Introduction to

Financial Management
 Overview of Financial Management

Professions typically develop standard documentation; so ubiquitous as to

impact more than 90% of the group in practice.

Examples

(1) Doctors: Medical charts

(2) Chemical engineers:

Process flow diagrams and piping and instrumentation diagrams

(3) Electrical engineers: Circuit diagrams

(4) Architects and civil structural engineers: Plan and elevation drawings

(5) Construction engineers: WBS, CPM, PERT

 Overview of Financial Management

Financial Statements
 Standard documents for doing businesses;
 Apply to all sizes of business.

Answer Three Key Questions

(1) How much do we make and how much do we keep?

 Income statement
 Statement of retained earnings

(2) How much do we have and where does the money come from to get it?
 The balance sheet
(3) Where did our money go?
 Statement of cash flow
 Overview of Financial Management

Financial Statements Are Part of a Chain

(1) Bookkeeping
(2) Accounting
(3) Financial statements
(4) Financial Analysis
(5) Action

The process turns data into information and into action.

 Emphatically, no need to be an accountant to understand financial

statements and do intelligent financial analysis;
 Equally, you can not be a good manager if you can not do such analysis.

The purpose of financial analysis is to guide action.

 Money

For almost all enterprises, money is an appropriate measure of value.

Business takes money to get things done to create value.

Two Flavors of Money (and a Hybrid)

(1) Debt

(2) Equity

They are so different in values and rights that need to be tracked differently.
 Bookkeeping
Business transactions:
Product or service sales for cash
Product or service sales to be invoiced and paid at a later date
Asset sales (e.g., used equipment that has been replaced)
Purchase of raw materials (for cash or future payment)
Purchase of services from third parties
Purchase of fixed assets
Payment of salaries
Payment of office expenses such as rent and utilities
Payment of taxes
Borrowing of money
Repayment of borrowed money
The investment of new funds (equity) into the business
A dividend to investors
 Bookkeeping

Journals

 Each transaction (should) generates a paper trail.

 Bookkeepers note every transaction taking place in a business.
 Capture raw data and put it into first level categorization in a journal.

Journals are chronological and by subject area.

Balance in Financial Accounting

 Energy accounting: in ordinary thermodynamics, energy is neither

created nor destroyed; a zero sum game.
 Financial accounting: financial credits and debits always balance.
 Bookkeeping

Double Entry

Journals are double entry, with offsetting credits and/or debits.

Debit

(1) An increase in an asset account

(2) A decrease in a liability account (including shareholder equity)

Credit

(1) A decrease in an asset account

(2) An increase in a liability account
 Bookkeeping
Double Entry Examples

1. ABC Co. borrows $40,000 and uses an additional $25,000 of cash to

buy a machine.
 Fixed assets (equipment) account increases by $65,000.
 Debit
 Bank loan account increases by $40,000.
 Cash account decreases by $25,000.
 Both are credit.

2. A customer pays ABC Co. $10,000 for goods received 30 days ago.
 Cash account goes up by $10,000.
 Debit
 Receivables account goes down by $10,000.
 Credit
 Bookkeeping

Five Ledger Categories

Journal entries are transferred to five categories of ledgers:

(1) Revenue

(2) Expense

(3) Assets

(4) Liabilities

(5) Shareholders equity

Debits and credits are separated, each being put into appropriate account.
The sum of all accounts should balance. Why?
Such balance is checked periodically, usually monthly.
 Bookkeeping
Trial Balance
Lana is the accountant of ABC Co. that commenced business a month ago.
She extracted her trial balance on the last day of the first month as shown
below. It failed to balance. What is the reason of this non-balance?
 Bookkeeping

Trial Balance

Solutions
 Progression of Financial Management

Accountants assemble ledger level data into financial statements.

Financial analysts analyze financial statements and make suggestions.
Managers make decisions and implement them.

Sequential Activities:
 Transaction
 Journal
 Ledger
 Financial statements
 Financial analysis
 Decision making
 Implementation

From bookkeeper to accountant to financial analyst to manager.

 Accounting

Accountants takes the accounts and consistently display the results in

standard formats:

(1) Income statement

(2) Statement of Retained Earnings
(3) Balance Sheet
(4) Statement of Cash Flow

 Year to year consistence is crucial; standard formats are not.

 “Materiality” governs adjustments and corrections.

 Materiality
Mistakes are inevitable given the many transactions recorded daily.
Do all these mistakes have to be corrected?

Material or Not?

Case 1: A miscoded $50 item on a $2.0 million project will not be

corrected if the books have been closed.
 Correcting minor mistakes unlikely to add any insight into the business;
 “Not material” and the correction is not to be made.

Case 2: An error of $50,000 on a $2.0 million project would likely be

corrected by a “post period adjustment”.
 “Material” and the correction has to be made.

Companies need to define standards for materiality.

 Timing Issues

Example

A company makes large steel vessels for the petrochemical industry.

It takes several years to fabricate.

Various costs incurred in each period of the manufacturing process:

 Steel purchased early in the process
 Fittings (e.g., nozzles and valves) purchased in various periods
 Direct labor charges over the course of manufacturing
 Timing Issues

What is the profit of the company in each month/year?

Profits is simply Revenues – Expenses.

If expenses and revenues were shown in accounts as they were realized,
the company would
 show a loss over many months/years, and then
 an enormous profit in last month/year when payment is received.

Problem

Virtually impossible to determine how the company was really doing

financially.
 Timing Issues

How to Avoid the Problem?

Accrual accounting matches the timing of expense and revenues.

 Revenues and expenses are recognized in the same time period.

 To postpone expenses as assets until the sale is booked:

1. Initially, steel and fittings are held in raw materials inventory.

2. In the manufacturing process, steel, fittings, and direct labor charges
are held in work in progress;
3. Vessel not shipped at completion is held in finished goods inventory.
4. At the time of sale, finished goods inventory is converted to cost of
goods sold; Cash not received yet, and receivable is created;
5. At the time of payment, receivable turns to cash.
 Timing Issues
Conclusions

Lining up revenues and expenses into the same time period facilitates
the management in analyzing the performance of the business.

One key question: Is the company creating value?

Financial statements give insights into the business and allow informed
management decisions.

The accounting procedure is complicated:

 The same steel and fittings move from raw materials inventory, work in
progress, finished goods inventory, to ultimately COGS.
 The same product (vessel) goes from sales revenue, receivable to cash.

Complexity is more than offsetting by the insights the information provides.

 Financial Statements

Accounting is a rigorous profession with many rules and standards.

With some training, an engineer can understand financial information

once it is in the form of financial statements and make informed decisions.

Income Statement

 How much money (value) did we make in a given time period?

 e.g. a month, a quarter, or a year;
 Measures profitability.
Example: Income Statement of XYZ Co. for the Year Ended 2015
 Financial Statements

Statement of Retained Earnings (SRE)

Of the money made, how much has been kept in the business vs. being
paid out in dividends to the owners?

SRE is cumulative:
 Showing how much earned value has stayed in the company since
the start of the business.

SRE is also incremental:

 Showing the most recent year, i.e. how much money was kept in the
business in the last year.
Example: Statement of Retained Earnings of ABC Co.
for the Year Ended 2015 ($000)

Retained Earnings, December 31, 2014 2,341

Net Income for the year 2000 389

Less: Dividends paid, 2000 125

Retained Earnings, December 31, 2015 2,605

 Financial Statements
Balance Sheet
How much asset does the company have at a given point in time?
Where did the money come from to acquire the various assets?
Balance sheet measures the wealth of the company.

It is at a point in time; company’s assets and liabilities change day by day.

Customers:
 Buy goods and pay their bills;
 Return sub-quality products.
Company:
 Buys raw materials/equipment;
 Pays its bills and payroll;
 Borrows a loan from a bank.
Example: Balance Sheet of John Co. as End of 2020 ($000)
 Financial Statements

Statement of Cash Flow (SCF)

SCF is for a period of time:

 How much money flowed into and out of the company in some time
period.

 SCF is usually prepared on the same time basis as Income

Statement, i.e. monthly, quarterly, and/or annually.

Activities affecting cash flow are classified into three categories:

 Operating activities
 Investing activities
 Financing activities
Example: 2020 Statement of Cash Flow of 123 Co. ($000)
 Understanding a Business
Historical and Societal Perspectives

 Historical versions of the documents; social events and impacts;

 To pore over so that actions are appropriate and helpful.

Managing an existing business or buying a stock:

(1) Growth
(2) Short-term and long-term profitability
(3) Justification of business activities

Founding a company?
Need to develop Pro Forma Statements for

(1) Financial feasibility analysis;

(2) Backing outside financing.
 Operational vs Financial Management
Financial analysis facilitates good judgments and sound decisions about
operational and financial management.

Example

Two companies making identical manufactured products.

(1) has less wasted raw materials

(2) uses less labor per unit

(3) has less inventory
Company A
(4) has more sales

(5) has lower marketing costs

(6) has fewer units returned for warranty claims
 Operational vs Financial Management

What conclusion can be made?

Company A is better!
From what perspective?
Much more operationally efficient than Company B.

What will you do if you are shareholders of Company B?

You may ask the management team why Company A was so much better
at using resources, assets and staff to make and sell goods.

What will you do if you are shareholders of Company A?

You may reward the management team on operating the physical assets
of the company so well to create value in the process.

Do the management deserve?

 Operational vs Financial Management

Imagining Following Situation for Company A

 Having paid excessively high dividends over the years;

 Depleting its cash reserves;
 Increasing its debt to a high point;
 Very bad financial and economic conditions in the current year.

Consequence to Company A

 Cannot pay back the debt;

 Bankrupt in the current year;
 Owners suffer a great loss.
Operational vs Financial Management

Consequence to Company B
 Less dividend paid to owners over the years;
 Has built up cash reserves;
 A low debt level;
 Ride out the bad financial year.
 Operational vs Financial Management

What conclusion can be drawn from this example?

Company A:
 Financially reckless;
 Better operational but poor financial management skills.

Company B:
 Quite conservative;
 Poor operational but better financial management skills.

Many companies get bankrupt when they can not service the interest and
principal payments on their debt.
 Operational vs Financial Management
Operational Management
 How efficient in using resources to deliver a product/service that
meets customer's needs.
 Delivering more value while consuming fewer resources

Resources: Money, materials, assets, and manpower

Financial Management

Less clear, but not less important. Normally involves:

(1) Combining appropriate amounts of debt and equity
(2) Meeting obligations to lenders and suppliers and
(3) Rewarding equity owners with a growth and dividends

To ensure a company stays healthy and if needed it can attract more debt
and equity in order to grow.