You do the math

by Paul J. Zak

One thing we should have learnt from last year’s global financial meltdown and the ensuing recession is that, when it comes to the numbers, we can’t stick our collective heads in the sand.

We will probably never know how many senior staff in the banking sector did know something was amiss or how many simply did not understand the numbers. But it still raises an important issue for HR – are we as financially literate as we should be?

Not according to David Smith, former people director at Asda. “I passionately believe that many in the HR community have not got sufficient numeracy to do the job,” he says. “It’s a real weakness.”

Vanessa Robinson, head of HR practice development at the CIPD, is sympathetic to the fact that HR professionals “aren’t the finance department” – but she is no less clear about the importance of financial literacy.

“A big part of business is making sure that the books add up,” she says. “Not being able to do that means it’s harder for you to connect and converse with the people you are working with.”

Both Smith and Robinson agree that HR professionals who don’t understand the financials that underpin their organisation have no place being on the board.

“Anybody who wants to be on a board shouldn’t rely only on their specialism,” says Smith. “I’ve heard HR directors saying ‘I have no comment; I can only talk on the people bit’ – to me that’s complete failure. Financial aptitude is the mark of a true business person as opposed to simply a professional.”

The importance of understanding the numbers can, to some extent, be seen in the shortcomings of words alone. The HR community is not averse to terminology and the phrase “people are our greatest asset” is often repeated. But true as it might be, says Robinson, people are also the main cost for many organisations.

“Looking at it on paper can really make you see it a bit more clearly,” she says. “Don’t merely say ‘people are our greatest asset’, look at the profit and loss and see exactly what they cost!”

The accounting world, similarly, has a language of its own – one that can seem foreign to those of us who have not spent several years studying its intricacies. Finance and financial implications should underpin all key business decisions. Yet battling your way through the information presented in a set of company accounts can be challenging, at best.

To help to address this, over the next few pages we aim to give the uninitiated - or the rusty – reader a basic grounding in how to read the company accounts and identify the numbers that you should really be looking at.

What you need to know

The key components of a set of financial statements are:

- Profit and loss account (P&L).
Also known as the income statement. Outlines how much has been earned during the year and what is available to invest or give back to shareholders.

- Balance sheet.
Provides a snapshot of what the business owns, less any amounts payable to other parties, on a particular day (usually the end of its financial year).

- Cash flow statement.
Indicates where cash is coming into and being used in running a company and can be useful in determining its ability to meet its short-term liabilities, such as the payment of bills or the repayment of a loan.

- Notes to the accounts.
These provide extensive background information, such as how a decision on the value of an asset has been reached. It is not a bad idea to read financial statements from back to front to understand the underpinning judgments before looking at the actual results.

Each of the financial statements interacts with the others. For example, if equipment has been purchased with a loan, then: - the equipment will be recognised as an asset and the loan as a liability on the balance sheet; - the loan and the cash paid for the asset will show up on the cash flow statement; - the decreasing value of the equipment over time will be reflected as depreciation within cost of sales on the P&L. It will also reduce the asset on the balance sheet (this is the concept of double-entry book-keeping).

All EU-listed companies use the international financial reporting standards (IFRS). Companies not listed may use UK generally accepted accounting principles (UK GAAP), which are similar but include detailed differences in the way some items are recognised, measured and presented. Companies must comply with the appropriate standards but they may also decide to provide additional non-GAAP information in their company accounts.

Profit and loss account (also known as the income statement) shows how the money received from the sale of products and services is transformed into income. Its purpose is to show managers and investors whether the company made a profit or loss.

Revenue (also known in Europe and the UK as turnover) is the amount a company actually makes through the sale of products and services in the normal course of business. In this fictional example, it has grown by 21 per cent year on year. Companies may also provide information on organic or underlying revenue, which excludes revenue from acquired businesses and the disposal of operations and can be a useful indication of how the core business is doing.

Cost of sales relates to costs that are directly attributed to the purchase or production of whatever the company sells or delivers and includes salary costs for employees directly involved in the production or delivery process. In this case these have increased by 22 per cent but, as this is broadly in line with the increase in revenue, the company is keeping good control over its direct cost base.

Gross profit is the difference between revenue and cost of sales. It is the direct margin that the company makes and is a good indicator of the feasibility of the organisation. A healthy business will aim to increase gross profit year on year. This figure would be shown in brackets if the company had made a loss.

Gross margin expresses gross profit as a percentage of revenue and can be a useful way of comparing the financial results of different companies within the same field. But it should not be looked at in isolation because, as with this example, the margin can decrease while both revenue and profit increase (perhaps as a result of the acquisition of a company with lower margins).

Operating profit is the profit (or net income) earned from core business operations, after deducting both direct cost of sales and indirect expenses, including administration and distribution costs, such as support and HR roles and pension costs. In this example it has risen by 16 per cent compared with revenue growth of 21 per cent so the company is also controlling these costs well. Some companies will also include EBITDA (earnings before interest, tax, depreciation and amortisation) in their accounts. This non-GAAP measure of profit is essentially operating profit with depreciation and amortisation (the process of spreading the cost/value of assets over their useful lives) added back in. However, many companies interpret this differently, so in comparing companies you should check the notes to the accounts.

Profit for the year takes into consideration any income or expenses relating to the way the business is financed – for example, interest accruing on a loan – as well as income tax. This leaves the profit that can either be paid out to the shareholders (or equity holders) in the form of dividends, or be retained within the company in the form of retained earnings.

The profit made by the company after all obligations have been met belongs to the owners (or shareholders) of a company. The amount accruing to an individual shareholder is calculated by dividing this profit by the number of shares in issue and is known as earnings per share (EPS). Diluted EPS also includes shares that may be issued in the future (eg, share options).

Operating margin expresses the operating profit as a percentage of revenue.

The balance sheet gives a company’s financial position, or value, on a particular day and shows the total value of the net assets (assets less liabilities). There is a lot of debate about how items should be valued – traditionally the price items were acquired at has been used, but increasingly companies are required to look at the “fair value”. When the value of an asset has to be reduced because it is overvalued compared with its market value, it is known as an impairment or write-down – something that is all too common in current trading conditions.

Assets are categorised as current (those that can be converted to cash in less than a year) and non-current. Where the overall value of assets declines over time it may suggest that the company is not investing adequately in its future, or is not retaining sufficient liquid assets. The term "working capital" refers to current assets less current liabilities and illustrates whether a business is able to pay its bills in the short term.

Intangible assets do not have a physical nature and include patents, brands and customer lists. The cost will usually be spread over the period in which they are considered to have value (amortisation). In this example, these assets are much higher in 2008 than 2007, but this is down to the acquisition of a new business.

Property, plant and equipment (PP&E) are physical assets that are used in day-to-day activities, including buildings and machinery. As PP&E is used over time, a charge is made to the P&L to spread the cost of the assets over their useful lives.

Inventory is stock held by the business that will be either sold or used in manufacturing or development. It is generally held for less than a year as a current asset. In this case, it has increased by 8 per cent, which is less than the growth in revenue (see P&L), so the company is managing its inventory levels effectively so as not to tie up too much cash.

Trade and other receivables, also known as debtors, is the amount owed to the company by third parties. Here, debtors have risen 16 per cent, but again this is less than the growth in revenue.

Cash and cash equivalents are considered to be the most liquid assets. Cash equivalents may be converted into cash within three months and include short-term government bonds and Treasury bills. Movements in the cash balances are explained in the cash flow statement.

Equity. When all liabilities have been paid, the remaining value of assets is known as equity and is the amount that shareholders have claim to. It is made up of the initial value of the shares issued plus the earnings that have been retained by the company over the life of the organisation, rather than paid out to shareholders as dividends.

Liabilities are obligations that a company must settle, normally in cash, and are divided into current and non-current items.

Deferred tax is an accounting concept that usually represents the tax payments that must be settled in the future as a result of current activities. There may also be a deferred tax asset.

Provisions are liabilities for which the timing or amount of payment is uncertain, such as litigation or restructuring costs. Currently, there is often an increase in provisions, as is the case here, because of rising pension scheme deficits.

Loans and borrowings are long or short-term loans and the interest on these can be seen as a finance expense in the P&L. In this example the company has taken out additional long-term loans, possibly to finance the new business.

Trade and other payables, also known as creditors, represents amounts payable for goods or services provided by a third party. In this case, creditors have risen by 19 per cent, which is broadly in line with the average of increases in direct and indirect costs on the P&L.

Income tax. At the end of the year, the company calculates its net profit and estimates the tax liability, although this will not be paid until nine months after year end.

The cash flow statement illustrates the movement of cash into and out of a company over a financial period (usually 12 months). Net cash flow is the term used to describe all cash received by the company over that period, less the cash paid out. This is in contrast to profit in the P&L, which is the result of recording income when it is earned and expenses when the liability arises, whether or not the cash has been received/paid.

Cash is the lifeblood of any organisation. It is not unknown for companies that would appear to be profitable and have positive net assets to go under because they cannot pay their immediate bills. Current tough trading conditions have exacerbated the situation – a significant number of companies have already gone into administration because their banks called in loans and there was insufficient cash to cover the repayment.

Companies that are healthy and growing usually choose to spend or invest most of their cash in order to enable them to make income in the future. In this example, the company had profits before tax and finance costs of £27 million. However, it has invested a significant amount in the acquisition of a new subsidiary, purchasing new plant and equipment and repaying loans. It has also significantly increased year on year the amount it has paid out to shareholders in dividends. All of these are healthy activities, indicating the company is in a good position.

Cash flows from operating activities arise from the revenue-producing activities of the business, including day-to-day trading.

The starting point for calculating these cash flows is the profit before tax and finance costs (see P&L). This is then adjusted for accounting entries that do not relate to the exchange of cash, such as depreciation and amortisation; losses made on the sale of assets (where the asset value in the balance sheet was greater than the cash received); and increases or decreases in provisions for future potential liabilities.

It is also necessary to make an adjustment for changes in net current assets (working capital) held by the company. For example, if the level of stock one year was £10,000 and in the subsequent year increased to £15,000, an additional £5,000 of money would be tied up in this stock and would therefore be shown as a cash outflow.

In this example we also see significant additional payments in both years to reduce pension scheme liabilities. Any impact of changing exchange rates (not relevant in this case) would also be recorded.

Lastly, adjusting for interest paid and received and tax payments made in the year allows you to arrive at the total net cash flows from operating activities.

Cash flows from investing activities are associated with the purchase and sale of non-current assets, such as property, plant and equipment, and the income from investments held by the company.

Where the company purchases another business, as has happened in this example, the cash impact recorded on the cash flow statement takes into consideration the amount paid for the company as well as the cash that it then has within the business when the new company is first consolidated into the group. In this example that amounts to £4 million.

Cash flows from financing activities are associated with the long-term financing of the company. This includes dividends paid out to those who have equity in the parent or holding company as well as debt financing such as new bank loans or the repayment of existing loans. In our example the company has acquired new bank loans of £2 million and has repaid existing loans of £6 million. The new loans may have been used to finance the acquisition of the new business.

As a result of all of the above cash flows there will be a net increase or decrease in cash and cash equivalents over the period.

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