MODULE 4--Financial Concepts and Applications Flashcards
What is Forecasting?
A forecast is a “best guess” of what the future holds for the organization. Forecasting relies on internal factors, such as historical accounting and sales data. It also looks at external factors such as market conditions and economic indicators. Forecasting attempts to answer questions such as:
What will our workforce needs be?
How will our pension liability change?
How fast will our markets grow or shrink?
Can we gain market share? How?
Can we increase pricing?
How much do we need to invest to achieve our goals? (Capital investment such as equipment, intellectual capital, etc.)
What is our cost investment? (employees, R&D, marketing, etc.)
Are prices stable, increasing or decreasing for:
* Goods and services provided?
* Input prices such as energy costs?
What are the forecasting questions?
The forecast helps the organization recognize possible issues and concerns that will drive budget planning and ask questions about the forecast that will help them plan their budget.
Profit
* How much profit are we earning for each dollar of revenue (margins)?
* How much profit are we earning compared to peers?
Growth
* How fast are we growing by measuring revenue (top line)?
* Fixed and variable costs?
* Profits (bottom line)?
* Division or product line?
Investment
* Where do we have to invest to generate profit and growth?
* What is our maintenance capital expenditure (fixing what we already have)?
* What is our investment capital expenditure (putting more capital into the business)?
What are Business Analytics?
Business analytics refers to the skills, technologies, applications and practices of continuous iterative exploration and investigation of past business performance to gain insight and drive business planning. Business analytics makes extensive use of data, statistical and quantitative analysis, explanatory and predictive modeling, and fact-based management to drive decision making.
Organizations are increasingly using business analytics tools/capability to track progress and analyze the effects of any single development on the entire business ecosystem. Business analytics is especially powerful for evaluating and communicating how compensation fits into the organization, and the impact that changes to the compensation plan will have.
What is Strategic Analysis
Strategic analysis typically consists of investigating multiple issues, such as:
Evaluating the industry and the market economics
* What is the state of the industry now? Is it expected to change?
Understanding your business and its competitive strengths and weaknesses
* What is your competitive position relative to other industry participants?
* What are your competitive advantages? Disadvantages?
Determining possible future changes
* How is the industry expected to change?
* What are we doing to improve our competitive position?
What is Data Analysis?
Gathering the business and financial data you need can be challenging. Being able to translate this information into organizational action is a key trait of business acumen.
Gaps
* Identify what data might be missing and plan how to address the gaps
* Recognize when the organization is not using data effectively
Trends
* Identify and pull together trends and key messages emerging over time
* Review budget requests over two to three years to identify key issues and messages
What are some Important Financial Concepts?
Different industries and organizations have their own set of key performance indicators (KPIs), but there are some financial indicators that compensation professionals should be familiar with. These
important financial concepts help round out our understanding of how finance and compensation are interrelated:
Cost analysis
Profit measures
Cost leverage
Operating profit
Marginal cost
What are the two Types of Cost Analysis?
Cost Analysis
Fixed costs
* Do not vary for each dollar of revenue
* The organization will pay the same regardless of how much it makes by selling its product
* Examples:
– Corporate staff (accountants, lawyers, HR)
– Audit fees
– Basic repair and maintenance costs
– Rent
Variable costs
* Vary for each dollar of revenue, often at a relatively consistent rate
* If sales are low, variable costs are low; as sales increase, production costs increase
* Examples:
– Hourly wages of production/staff services
– Sales compensation
– Costs of running machines
– Raw materials costs
What is Profit Measures?
In order to fully understand financial reports, you must be familiar with the way organizations measure their profits.
Revenue: the top line or starting point of an organization’s income
Gross profit: how much the organization earns from each unit (e.g., product sold, service delivered)
EBIT: earnings before interest and taxes, also called Operating Profit; how much the organization earns before financing the business
EBITDA: earnings before interest, taxes, depreciation and amortization; same basis as EBIT but adds in the annual charge from previous capital investments
Depreciation and Amoritization is often the largest non-cash expense
* Net income: earnings available to equity owners after paying debt and taxes
* EPS: earnings per share, or earnings attributed to each share of stock
Growth and margin
* Growth rates look at how fast the organization is growing
* Margins look at how much the organization earns per dollar of revenue, how efficiently the organization is operating and what the operating leverage is for the organization
– Gross margins look at how efficiently the organization is operating
– Net margins include the addition of such costs as taxes and loan interest
What is Cost Leverage?
Cost Leverage
If an organization grows its revenue faster than its costs, the profit growth will accelerate. This is leveraging fixed costs relative to variable costs. If the cost of producing that revenue decreases with volume, the profit growth will accelerate even more. Organizations strive to find a balance in order to maximize profit.
What is Operating Profit?
Operating Profit
Profits accelerate when you sell more for the same level of fixed costs
Even better is when the variable costs do not increase at the same rate as sales
Operating profit is synonymous with EBIT
What is Marginal Cost?
Marginal cost is another way of looking at the same phenomenon. If revenue accelerates faster than costs and/or if you have high fixed costs, then the cost per unit sold will decrease as you produce and sell more. Not all businesses have the same leverage.
Example: professional services businesses tend to have low leverage as each incremental dollar
generally translates into more people and more pay (low fixed costs).
What is Working Capital
Working capital efficiency: Describes how quickly the organization is converting short-term capital into cash. It also aids in forecasting future working capital requirements. Working capital metrics include:
* Accounts receivable turnover/days receivable
* Inventory turnover/days inventory
* Payable turnover/days outstanding
What are Market Metrics?
Market metrics measure the potential gap between shareholder and management expectations for the future. They include market ratios and multiples that indicate the premium investors place on a company’s earnings or capital (combined perspective of future growth potential and perceived risk of business). Examples include:
Price to earnings ratio = stock price/net earnings per share
Price to EBIT/EBITDA ratio = stock price/EBIT or EBITDA per share
Price to revenue ratio = stock price/net sales per share
Market-to-book = stock price/book value per share
TSR (total shareholder return) measures the total return shareholders
What Does Return on Capital Mean?
Return on capital: describes how effectively the organization is investing capital. Higher rates of return on investments create more value, whereas investments below the cost of capital destroy value. Factors include:
* Return on equity = net earnings/shareholder equity
* Return on assets = net earnings/total assets
* Return on capital/invested capital = net operating profit after taxes/invested capital
* Economic value added = net operating profit after taxes – (capital × cost of capital)
What are other Peformance Metrics?
Balanced Scorecard: a balanced scorecard seeks to use multiple metrics to capture trade-offs when
it comes to making decisions and investments
Financials
* Metrics include revenues, earnings, return on capital, cash flow
– Data is instrumental in measuring financial success
– Too much focus on financials can overshadow other critical factors
Customers
* Metrics include market share, customer satisfaction, customer loyalty
– If a customer is dissatisfied they will seek other vendors
– Poor performance can indicate future decline, even if the current financial state
appears strong
Internal processes
* Metrics include productivity, quality, deadlines
– Tell how well the business is running and meeting customer requirements
– Align processes, reduces duplication, improves productivity
Innovation and learning
* Metrics include employee satisfaction/engagement, turnover, employee value proposition
– Includes employee training and development
– Essential in knowledge-based industries where the employees are the primary resource
