Money is better than poverty, if only for financial reasons.

Woody Allen, Without Feathers

In a nutshell

This chapter covers the effective use of financial and economic data to support planning, control and decision making for value creation. It’s a misconception (albeit a tempting one) that the job of an experienced chief financial officer (CFO) is to find a thousand different ways of saying no. A CFO’s job is to agree robust ways of saying yes to value creation and their caution is usually because they are custodians of the resource that is our store and measure of value: money.

Accounting can be jargon-heavy and is highly regulated, but you do not need to know everything a CFO or accountant knows to work alongside the financial experts. When you understand something of the tools and principles of accounting and finance, it is directly applicable to the work you do and you will be better equipped to justify and defend your use of the organisation’s resources to achieve its goals.

In this chapter you will:

• learn the difference between management and financial accounting
• study economic theory at the level of individuals and organisations
• understand the importance of the time value of money
• evaluate an organisation’s performance using financial statements

The basis of accounting

Before diving into an alphabet soup of ratios and economic formulas, the best place to start is with what managers actually do day to day. Yours is a world of decisions and actions, but the logic behind many of an organisation’s plans comes from economic theory. The language and practice of accounting are designed to measure the performance of decision making and so all the information provided in this view of accounting is historical. In other words, it comes from looking back. There are two broad areas of accounting:

• Management accounting has an internal audience. It is about the planning and decision making required to meet given objectives and is linked to microeconomic theory (the economics of individual actions). As a part of this, cost accounting establishes budgets linking detailed activities in the short-term future to various types of cost. Most managers are involved in preparing, managing and then tracking variances in budgets.
• Financial accounting uses data from past performance to analyse and interpret where you are in the present and to gauge the current viability of your business. Accounts have to be produced by all limited-liability companies. They summarise and consolidate all the activities from the last year and express them as numbers. Financial accounting thus presents the outcomes of the decisions made in management accounting in a way that is consistent and comparable. In The Every Day MBA we’re going to use the published accounts of a major UK grocery retailer, Morrisons, to illustrate some of the main aspects of this part of accounting.

I will begin with management accounting, then look at financial accounting, in order to see in more detail the differences between them.

Management accounting

In buying this book you made a decision. You incurred a cost, which was balanced with an expectation of a benefit that would be worth something in return. You could have done other things with your money, so the chances are you weighed up any benefits relative to, for example, buying a different book, or a meal, or perhaps using the money to pay off a debt. That is a small example; a much bigger one could be the cost of signing up for an MBA, which is why managers often spend years thinking about it. Getting the most out of limited resources is always an issue. In organisational settings, when it’s someone else’s money, you need to show judgement and rigor in the decisions you make because they will usually have an effect on the bottom line.

Economic activities need to align with organisational goals. Every organisation has limited resources – it can’t do everything and what it can do usually can’t be done all at once. Remembering the twin roles of management from Chapter 1 (standing in place of the owners and the ethical creation of value), you begin to see – regardless of whether it’s the monthly budget or 10-year capital expenditure – how financial information can help you move from being a re-active to a pro-active decision maker.

Management accounting employs concepts from business economics to help you decide on future courses of action that can be justified on managerial grounds, so let’s begin there.

Microeconomic concepts

Economic theory tries to explain everything from macro levels of universal market forces through to the micro levels of what goes on inside an organisation. Economic theory influences tactical and strategic decisions on pricing, performance management, marketing and future investment. MBA programmes often look at this topic from a perspective that assumes rational decisions are made by self-interested individuals who are motivated to maximise efficiency for economic return.

Here are five key microeconomic concepts that are basic to an understanding of finance.

1 Scarcity and utility

The basis for what most organisations do is scarcity. Simply put, a demand is created as soon as people perceive a shortage of something. When this happens, choices have to be made, and there is a close relationship between choice and scarcity. In the rational view of the individual (or the firm), scarcity plus enlightened self-interest lead to decisions based on available information. Organisations not only try to identify what is scarce (and in demand), they also see whether they can limit it, or add to it.

Utility is the level of expected satisfaction derived from a good or service. It might seem straightforward to expect that more of something provides greater satisfaction, but this is not so. Utility diminishes (the second sip is never as refreshing as the first).

2 Forms of competition

Perfect competition is a special (and theoretical) situation where there are enough buyers and sellers in a market – each with access to perfect information – that it is impossible for any single entity or party to influence the price, which is set in terms of the margin over the cost of production, not in terms of what others are charging. In perfect competition, demand drives down price only to a point where the threat of a new competitor is removed. A higher price would attract competition (i.e. it would be worth entering the market). A lower price is unprofitable. At this point it meets the optimal supply at a rate that produces normal profit, or what it takes to keep the business a going concern. Normal profit needs to be considered as a cost because the price set at this point is the minimum expectation of return. Perfect competition doesn’t really exist, but its consideration guides just about all investment decisions and policy or law regulating markets, especially utilities.

The opposite of perfect competition is monopoly, another largely theoretical state where a dominant player supplies at a price of cost plus margin unrestricted by competition. Many markets operate as oligopolies, where there is limited competition between a few suppliers that are dominant in the market. These competing organisations tend to be of roughly the same size and will tend to act reactively and proactively in regard to competitors. The interdependence among players is what makes an oligopoly special and this drives strategic analysis and planning among profit-maximising firms. Oligopolies are often the subject of mathematical modelling of two theoretical players using game theory.

3 Costs and revenue

Revenue (or turnover) is defined by the effective demand in the market × price. Costs are dictated by the price paid for inputs (materials, labour and capital) and the efficiency in management of processes needed to transform them to outputs. A marginal cost is the change in total cost that results from the production of one extra unit. If costs for inputs are known, the total cost can be calculated. Microeconomics also recognises the opportunity cost of choosing one course of action over another.

4 Supply and demand curve

Supply and demand curves (see Figure 5.1) are lines plotted on a graph on axes of price (P) versus quantity (Q) and illustrate that:

• demand (D) is the ratio of how many or how much of a good or service a customer is willing to buy at a given price. The lower the price, the more that customers will want (in theory), though it matters also what alternatives are available and how much money you have to spend
• supply (S) is the ratio between the given price a supplier of a good or service must charge to cover costs and make a margin and the quantity that it can supply at that price. The higher the price, the more it can make or supply.

Demand curves slope downwards while supply curves slope up. At some point, these two theoretical lines meet in equilibrium where supply and demand are matched by what buyer and seller are willing to accept in price. When there is more demand for something than there is supply, a shortage results and, generally, the price will go up. Similarly, where there is an excess of supply, the price tends to reduce. Getting the supply side of this equation correct is crucial for many businesses and organisations, and this is often the primary goal of operations managers. Elasticity is the sensitivity between variables in a supply and demand relationship. The ratio between a change in a price and the demand for it is called the elasticity of demand. Inelastic is if you put the price up (or down) and demand stays about the same.

FIGURE 5.1 Supply–demand curve

5 Economic profit (EP)

Economic profit is a way of measuring the effectiveness of how resources are used. As a part of goal setting, evaluation of performance, capital budgeting and valuation it can be very important. Value is derived by subtracting cost of capital from net operating profit over a given period. EVA, or economic value added, is one way to show how much wealth has been generated and is an alternative to budgeted targets. It works only with accounting centres that are responsible for their own income, but can link several centres to track performance overall.

Costs and benefits

Decisions always need to be made about the best use of scarce resources. At some point the costs and benefits of your decisions will be assessed and measured beyond what was set out in a budget. One of the best ways of doing this is by calculating and comparing future marginal or additional costs and benefits resulting from a decision. Even if you have only one choice in mind, the comparison between that and what would happen if you just left things as they are can help.

For the purposes of most business or management decisions, the future is converted into a relationship between time and the value of money. It is no simple matter to measure every type of future benefit in money terms. Some of this is driven by an understanding of the concepts of demand and of supply, which will always incur a cost to make happen. There is a great deal of debate in accounting on the language of costs, but the most important principle to keep in mind is knowing which sorts are relevant to your decision making and which are not. The most basic division is between fixed costs (which don’t change with increases or decreases in activity) and variable costs (which change in direct proportion to activity). Typically, tactical decision making involves using a set of assumptions to adjust capacity to meet demand and then modelling changes in variable costs to identify the break-even point (also known as cost-volume-profit analysis, or CVP). There is always an opportunity cost incurred, if only because the time used in one activity cannot then also be used to generate value in another.

Another important aspect of this is whether an organisation is better off paying outside contractors or bringing work inside, often known as the make-or-buy decision, such as Morrisons outsourcing online and home delivery to Ocado (see case study above).

Future cash flows and net present value

Short-term decision analysis requires the following steps:

• Define the problem requiring a decision.
• Make a thorough list of alternative courses of action.
• Identify and discard alternatives that do not deserve closer analysis.
• Calculate the financial cost–benefit differences of the remaining choices.
• Weigh up the financial and non-financial factors to make a decision.

Longer term, options for growing or for development that do not rely on external sources of funding require an extension of managerial decision making beyond budgets. Finance now begins to resemble investment, and although the basic principles are the same as for short-term spending, there are several tools that a manager needs to know about to evaluate the different options open to them.

The most important consideration, bearing in mind the focus on value, is knowing the effect of any investment on future performance – whether replacing worn-out assets, cutting back on costs, funding internal expansion or reacting to external conditions. Most managers will not have direct responsibility for sourcing or appraising capital expenditure, but are fully involved in justifying, preparing and delivering such projects. It helps to know that the main financial criteria for justification of investment projects are that they:

• are in line with the objectives of the organisation
• will produce a return that exceeds the financing cost over their economic lifetime
• are the best choice financially among all those available, including their residual value at the end of the project.

Assuming that you can work out the future cash flows and predict the many variables that could affect this, how do you work out what’s the best way to invest in a project?

The simplest method, payback period, compares the initial capital outlay for each option under consideration and calculates how long, in years, it will take to recover that original investment, and then how far into the expected economic life of the project this payback occurs. Payback is simple, but is unadjusted in that it ignores the time value of money (this is the fundamental idea in finance that money in the present is preferable to the same amount in the future). Techniques that factor in the value of the rate of return (or return on investment, ROI) over the whole economic life of the project need to adjust to this.

A commonly used technique to calculate the value of the various investment choices over a period of time longer than one year is net present value (NPV). If the present value of future benefits can be shown to exceed the present value of future costs, the project should be undertaken as it will add value to the organisation. Discounting is the process of finding the current value of future cash flows when they have been adjusted for future interest or inflation. What rate to discount at will usually be a given and is termed the cost of capital. Any project meeting this hurdle rate will, in theory, end up adding value.

Budgeting and budgets

An important sign of career progression is budgeting responsibility, so nearly all managers seek it. Actual budget preparation and appraisal can be the cause of much stress at work so it’s worth looking at the distinction between the process and the product:

• Budgeting is a process to forecast the appropriate allocation, control and use of resources. It is often cultural, political and idiosyncratic (i.e. how one organisation goes about it is likely to be different from others). Budgeting cycles can be lengthy and expensive. For example, the Ford Motor Company spends in excess of $1 billion each year just on its budgeting process. For some, budgeting is an area of controversy because it is seen as being old-fashioned and out of touch with the fluid, project-based structures found in many companies.
• A budget is an approved plan that quantifies in monetary terms and over a fixed period an organisation’s future activities. Because a budget predicts, it can be used as a control mechanism by prompting explanation of any difference or variance between the plan and the actual. Budgets may be incremental (new activities receive new funds), zero-based (each new round assumes activities are being done for the first time), rolling (on-going process of adding a new accounting period when the current one has expired) or flexible (designed to be adjusted to suit changes in activities).

Budget variance and approval are day-to-day features which will be found in all organisations. The largest operating cost for many firms relates to people, but using budgets to manage staff performance is risky. Where this happens, managing variance produces short-term or self-interested thinking and becomes a stress on people.

Fluency in accounting should matter to you because it will help answer questions that go beyond how things are going compared with the plan. This is important because as a senior manager you will always need to answer four questions:

1. Do we have enough cash to pay the bills and remain viable?
2. How are we doing compared with our competitors?
3. Are we better or worse off than we were in the past?
4. What will our financial position be at a given time in the future?

To reach conclusions and understand the effective use of these and other accounting principles you must know something about using financial statements to produce financial ratios.

Financial accounting

The audience in financial accounting are people outside your organisation with an interest in how it is performing (whether you are creating value). Because companies with publically traded shares must publish their audited accounts in annual reports, we are able to examine their statements for the story behind the performance. Looking at the three financial statements from the 2012–13 accounts of Morrisons plc should provide a few clues to the decision making in the company around its tactical and strategic position in the market. Remember, the notes section of the annual report contains information to help you read the statements, as well as a lot of the company detail and background the consolidated numbers cannot show you.

Financial statements

All organisations must ensure access to cash, even when making a profit and especially when that business is new or has invested in non-current assets (e.g. equipment, vehicles and buildings that the organisation plans to own for more than one year). So first we need to understand the significance of the cash flow statement, not least because a lack of liquidity is the single most frequent reason businesses fail. See Table 5.1.

The cash flow statement consolidates income from three sets of activities: operating, investing and financing. The critical number on this statement is the £1,104 million that Morrisons generated from its operations in 2013, up from 2012. It is essential to generate this revenue inflow in order to invest in the business without relying on external sources of finance. If this number falls, then the company will be less able to finance its growth. You can see that the outflow was £1,008 million, which is what the company was able to invest in that year.

The cash flow statement is a common-sense record of actual (as opposed to booked) inflows and outflows of cash over a period, showing start and end cash balances. A cash flow forecast is the same, but for a future period. The advantage of this is that it enables management to adjust to future shortfalls in liquidity, either by sourcing funds temporarily to cover the cash shortfall or by speeding up the arrival of revenues and delaying outgoings from business activities.

The income statement, or profit and loss (P&L), covers the period of time between two balance sheets, but unlike the cash flow is not dependent on whether money has been received or spent yet (not only are ‘profit’ and ‘cash’ different concepts, but profit is multi-layered and potentially confusing as a comparable measure). Table 5.2 shows the Morrisons 2013 P&L.

The P&L is a retrospective (and statutory) annual income statement that shows the balance of revenue (turnover) less any direct cost of sales. This gives you the gross profit, from which all other expenses such as wages, overheads, dividends and due taxation are deducted, leaving the net profit (the infamous bottom line). The P&L is the most important measurement with input to strategy because it is what organisations use to measure themselves against their competition.

TABLE 5.1 Consolidated cash flow statement for Morrisons plc, 2012–13

	2013 (£ m)	2012 (£ m)
Cash flows from operating activities
Cash generated from operations	1,432	1,264
Interest paid	(85)	(55)
Taxation paid	(243)	(281)
Net cash inflow from operating activities	1,104	928
Cash flows from investing activities
Interest received	3	6
Investments	–	(31)
Proceeds from sale of property, plant and equipment	5	4
Purchase of property, plant and equipment, investment and software	(846)	(724)
Purchase of intangible assets	(134)	(72)
Cash outflow from acquisition of businesses	(36)	(74)
Net cash outflow from investing activities	(1,008)	(891)
Cash flows from financing activities
Purchase of own shares	(514)	(368)
Purchase of treasury shares	(65)	–
Proceeds from exercise of share options	42	–
New borrowings	843	1,102
Repayment of borrowings	(81)	(486)
Dividends paid to equity shareholders	(270)	(301)
Net cash outflow from financing activities	(45)	(53)
Net increase/decrease in cash and cash equivalents	51	(16)
Cash and cash equivalents at start of period	212	228
Cash and cash equivalents at end of period	263	212

Source: www.morrisons-corporate.com

TABLE 5.2 Consolidated income statement for Morrisons plc, 2012–13

	2013 (£ m)	2012 (£ m)
Turnover	18,116	17,663
Cost of sales	(16,910)	(16,446)
Gross profit	1,206	1,217
Other operating income	80	86
Administrative expenses	(336)	(329)
Losses arising on property transactions	(1)	(1)
Operating profit	949	973
Finance costs	(75)	(47)
Finance income	5	21
Profit before taxation	879	947
Taxation	(232)	(257)
Profit for the period attributable to the owners of the company	647	690
Other comprehensive expense for the period, net of tax	(10)	(69)
Total comprehensive income for the period attributable to the owners of the company	637	690

Source: www.morrisons-corporate.com

Morrisons turned over £18.11 billion in 2013, but the most important number here is the £637 million profit that is attributable to the owners. This represents a decrease from £690 million from the previous year (which was achieved on a lower turnover). On its own this does not indicate a strong performance (though look for some qualification in the report) and restricts what those in a governance position in the company can do because they must decide how much can be paid to shareholders in dividends.

The balance sheet will show the good news, or the bad news, about what a business owns now compared with a year ago (see Table 5.3). What you see is a slice through the organisation on a given day. It’s rather like a snapshot, or freeze frame, and – like many individuals who know they are going to be photographed – organisations will try to look their best on that date. This is certainly true for large companies that need to reassure investors or owners that they are creating value.

TABLE 5.3 Consolidated balance sheet for Morrisons plc, 2012–13

	2013 (£ m)	2012 (£ m)
Assets
Non-current assets
Goodwill and intangible assets	415	303
Property, plant and equipment	8,616	7,943
Investment property	123	259
Investments and other financial assets	31	32
	9,185	8,537
Current assets
Stocks	781	759
Debtors	291	320
Cash and cash equivalents, other financial assets	270	243
	1,342	1,322
Liabilities
Current liabilities
Creditors	(2,130)	(2,025)
Other financial liabilities	(55)	(115)
Current tax liabilities	(149)	(163)
	(2,334)	(2,303)
Non-current liabilities
Other financial liabilities	(2,396)	(1,600)
Deferred tax liabilities	(471)	(464)
Net pension liabilities	(20)	(11)
Provisions	(76)	(84)
	(2,963)	(2,159)
Net assets	5,230	5,397
Shareholders’ equity
Called-up share capital	235	253
Share premium	107	107
Capital redemption reserve	37	19
Merger reserve	2,578	2,578
Retained earnings and hedging service	2,273	2,440
Total equity attributable to the owners of the company	5,230	5,397

Source: www.morrisons-corporate.com

The balance in a balance sheet is between what the company owns versus what it owes to third parties and shareholders. There are different ways of expressing this equation, for example Morrisons deducts liabilities from assets and then balances the result with what is owed to shareholders, but the basic formula is:

total assets = total liabilities

Assets are those resources owned by the business that can be represented in monetary terms and that are expected to be used in some way for economic benefit. Current assets include the working capital (anything ‘liquid’ or available in the short term to generate value), while fixed assets are those items that the organisation owns and that will have an expected economic life of more than one year.

On the other side, liabilities show where the organisation has a monetary obligation to others. This will include any loans outstanding as well as the capital invested by the shareholders, or reserves such as retained profits from past years.

As for Morrisons, if liquidated, it would be worth on paper £5,230 million because this is in effect the amount liable to the shareholders. You can see that this is less than the previous year, so arguably the company is not doing as well as it might have hoped. This is in line with the fall in profits in 2013.

Financial ratios

Ratios work by expressing one thing (e.g. profit) in relation to another (e.g. total assets) in order to provide useful heuristic information for decision making. It is not difficult to calculate ratios with the right data; the art lies in how you make sense of the results. But there are a great many key ratios, even at a high level, and too many to list in detail. The main categories are indicated below:

Profitability ratios: These look at earnings (profit) before interest and taxation as a percentage of total assets.

Generally, the higher the ratio, the better the indicator of how much value the business is generating from its assets, but much depends on what is normal for that type of sector, or between similar competitors.

Liquidity, or working capital ratios: (‘Can we pay our way?’) It has already been mentioned that a business or organisation that has no cash available is not going to remain a going concern for very long. Liquidity ratios look at the way working capital cycles through a business.

Gearing, or leverage ratios: The two principal sources of financing a venture are shareholder equity and loans. The global recession that began in 2008 showed how access to short- and long-term loans is fundamental to businesses’ growth and development. It is true that loans normally carry an interest obligation, but unlike dividends paid to shareholders, loans often benefit from the ‘tax shield’ and are deductible from tax. There is often an advantage in managing the relative amounts of debt from different sources. The relationship between debt and equity is called gearing.

Productivity ratios: An interesting use of financial ratios, though one that makes sense only in comparison with other factors, is to derive how much value is being provided by the human resource (nearly always an organisation’s biggest cost).

Investor ratios: Finally, and frequently quoted for publicly traded companies, some specific ratios are used for investor decision making.

Ratios are something of a minefield for MBA students because they come alive through calculation and interpretation in a context. On the page they remain rather superficial. Because different organisations calculate and use them in different ways, it usually makes sense to get to know the ones that inform your industry, sector or company.

Putting it together: it all adds up

Accounting is a universal language, but it is spoken in many different accents and dialects. Practice varies not just among companies but from sector to sector and country to country. The presence of external regulation and standardisation in accounting means that everyone has a platform for comparison to look at their performance, but an organisation’s internal financial decision making will constantly evolve. The use of numbers, ratios and mathematics in managerial accounting doesn’t mean there are no skills of interpretation or judgement required; on the contrary, deriving meaning from numbers is the craft of doing business.

The economic principles and use of accounting mentioned in this chapter have been about an organisation’s past performance. In Chapter 8 we will revisit the finance link, but in terms of valuation and planning for the future.

Further reading

A classic text:	Intelligent Investor: The definitive book on value investing – a book of practical counsel by Benjamin Graham (2006), Collins Business. First published in 1949 and on Warren Buffett’s list of top three books about finance.
Going deeper:	Principles of Business Economics by Joseph Nellis and David Parker (2nd Edition, 2006), Financial Times/Prentice Hall. Contains everything you need to know.
Visit this:	‘Beyond Budgeting Institute’: www.bbrt.org. Dedicated to the sharing of best practice among organisations in planning and budgeting.

Note

1 www.morrisons-corporate.com/