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
- 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?”
In simple terms the balance Sheet has 2 columns viz. Money required and Money Funded:
Application of Funds
Source of Funds
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.
(-) Increase in Working Capital [other than cash]
(+) Decrease in working capital
|Sale proceeds from fixed Assets or investments
||Issue of share capital
(+) Long term loan taken
(-)Repayment of loan
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.
- 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
- Increase in Sales Volume
- Decrease in Fixed Cost
- Increase in Selling Price
- Decrease Variable Cost
- Change in Product Mix
- Reduction of Fixed Assets
- 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.