows the bank to easily compare a firm’s financial performance over a period of years. Important financial details can be easily highlighted. Equally important, it guarantees that a consistent way of financial analysis is followed in all of the bank’s branches. Thus, key ratios can be developed not only for particular balance sheet items but for entire industry sectors giving lending officers a deeper insight into a firm’s standing within its industry. You will find two specimen balance spread sheets at the end of this section.

The most important items on the balance sheet are as follows (For a more detailed, in-depth presentation of all balance sheet items please see the advanced textbook level 2):

a. Assets

These are assets that will probably be converted into cash within 12 months of the balance sheet date or within the normal business cycle of the company. Explanation of the most important current issues are found below.

Cash and bank deposits

This item can be easily manipulated. The firm’s management may have sound reasons to show a particularly high or low amount of cash or bank deposits. Therefore, this figure has to be compared with the previous year’s figure and those of other companies in the same industry sector. If a firm settles all or most of its payments via one bank, this bank should compare the cash and bank deposits statement in the balance sheets with the average amount held in its current account. These items should always be sufficient to meet the firm’s current financial obligations.

Debtors / accounts receivables

Accounts receivables should form a reasonable proportion of total assets. Too many accounts receivables consume funds and may hint at the companies’ inability to make its debtors pay. The more receivables on the balance sheet, the greater is the risk that some amounts are unlikely to be recoverable and have to be written off. Therefore, it is necessary to know who the key debtors are. The company should not be dependent on a single debtor. Since the debtors figure in the balance sheet will represent a number of different items, it should be broken down to its constituent parts (e.g. prepayments, trade debtors, other debtors, etc.). Receivables can be turned into cash by collecting them or by selling them, for example to a factoring company.

Stocks and inventory

Stocks are valued at the initial price paid for the asset plus costs incurred in bringing them to their present condition. Stocks can also be valued at their net realizable value. Finished products must be sold at last: The rate of inventory turnover can indicate whether a firm can quickly sell its products in the market quickly or if its products only collect dust, consuming funds without raising cash.

a.b. Fixed assets

These are assets which the company wants to retain for a long period of time and which it does not intend to resell. They are used in the production of the company’s goods or services. Fixed assets fall into two categories, which are land / buildings and plant / machinery.

Land and buildings

Companies can value these assets at historic cost or at valuation. In any case it is important to know the current market value of the land and buildings of a company. The balance sheet value can be very different from the current market value. In Great Britain, any significant difference between market and book value must be disclosed in the Directors’ report. In Germany, such a difference is not openly disclosed in the annual report. This results in hidden reserves, since many older buildings have already been depreciated and are shown at the books with only a fraction of their current market value. The bank must, therefore, obtain this information from its clients. Whenever land and buildings are needed as collateral, an independent expert’s opinion on the net realizable value of the real estate should be required. This expert’s opinion must then be held in the credit files.

Plant and machinery

The type and quantity of plant and equipment is determined by the type of goods a company produces. It can be useful to compare these fixed assets with those of other firms in the same industry to get a better impression of the appropriateness of its asset structure. Every account manager should visit his corporate clients’ sites to get an impression of his own about the equipment; is it in good shape or hopelessly outmoded? Are there enough machines to produce additional goods in case the management planned for further growth?

Intangible assets

Intangible assets represent values that are ascribed to certain rights or future benefits. These are normally

-          patents, trademarks and licences,

-          goodwill or

-          brand names

Goodwill is created where a business is acquired for more than the net value of its assets. Purchased goodwill is included in the accounts of a group of companies.

Often the price paid for acquiring a company also relates to the value of a brand name. Such firms have included an estimate of the value of the brand name within their balance sheet. Some do not amortize the brand name on the grounds that it does not loose value over time. From the banker’s point of view, it has to be considered that brand names could be the most valuable asset of a company. Brands like Coca Cola or Mercedes Benz are priceless items, although not shown in the balance sheet.

Patents and licences can have substantial value and should be noted when analyzing financial statements.

b. Liabilities

b.a. Current liabilities

These are all amounts owed by the company that are due within twelve months of the balance sheet date.

Creditors – trade

This is the amount the firm has to pay to its suppliers. It should form an appropriate portion of total assets. The amount of creditors shows the degree to which the company is financed by its suppliers. Careful comparisons should be made with other companies of the same industry to see if the level of trade credotors is appropriate. The bank has to consider whether any creditors hold security over goods supplied or other assets of the company.

Bank overdrafts and current loans

These short-term bank facilities are normally provided over a considerable period of time. It is a typical feature of an overdraft facility, however, that it has to be repaid on demand. There is usually no commitment on the part of the bank to advance funds for a longer period of time. Other short-term bank loans are included in this balance sheet item as well. Notes should be made whether these loans are secured or unsecured.

b.b. Medium and long-term loans

It is necessary to know the details of these loans, that is the amount, when they are due for repayment, and whether they are secured or unsecured. The general rule is that long-term loans should be secured, preferably by long-term assets (mortgages). The bank should know when payments are due in order to get a broader picture of the firms solvency. It is important to know whether the company is dependent on only one or two creditors.

Dividends

Dividends may have already been declared but not yet paid. The company must have sufficient cash, or access to cash, to pay the dividends. Uncovered dividends that are paid for by short-term loans are a warning signal.

Provisions

Provisions are reserves established from profits to meet future obligations like pensions. A bank has to consider the size and the time when these obligations must be paid.

b.c. Equity / net worth / shareholders funds

Shareholders’ funds are residual claims of the owners of the company against the company’s assets. Equity falls into two categories, shares and reserves. A company may have different classes of shares, giving different rights to their respective shareholders. The most common type of reserves are retained earnings which represent the balance of the profits and losses made over the years.

A bank has to consider how and why equity has changed over the years. Losses can only be compensated by equity. An appropriate amount of equity is crucial for the firm’s independence and survival. Only sound equity enables a company to survive a number of bad years. An international comparison of equity ratios shows that this ratio is especially low in Germany, in contrast to Anglo-Saxon countries. German small and medium-sized companies have equity ratios that range between 5 % and 15 %. Due to the lack of appropriate equity, 70 % of all start-up companies fail during the first seven years.

c. Profit and loss account / income statement

The profit and loss account records the income and expenses of a company during its fiscal year. It reports the results of a series of transactions over the time of the company’s fiscal year. Just like balance sheets, banks analyse the profit and loss statement by spreading them in a logical and consistent manner. The most important items of the profit and loss account are as follows:

Sales / turnover

The sales of goods or services are normally the primary source of income for a company. Other revenues, e.g. capital gains or extraordinary income generally account for only a tiny friction of total sales. The sales figure in the profit and loss account is one of the most interesting pieces of data for a credit analyst who should examine the following questions related to a company’s turnover:

How – and why – did sales figures change over a period of years? Was the firm able to sell more goods, could it charge higher prices, or both? In any case, total sales should increase at a rate that lies well above inflation, otherwise the company would have stagnant sales. It is always a good sign if a firm grows faster than its industry sector and the markets where it operates.

A disproportionately strong growth of sales can, however, be a warning sign; as growth must be financed in a sound and secure manner, the company must have access to appropriate funding. Otherwise, the additional cash needed to pay for increased raw materials and personnel costs can eventually threaten a company’s solvency.

The company must disclose a detailed breakdown of its sales according to products, regional markets, customer groups etc.

The company’s product range should be well diversified, and the bank should have information on the contribution that each product group makes to the firm’s turnover. A well-established method to gain deeper insight into a company’s product range is the product portfolio analysis which is explained in this book..

To which countries are the goods exported? Is there any danger that funds are not allowed to be transferred from these countries? Has the firm taken care to safeguard against foreign exchange risks? Does it make use of letters of credit?

It is important to know who the most important customers are. What will happen if the most important customer fails to pay its bills? Can other customers make up for this loss, or will the company suffer serious damage?

Raw material and consumables

German accounting principles explicitly show the expenses for raw material, as well as for staff expenditures. Are changes in that figure in line with changes in the company’s  sales over the years? Are prices for raw materials expected to increase? Is the company dependent on one or a few key suppliers?

Personnel / staff expenses

Changes in personnel expenses; should be in line with changes in turnover as well. A comparison with other companies of the same industry shows if sales per employee are appropriate. In smaller companies, the director’s remuneration can make up a large part of total personnel expenses and should be disclosed to the bank.

Other operating expenses

Other operating expenses include payments for electricity, leases, insurance, advertising, legal counsel, auditing etc. If this figure is exceptionally high, the credit analyst must find out its components.

Anglo-Saxon profit and loss accounts

British and American income statements do not explicitly show expenses for raw materials, staff and other operating expenses. These figures are included in the following three items:

-          cost of sales /cost of goods sold

-          administrative expenses

-          research & development and other operating expenses

These three figures may include many different items which a credit analyst has to isolate in order to get a clear view of the company’s cost structure.

Operating profit (before depreciation)

A company’s operating profit is the result of its total revenues minus the above-mentioned items. Then, exceptional (that is non-operating) income and expenses have to be considered, as well as the result of the company’s financial transactions. The largest part of the financial result will normally be made up of interest paid for loans and interest received for bank deposits.

Cash flow

The gross cash flow is the result of all the above-mentioned profit and loss items. The cash flow is one of the most important ratios when analysing financial statements. It shows the actual amount of cash that is available to cover the expenses for interest and principal of loans, for depreciation and for new investments. Generally speaking, the cash flow consists of the net profit plus depreciation. Since depreciations are expenses that are not paid in cash, they, plus the net profit show the amount of cash the company can operate with. So, from the banker’s point of view, the cash flow is even more important than a firm’s net income or loss. A detailed discussion of the cash flow will be given later in this book.

Depreciation

As fixed assets loose value over time, this loss of value has to be charged to the profit and loss account, although there are no cash expenses related to them. Depreciation methods must be disclosed in the annual report. Continued depreciation of long life assets, e.g. buildings, can

result in hidden reserves:-the book value of the asset is then lower than its market value. In German balance sheets, particularly hidden reserves can play a significant part. A bank should know about the net realizable value of a corporate client’s largest fixed assets, such as buildings and machines.

After taxes have been deducted, the final result is the net income or loss of the company in the respective fiscal year. The net income, or a proportion of it, can either be paid as dividends to the shareholders, or it can be transferred to reserves (retained earnings), so that it increases equity in the balance sheet. The use of net income can help distinguish good management from a poor one. As many companies have a thin equity position, a bank normally prefers that its borrowers transfer profits to equity.

d. Case study and worksheets

On the following pages, you will find balance spreads as they are used by a leading German bank. There is a completed form of a company called “Specimen Chemical Ltd.” and an empty spread that can be used for exercise, for example on the financial statements attached. The data are realistic, although the companies are fictional. You will also find spread sheets showing the mathematical formula.