Notes from My First Lesson on Finance- part two

Since you are here I believe you have already read the prequel to this post found here.This post would cover the following topics as promised:

    • Basics of the Balance Sheet
    • Fundamentals of the Profit and Loss account
    • The Cash flow statement
    • Validating your assumptions
    • The Seven financial reactions to any decision you would take.

    1. Basics of the BALANCE SHEET

    In simple terms the balance Sheet has 2 columns viz. Money required and Money Funded:

    Money Required

    Money Funded

    Capital employed

    Capital Employed

    Investing

    Financing

    I Own

    I Owe

    Operations

    Finance

    Application of Funds

    Source of Funds

    Fixed Assets
    +
    Working Capital

    Net Worth
    +
    Loaned Funds

  • Money Required.: Fixed Assets + Working capital (cycle) – Liquid cash is the worst asset- it cant get liquid any further and we don’t get any returns on it. Although some amount of petty cash is a must for day to day business expenses- more than that is a waste.
  • Money Funded : (Share Capital + reserves = ) Net Worth + loaned Funds – Net Worth = Money brought in by the owner and that retained in the business.
    – Reserves = assets, land, Accounts receivable etc. Reserve Rich not= Cash rich
  • Equity is more expensive than debt
  • “Profit is a liability for a business -cause it is the investors money to be returned. So is Loss an Asset?”

2. Basics OF Profit and Loss Accounts

  • Money that comes from Sales –> Income
  • Income – Variable Cost = Contribution i.e the surplus from income that covers for the foxed costs
  • Contribution – Fixed Cost = Profit Before Interest and Tax (PBIT) aka Operating Profit
    If PBIT is +ve –> operationally we are making a profit – operating profit
  • PBIT – Interest on Long term Loans = Profit Before Tax (PBT) aka Taxable profit
  • PBT – Tax = Profit after Tax (PAT) aka Net Profit
  • PAT – Dividend = Retained Earnings –> Net worth
  • USA norm for PBIT is EBIDTA – Earnings before Interest Depreciation Tax and Amortization
    Amortization: like depreciation – you spread the expenditure across a period e.g. you don’t depreciate Brand Name/Goodwill. IPL/EPL teams bought would be typically amortized.

“Profit is a liability for a business -cause it is the investor’s money to be returned. So is Loss an Asset?”

3. CASH FLOW STATEMENT

The following table illustrates the fundamentals before one ventures into drafting a cashflow statement.

    Operating Investment Finance
    PBDIT
    (-) Increase in Working Capital [other than cash]
    (+) Decrease in working capital
    (-) Taxation
    Sale proceeds from fixed Assets or investments


    (-)Purchase of fixed
    Assets/investments
    (+) Interest from investments

    Issue of share capital

    (+) Long term loan taken

    (-)Repayment of loan
    (-) Drawings
    (-) Pyment on Interest of loans
    (-) Dividend paid on capital

A successful business depicts the following traits:

  • Share Capital is issued only to purchase fixed assets and investments and for drawings.
  • Sale proceeds from fixed asset/investments are used only to purchase fixed assets/investments
  • Operational profits are used for repayment of loans and for further investments.

Other points:

  • Cash flow statement cannot be easily fudged and one should not try to do so just for the sake of impressing potential investors.
  • Working Capital is technically the working capital ‘gap’ and is always a cycle.

3. Validating your assumptions

    • Apply Ockham’s razor : Get as close to reality as possible.
    • Possible ways to validate:
      – Get an industry insider to invest in you.
      One of the best ways to validate as he is a better judge of the industry trends and unsolved problems through his experience than you are with your market research.- Get a gainful employee to join your Co.
      If s/he can leave his stable and plush job to join your new venture it means either your venture is super or that he is a bozo.
    • Mistrust the obvious.
    • Understand your sphere of influence ,concern and control.
  • 4. THE 7 FINANCIAL REACTIONS TO ANY DECISION YOU TAKE

    There are seven distinct and finite financial reactions that can take place for any decision we make

  1. Increase in Sales Volume
  2. Decrease in Fixed Cost
  3. Increase in Selling Price
  4. Decrease Variable Cost
  5. Change in Product Mix
  6. Reduction of Fixed Assets
  7. Reduction of Working Cap (gap)

That brings us to the end of my notes from my first lesson in finance.
They seems pretty logical to me , however I do not endorse or assure that these would work for everybody/anybody- as an explorer and a learner I just wanted to share this the likeminded readers.

Cheers!