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Corporate Financial Reporting by Gautam Koppala

Corporate Financial Reporting

This POME Chapter is designed to identify and define the key standard Financial Reports and Metrics required by Company Corporate Leadership to consistently and systematically measure financial results and key performance indicators across all the Strategic Business Groups (SBGs), where an SBG is defined as an operating business unit

Financial analysis refines the understanding of financial statements, taking on a scientific, structured focus that facilitates the interpretation of results. The use of both traditional and nontraditional ratio analysis shows you what other analysts see. Your growing ability to analyze problems will lead to the development of management actions, and a discussion of alternative courses of action.

 

Financial reports and metrics are compiled by the Company Finance function and reported to Corporate leadership and operating business unit management; however, at the discretion of the Strategic Business Group (SBG) or Strategic Business Unit (SBU), additional reports and metrics may be used for their own internal management reporting purposes.

 

Operating business units may not alter metric calculations or report to Company Corporate metrics using definitions other than those described in this POME Chapter.  Operating business units are encouraged to minimize the proliferation of financial reports and metrics that differ in format and content than those described in this POME Chapter.

 

SBG financial information contained in these reports and the basis for the metric calculations captures revenues and margins based on an “external” view in which inter-company (between SBGs) transactions are excluded.  Even though internally driven revenues are reported separately by each SBG, externally generated revenues and margins are the key measures for evaluating each SBG’s contribution to Company’s Net Income.  SBG external sales and corresponding margins are used for external reporting purposes and for internally measuring operating results.

 

This section provides:  1) an inventory of key financial reports and metrics, 2) a brief description of each key report, and 3) the calculation of key financial metrics used in the report including reference to Company’s common Chart of Accounts (COA).

POME Case Study:

Seeing Results

“Good morning. Please help yourself to some of the pastries and sodas on the table. Your efforts are really paying off. Our sales growth hasn’t slowed down at all, and our numbers tell us that we’re keeping our operations under control. Take a minute to congratulate yourselves for a job well done.

“You were going to analyze some of the ratios that weren’t under the obvious control of your department before we got together today. What did you look at and why did you select that ratio? I’ll be extremely interested to find out what you’ve learned from your investigation. And I really want to hear how our performance today compares with what we were doing before we started this program to teach everyone in the firm the basics of finance and accounting.”

Pat was the first person to respond. “My department’s been looking at a couple of these ratios and talking about how we can improve them during our weekly department meetings. We never really thought about how customer service could affect receivables before. But now our customer service reps have come up with really interesting techniques to resolve the problems some of our customers have been having with the A300 line and to encourage them to pay us faster. You can see that our average collection period was 65 days before the program started. It’s down to 56 days today, and when I had lunch yesterday with Mary from accounts receivable, she said she’d noticed a real difference since we initiated this new effort.”

Analysis of Financial Information

Traditional ratio analysis, a process used for many years by many financial analysts and Project Managers, looks at financial information in terms of liquidity, activity, profitability, and debt management, considering each measurement by itself. This analysis method helps the analyst develop an assessment of the company at the time of the statements analyzed. Nontraditional ratio analysis considers the relationships between financial data from an interpretive perspective, permitting the analyst or Project Manager to make judgments or decisions related to operations. Nontraditional ratio analysis recognizes that some information is as indicative of future performance as it is of past performance.

Financial analysis incorporates some of the tools used by analysts and Project Managers to assess the financial status and the financial condition of a company. Such analysis, utilizing financial ratios and analytical logic, provides information for assessment and is used by a wide range of interested parties. This POME Chapter explores these techniques and provides experience in analyzing financial statements and seeing the story the numbers can tell.

Exercises and interactive examples demonstrate how the techniques of financial analysis may be applied to functional responsibilities at the company level and at Project Managerial levels throughout the organization. Sources of comparative information are identified and use of the analytical tools is explained in depth.

Everyone in business wishes they had a crystal ball and could anticipate future challenges and opportunities, allowing them to take appropriate and effective Project Managerial action. Through the careful application of the tools of financial analysis, the Project Manager can gain insight that is close to that crystal ball.

Financial analysts, in conducting a financial analysis, generally compute and interpret several ratios, which are drawn from financial statements, followed by a written interpretation of the results of the computations. Ratios can be represented in one of the following ways:

• Comparative analysis, often called cross-sectional analysis or industry analysis, may provide some meaningful benchmarks for performance.
• Trend analysis, also known as historical analysis, compares a company against itself over time.
• Ratios may be a combination of both of the above. Ratios are grouped as follows:
• Liquidity—assessing the ability to meet maturing obligations
• Activity—assessing the effective utilization of assets
• Profitability—assessing operating performance
• Debt—assessing the management of borrowed funds, sometimes known as “coverage” ratios

 

Specifically, we will look at a group of ratios that have been described as Effect Ratios:[*] the Current Ratio, the Quick Ratio, Net Working Capital, Accounts Receivable to Working Capital, Inventory to Working Capital, Debt to Assets, Debt to Equity, Short-Term Debt to Equity, and Short-Term Debt to Total Liabilities. We will also look at period-to-period change in these measurements. These ratios highlight the application of financial analysis tools and the types of information that such an analysis provides. As we will see, they also give the analyst or Project Manager a good idea of where to look for additional information.

 

In addition to ratios and relationships within the two key financial statements, many ratios relate an element of the Income Statement to an element of the Balance Sheet. These ratios are also very valuable tools for assessing management and for identifying actions or situations that will affect future results. Among these ratios are Return on Assets, Return on Equity, Average Collection Period, Inventory Turnover, Fixed Asset Turnover, Total Asset Turnover, and Sales to Net Worth.

 

Liquidity Ratios

Liquidity ratios assess the ease with which a company can generate the cash to pay its bills, service its debt, and assure that it will satisfy the requirements of its current account creditors. Liquidity ratios recognize the relationships between the current assets and the current liabilities in the Balance Sheet.

Current Ratio

This ratio assesses the company’s ability to pay its bills on time, to meet its maturing obligations.

 

The Current Ratio provides a measure of the Project’s ability to meet its debts by comparing those assets the company expects to be converted to cash within one year to those obligations of similar time frame. Bearing in mind that the liabilities are often of shorter duration than, for example, the inventory, traditional analysis measures as acceptable a current ratio significantly greater than 1:1. However, a current ratio that is too large might indicate excessive liquidity—more than is required for normal operations. If liquid assets are too large, and too large relative to current liabilities, the assets in excess may not be earning as much return for the shareholders as they should.

The internal analyst, considering the current ratio, would be concerned first with any covenant requirements imposed by a lender and then with how well the Projects is using its current assets. For example, if the Projects holds substantial amounts of cash and marketable securities, its current ratio may be well above 2:1, but the Projects may be sacrificing earnings for liquidity. This results in less profit and less return to the shareholders, the real measure of success for a business. Cash provides a comfort to Project Managers, so there is a tendency for companies to hold cash “just in case.” Cash held as insurance may limit Project Managers’ flexibility to take full advantage of business opportunities. Therefore, the Project Manager analyzing the Current Ratio and cash balances needs to consider Project Managerial philosophy.

Quick Ratio

 

Similar to the Current Ratio, the Quick Ratio, also known as the Acid Test Ratio, removes Inventory, recognizing that it may be hard to turn inventory into cash quickly. Analysts from creditors look for a company to have more quick assets than current liabilities. Comparison of the Current Ratio and the Quick Ratio quickly demonstrates the importance of inventory to the assets of the company. Because inventory is less liquid than the other current assets, this comparison helps assess the overall riskiness of the Projects.

Net Working Capital (NWC)

An alternative measure, not really a ratio, NWC indicates how much current asset value is in excess of current obligations. It is expressed in the following formula:

Net Working Capital (NWC) = Current Assets – Current Liabilities

Although it is difficult to assess Net Working Capital, the amount of net working capital that a Projects has affects its ability to withstand a sales downturn. The level of net working capital is a measure of the financial strength and operational comfort of a Projects. The number also serves as the denominator of a number of ratios that help Project Managers assess the riskiness of the business.

Accounts Receivable to Net Working Capital

 

Extending the discussion of net working capital further, accounts receivable to net working capital provides a measure of risk or risk avoidance for a Projects. If this ratio is high, it suggests that if any accounts receivable are uncollectible or even delinquent, the Projects may have difficulty paying its bills on time.

Inventory to Net Working Capital

 

Similar to the previous ratio, Inventory to Net Working Capital is a risk measurement. It is even more important than Accounts Receivable to Net Working Capital simply because inventory is harder to turn into cash. The higher the ratio the greater the risk that some of the inventory is obsolete or otherwise unsalable. This will result in difficulty for the Projects to meet its obligations. This ratio not only measures an already established condition, but also provides a window into the near future.

 

 

Activity Ratios

The Activity Ratios, also known as Asset Utilization or Asset Management Ratios, assess how well management is managing the company’s assets and using them to generate revenues for the company. Since assets cost money, the efficient management of assets is a highly desirable criterion for good management practice.

Average Collection Period

Average Collection Period is also known as Days’ Sales Outstanding (DSO). It is particularly useful in doing corporate cash planning.

 

The denominator is described as average daily sales. ACP tells the analyst many things:

• It assesses the quality of accounts receivable.

Because most companies pay their bills on time, if the average collection period is high, it may indicate a problem with the collectibility of the accounts that are due.

• It provides a measure of credit management.

If accounts are overdue, it may indicate that the credit Project Managers are not doing an adequate job of evaluating the creditworthiness of customers or are not doing an adequate job of collecting accounts.

• It provides a measure of overall management.

To the extent that receivables are an important asset to keep current as collection provides the cash needed to run the business, a high average collection period may suggest that overall management is not paying enough attention to this area of responsibility.

• It indicates how long it takes to turn a sale into cash.

To the extent that the average collection period reflects the average time it takes to receive payment for sales made on credit, the Average Collection Period provides useful information for the Projects’s annual budget and its cash budget.

• It may hold an indication of future profits.

To the extent that a high average collection period indicates overly delinquent accounts, it may be masking truly uncollectible receivables. When management decides to recognize these uncollectible accounts, the accounting transaction to recognize them is:

Dr. Bad Debt Expense

Cr. Allowance for Doubtful Accounts

The consequence will be a reduction in profits by the bad debt, equal to the entire sale, as reflected in the uncollectible account. This will adversely affect profits in the period when the bad debt is recognized. At some time later, probably during the year-end closing, the accountant will create an adjusting journal entry to reduce both Accounts Receivable and the offsetting Allowance for Doubtful Accounts to remove the uncollectible account from the books.

If the Average Collection Period is higher than desired, management must analyze accounts receivable to identify the delinquent accounts and then develop an action plan to collect the overdue amounts and bring the Average Collection Period into line.

Note: The “360″ in the denominator is important:

• It should reflect the relevant time period. (For a quarter, the denominator would be 90.)
• There are really 365 days in the year, but the result is meant to be approximate. Analysts commonly use 360 because the computations are simpler and can easily be converted to months or quarters. It is perfectly reasonable and appropriate to use 365 if you so choose.

A companion ratio, Receivables Turnover, indicates how many times a year the average accounts receivable balance is collected.

 

Inventory Turnover measures the movement of inventory, and potentially, inventory salability. Different analysts measure inventory turnover in different ways. With the first example shown, it may be easier to get the information to calculate. In trend analysis it is a reasonable formula because the company will generally account for inventory consistently from year to year. In industry analysis, there may be more difficulty with comparisons as different companies have different gross profit margins, and therefore will have noncomparable turnover ratios. This is why many analysts prefer the second formula; both cost of sales and inventory have the same valuation basis, computed without any profit.

Similar to the assessment of accounts receivable, inventory turnover can easily be converted to measure average days in inventory by using a ratio similar to the day’s sales outstanding:

 

Inventory turnover is as important an indicator as the average collection period. If the number is low, it indicates that there may be excess inventory in the Projects. This, in turn, may indicate an obsolescence problem that will result in a write-off at some time in the future. Such an action will be reflected in Cost of Goods Sold and will reduce profits. The decision to write off excess inventory also requires its disposal. To write the inventory off and then keep it means that management feels it still has, or might have, value that conflicts with the write-off decision.

If the inventory is salable, but there is just too much of it, alternative actions have similarly unfavorable consequences. A decision to stop or slow production will result in layoffs or unabsorbed costs, which results in lower profits. A decision to stop or reduce purchases will distress vendors, particularly those to whom you owe money. They will seek to collect their receivables, your accounts payable, adding to the pressure on management just when it is concentrating on making the business better. Regardless of management action, the consequences of having excess inventory, reflected in a low inventory turnover rate, will be pressure on management and on profits.

 

 

Fixed Asset Turnover

This ratio assesses how well the company utilizes its investment in capital assets (i.e., its productive capacity).

 

A high result is generally perceived to be positive, but it may result from high sales relative to fixed assets or low fixed assets relative to sales.

If the high ratio results from high sales, it may indicate active and favorable use of expensive and important investment assets, but if the high ratio results from low fixed assets, it may indicate:

• old, fully depreciated assets in need of replacement
• a small investment in just the right productive assets

Inventory Turnover

 

If the high ratio results from high sales, it may indicate active and favorable use of expensive and important investment assets, but if the high ratio results from low fixed assets, it may indicate:

• old, fully depreciated assets in need of replacement
• a small investment in just the right productive assets If the ratio is low, it may be the result of low sales relative to fixed assets or of high fixed assets.

If the sales are lo

• this is a problem in itself.

If the fixed assets are high, it may indicate:

• excessive investment in capital assets
• prudent investment in the latest, as yet undepreciated, equipment poising the Projects for superior performance for many years to come

Clearly, as with so many ratios, the computation of fixed asset turnover leads to as many questions as it does answers, but generating the answers to these questions makes management smarter about the situation facing the business.

Total Asset Turnover

This ratio evaluates the utilization of all resources to generate sales:

 

Many analysts use asset turnover to assess overall management performance as well as to measure the effective utilization of invested funds. Studies have shown that low asset turnover is a strong indication of severe financial risk.

Many analysts use asset turnover to assess overall management performance as well as to measure the effective utilization of invested funds. Studies have shown that low asset turnover is a strong indication of severe financial risk.

Analysts also use total asset turnover to assess the overall health of the business. There is a very high correlation among businesses that have hard assets, that a low Total Asset Turnover indicates a fundamental weakness in the business. Total Asset Turnover is the most important component of Edward Altman’s “Z-score,”[*] which is used as an indicator of potential business bankruptcy.

The higher the Total Asset Turnover number, the more effective the Projects is in managing its assets and using them to generate sales. With sufficient sales, managing costs will lead to success. Without sales, without asset turnover, all the cost management effort will not be enough to make the Projects successful.

 

 

Profitability Ratios

Profitability Ratios are performance measures, assessing the company’s ability to cover expenses and reward investors. They measure the quality of sales and point to profitability and sales success.

Gross/ Operating Profit Margin

 

Calculating the Gross Profit Margin tells the analyst if the company’s products cover the cost of managing the company and bringing the product to market.

Specifically, we begin by looking at Gross Profit Margin, Efficiency Ratio, Operating Profit Margin, Net Profit Margin, Times Interest Earned, and Percent Change Measurements. These ratios highlight the application of financial analysis tools and the type of information that such an analysis provides. As we will see, they also give the analyst or Project Manager a good idea of where to look for additional information.

 

Profitability ratios measure the quality of sales and point to profitability and sales success. Calculating the Gross Profit Margin tells you if the Projects’ products cover the cost of managing the Projects and bringing the product to client.

Measuring Gross Profit Margin tells Project Managers inside the Projects if the sales in the period under study have been as successful and effective as planned or desired. If the answer is affirmative, you’ll want to understand what went right and how to perpetuate those results. If the answer is negative, you can examine individual products or product groups more specifically to identify particular products that are dragging the margin down, or you can consider other actions to improve margins by either raising prices or reducing costs. If you decide that costs have to be reduced, analyzing particular product or group margins may help you focus on specific costs to be addressed. As you can see, the analysis continues to drill into the information until you have a very clear idea of what caused the results you want to change. The whole approach is one of identifying causes and consequences and then identifying appropriate management actions to respond to what is learned in the analysis. Doing analysis without continuing to act on the information gained is a waste of time and effort.

To the extent that Project Managers can start with more focused information, such as the margins for products or product groups under their responsibility, they can begin this analysis at a lower, more detailed level and determine the appropriate actions more quickly. Therefore, as Project Managers you should request information specific to your area of responsibility.

Operating Profit Margin

This ratio may be a better measure of profitability than the Gross Profit Margin ratio. It measures the profitability of sales, without regard to source of financing. Operating Profit is Earnings before Interest and Taxes:

 

 

Accounting policies or financing methods do not affect Operating Profit Margin. For that reason, this ratio may be a better measure of business performance than either Gross Profit Margin or Net Profit Margin because it is calculated after accounting for all normal operating expenses, without regard to particular accounting or classification practices.

From an internal analysis perspective, the combination of the Gross Profit Margin and the Efficiency Ratio helps explain the Operating Profit Margin. All three help a Project Manager focus attention on the activities that are contributing to success or are detracting from it.

Operating Profit Margin is not affected by accounting policies or financing methods. It may be a better measure of business performance than either Gross Profit Margin or Net Profit Margin because it is calculated after accounting for all normal operating expenses, without regard for particular accounting or classification practices.

Efficiency Ratio

 

 

The Efficiency Ratio measures the costs associated with bringing products to market and supporting them. If this ratio is high or is rising, the expenditure of support funds may be too great for the revenues and margin provided. A rising efficiency ratio is an early signal that spending is outstripping revenues and jeopardizing success. In part this is because Selling, General, and Administrative (S, G, and A) expenses are usually considered fixed expenses, that is, they are not expected to rise in proportion to sales. If they do, it suggests that spending is not completely under control. If the ratio is increasing, spending is rising faster than sales, indicating that management needs to invest more attention to either increasing sales or controlling the spending. In many companies the determination of the Efficiency Ratio is the earliest warning that the Projects has management control problems.

Net Profit Margin

This ratio is also known as Return on Sales. It measures profit as a percentage of sales dollars.

 

This ratio is the most frequently used business performance measure, and is often used to compare one company’s results against others or against an expectation. It provides a measure of the overall performance of the company. This ratio is the most frequently used measure of business performance, and is often used to compare one Projects’s results against others or against expectations. We frequently hear about Net Profit Margin when analysts are explaining significant volatility in a Projects’s stock price.

The internal assessment of the Net Profit Margin may be more stringent even than that of the outside analysis. Understanding the components of the margin computation, the Project Manager should be able to identify the places within the organization where costs need to be controlled or where additional selling effort will yield higher returns to the Projects and its operations.

 

 

Return on Assets (ROA)

ROA measures profit earned as a percentage of the value of the assets:

 

It assesses how well management uses the assets to produce profits. Because the assets require financing, the effective use of the assets leads to an acceptable return for the sources of the financing.

It assesses how well management uses the assets to produce profits. It is related to the Return on Sales (Net Profit Margin) and Asset Turnover ratios considered earlier. It is affected by the level of sales the organization achieves and by the amount of investment made to achieve those sales. If the Projects underutilizes its assets, this ratio will be low and the reward to the shareholders will probably also be low.

 

Return on Equity (ROE)

ROE measures the reward to the shareholders:

 

This ratio serves as the basis for investors’ assessment of the business. They care most about the return provided to the shareholders. As far as they are concerned, the other evaluations are interesting, but are most important when considered from the specific perspective of the shareholder.

Even though in public companies, and even in some private ones, the dollars in equity do not reflect the amount actually invested in stock of the Projects, Return on Equity is a useful measure of how effectively management is generating a reward for the shareholders. Recognizing that the profits of a Projects belong to the shareholders, the ability of a Projects to earn profits and reward shareholders is generally reflected in the market price of the stock. Profitable companies have higher stock prices relative to poor performers.

 

Debt Management Ratios

Debt management ratios help the analyst assess the risk level and the effective utilization of debt funds. Recognizing that debt is an important, but challenging source of financing, evaluating how well debt is managed is a critical part of financial analysis. The following three ratios are used toward accomplishing that end.

Debt to Assets

This ratio measures the percentage of total assets paid for with other people’s money:

 

The higher this ratio, the riskier the overall business because the lenders, whether banks, vendors, or others, have a priority claim on company resources if management fails to meet its obligations. It, too, is a measurement of risk. The higher this ratio, the riskier the overall business is because the lenders have a priority claim on Projects resources if management fails to meet its obligations. Therefore, if this ratio is high, the lender may consider the loan at risk and may apply pressure to collect outstanding amounts, even if they are technically not due.

 

Debt to Equity

This ratio compares the dollars of borrowed funds per dollar of invested funds. There are two different formulas that are used and they tell us different things.

The first assesses the overall riskiness of the business:

 

The second measures the sources of long-term, or capital, funds:

 

As with the previous ratios in this grouping, Debt to Equity, computed either way, is a measurement of risk. In this case, however, it may also be used to assess the Project Managerial philosophy of the Projects. The greater this ratio, the more risk management is willing to take and the greater should be the return to the shareholders as a result.

As with Debt to Assets, if this ratio is high, the lender may perceive an uncomfortable level of risk, requiring personal guarantees by Projects principals or other measures to protect the lender’s interests.

Short-Term Debt to Equity

Short term debt to equity= (current liabilities/ total equity)

 

As with the previous ratios, this ratio, too, measures riskiness. In this case, however, the concern is with management’s choices. The higher this ratio, the greater the risk because short-term debt requires cash for repayment sooner, leaving less time for other management concentration. However, it is also true that short-term debt is easier to obtain than other forms of financing, and it is also less expensive, either directly, in terms of interest payments required for other forms of debt, or in expected return, for equity. Therefore, the higher this ratio, the greater profits should be and the greater the percentage return on equity should be as well.

One significant issue that arises when this ratio is increasing is whether the increase is intentional or the result of lack of attention by management to the support requirements related to sales growth.

Short-Term Debt to Total Liabilities

 

As with the previous ratio, this can be used to measure riskiness and to assess Project Managerial philosophy. The choice of financing indicates management’s comfort with risk. Short-term debt is easier and less expensive to attract than long-term debt because it carries lower risk to the investor However, it is riskier for management because it must be repaid sooner. Therefore, the attractiveness of the lower cost must outweigh the importance of the repayment obligation for it to be attractive to management. If management is really conservative, the decision to fund with short-term debt will raise concerns in the mind of the analyst who would expect a less risky Balance Sheet structure.

Times Interest Earned

This ratio assesses the ability of the company to service the company’s debt. The higher the ratio, the easier it is for the company to service its debt.

 

Although management is less interested in this measure than the bankers are, the Times Interest Earned calculation provides an early warning system for the Project Manager. If earnings are, or become, low relative to interest expense, the Times Interest Earned ratio provides a focused warning. It alerts the Project Manager to a banker’s concern before the banker recognizes it, giving management time to correct the problem or prepare the response that will satisfy the banker.

This same ratio may provide a vendor with important information as well because a Projects will generally pay the bank (often because the bank automatically deducts payment) before it pays a vendor.

 

Sales to Net Worth

Sales to Net Worth is also known as the Trading Ratio. The higher it is, the more difficult it will be to assure business success. The Trading Ratio is an early indicator that a Projects is growing faster or has grown larger than its resources can support without creating excessive risk. With a high Trading Ratio, equity is low, implying that the Projects is utilizing substantial debt to pay for its assets. The consequences are high return on equity, satisfying the shareholders, and high risk, distressing the lenders. Although high Sales to Net Worth by itself will not hurt the Projects, it makes the Projects very vulnerable to any downturn in sales. Consider the example in Exhibit below.

Exhibit: Sales to Net Worth: Early Warning System

As you examine these numbers, you will see a Projects that is growing very rapidly, is profitable, is retaining all of its profits, and is increasingly risky. The liabilities are increasing faster than the assets and much faster than the equity. The accounts payable, which reflect the means by which the Projects pays for much of its increase in accounts receivable and its inventory, are rising very quickly, making the Projects much riskier. Although the Projects is successful by most measures, management, through its actions, is creating a situation where any slowdown in sales growth will jeopardize the Projects. An actual decline in sales and the Projects would be unable to pay its bills, possibly causing the vendors to force it into bankruptcy.

 

Each of these ratios, and others that you can create from your own knowledge and experience as being of particular significance to you or your organization, offer a range of interpretations. It is extremely important to remember that no one ratio, by itself, should be used as a basis for decisions or actions. Additionally, it is rare that one year, or a single other period, is sufficiently significant to warrant dramatic action in the absence of corroborating evidence.

Nevertheless, we can look at these specific measurements and reach hypotheses that we can then substantiate and, if appropriate, respond to.

Effect ratios tell you something about what happened to bring the Projects to its present condition. These ratios include:

• Current Ratio
• Quick Ratio
• Net Working Capital
• Accounts Receivable to Net Working Capital
• Inventory to Net Working Capital
• Debt to Assets
• Debt to Equity
• Short-Term Debt to Equity
• Short-Term Debt to Total Liabilities

Crossover ratios and causal ratios not only tell you about past experience, they indicate future results as well. By focusing on causes as well as consequences, you, as a Project Manager, can have a dramatic impact on future financial performance. These ratios include:

• Return on Sales
• Return on Assets
• Average Collection Period
• Inventory Turnover
• Efficiency Ratio
• Net Sales to Net Worth

 

Report examples are provided below

Key Financial Reports and Metrics

Report Name

Distribution List

1. Sales Flash

CEO/CFO

1. Income Statement

CEO/CFO

1. Free Cash Flow Statement

CEO/CFO

1. Orders

CEO/CFO/SBG Presidents

1. Working Capital

CEO/CFO

1. Income Variance

CFO/BAP/IR

1. Functional Census & Cost

CEO/CFO/Corporate Sr. VPs/SBG Functional VPs and FT Leaders

1. General & Administrative Expense

CEO/CFO/Corporate Sr. VPs

 

 

1. 9. Indirect Spend

CEO/CFO/Corporate Sr. VPs/SBG Presidents

 

The comparison of statistics to comparable statistics from other time periods, sometimes referred to as “horizontal” analysis, helps the Project Manager identify areas of concern. Using a relationship in which the growth (or decline) in sales provides a benchmark against which to compare, calculating percent change focuses attention on those statement lines, those account groupings, or even those specific accounts that are not performing as expected. Comparing one time period to another helps management concentrate its attention on those areas of Projects performance that are achieving or exceeding expectations and those that are falling short.

An extension of the percentage change analysis recognizes that many accounts included in the Income Statement should not keep pace with revenues. The analysis of period-to-period change should enable a Project Manager to examine the reasons for increases in such ratios. Another way to recognize this is to compare the Income Statements of two or more years, not by dollars, but by percentage that the Income Statement lines are to sales.

 

Sales Flash Report

The monthly Sales Flash Report provides high-level external sales and operating revenue data.  The report includes:  segment revenue information by SBG and SBU for current month, quarter-to-date (QTD) and year-to-date (YTD); and shows comparisons vs. latest forecast, Annual Operating Plan (AOP) and Prior Year (PY).

 

Key Financial Metric(s):

Revenue Growth %

Current Period
Net Sales & Operating Revenue – External (FM 410000)

¸

Comparison Period
Net Sales & Operating Revenue – External (FM 410000)

-1

 

Income Statement Report

 

The monthly Income Statement Report shows the operating profit or losses at the consolidated Company level, Corporate level and by SBG.  For management reporting purposes, the Income Statement provides an “external view” as such inter-company transactions are excluded.  The report includes:  higher-level revenue and expense information for the current month, QTD and YTD; and shows comparisons vs. latest forecast, AOP and PY.

Key Financial Metric(s):

Variable Margin % (FM 920301)

 

Variable Contribution

¸

Net Sales & Operating Revenue – External (FM 410000)

 

 

The numerator in this metric calculation is Variable Contribution.  The following calculation is performed to report the “external” view of Variable Contribution:

 

+   Total Revenue (Internal & External) (FM 400000)

–   Total Variable Cost of Goods Sales (FM 510000)

=   Variable Contribution (FM 920300)

Gross Margin %

 

Gross Profit (FM 550000)

¸

Net Sales & Operating Revenue – External (FM 410000)

 

The numerator in this metric calculation is Gross Profit.  Within FM, the following calculation is performed to report the “external” view of Gross Profit:

+   Variable Contribution (FM 920300)

–   Total Fixed Cost of Goods Sold (FM 520000)

–   Other Manufacturing Costs (FM 521600)

–   Distribution & Logistics Expense (FM 530000)

–   Other Operating Expense (FM 540000)

=   Gross Profit (FM 550000)

Research, Development and Engineering Expense (RD&E) as a % of Sales

 

Research, Development & Engineering Expense (FM 560000)

¸

Net Sales & Operating Revenue – External (FM 410000)

 

Free Cash Flow Statement Report

 

The Free Cash Flow (FCF) Statement Report shows cash flow from operating activities less capital expenditures.  Financial performance is reported by SBG, Corporate, and the consolidated Company level.  FCF excludes investing activities (acquisitions and divestitures) and financing activities (debt financing and share repurchases).  This FCF Statement report is used exclusively for internal management reporting purposes; the external CF statement presents certain cash flow items differently than the management report, most notably in working capital.  The report includes:  current month, QTD and YTD; and shows comparisons vs. latest forecast and PY.

 

On the FCF statement, the sign convention of positive represents cash inflows and negative represents cash outflows.  Additionally, as a general rule:  an increase in Assets is a use of cash; a decrease in Assets is a source of cash.  Conversely, an increase in Liabilities is a source of cash; a decrease in Liabilities is a use of cash.

 

The FCF Statement report is the basis for measuring the cash producing activities of the operations on a year-over-year basis.  Certain events such as acquisitions, divestitures, and inter-company Balance Sheet transfers impact the ability to compare performance versus a similar time period.  In example, an acquisition could have a higher Accounts Receivables balance than the acquiring business.  As this would inaccurately reflect the acquirers’ performance on a year-over-year basis, adjustments, identified as Cash Flow Blocks, are made to recognize the cash outflows as investing activities instead of cash flow from operations, therefore not impacting FCF.

 

Functional Census & Cost Report

Functional Transformation (FT) is a Company-wide effort to standardize processes, eliminate non-value activities, digitize, and consolidate work within core administrative and business support functions.  The FT effort encompasses multiple functions including

 

Finance, Health Safety & Environmental (HS&E), Human Resources & Communications (HR&C), Information Technology (IT), Law and Contracts,  Procurement, Real Restate, and Security.

 

The monthly Functional Census and Cost report provides high-level Census, Cost, and Functional Cost as a % of Revenue for only five selected functions covered under Functional Transformation efforts:

 

• Finance
• Human Resources (HR)   Note:  Communications function is excluded from FT
• Information Technology (IT)
• Law / Contracts
• Procurement

 

Financial Reporting:

 

• Data is collected and reported for the four SBGs, Corporate departments plus Company Shared Services (SS), Global Credit and Treasury (GCTS) and Global Technology Services (GTS).
• Census data is segregated between Developed Markets (DM) and Emerging Markets (EM).
• Cost data is categorized into:

–      Compensation and Benefits

–      Other Employee Related

–      Purchased Services

–      Overhead / Other

–      Shared Service Billings

• Current month and Year-to-Date (YTD) information is reported and compared versus the  Annual Operating Plan (AOP) and Prior Year (PY).  Full year data for AOP, PY, and the 2004 baseline is also reported.

 

Key Financial Metric(s):

Functional Cost as % of Revenue

The source of Net Functional Costs are cost center reports pulled from internal data warehouses and General Ledger systems; however, certain adjustments are made primarily for acquisitions and divestitures occurring since the 2004 baseline year.  Net Sales & Operating Revenue – External is used; however, certain adjustments are also made primarily for acquisitions and divestitures.  Other POME Chapter adjustments are made by Corporate FT Finance to include / exclude certain financial data to ensure comparability versus the 2004 baseline.

 

Census Reporting

 

Functional census is reported based upon data supplied by PeopleSoft.  Census data is classified by Developed Markets (DM) vs. Emerging Markets (EM), and (currently) excludes temporary contractors / employees.

Functional Cost Reporting

 

Functional Costs are expenses incurred by a function, or department such as HR or Finance.  Generally, these costs are employee related expenses such as salaries, wages, fringe benefits, travel and entertainment, and other employee related costs, and also include payments to third party service providers necessary to manage the function effectively.

In order to drive cost control and facilitate cost analysis at the appropriate levels of functional management, expenses are captured using cost centers.  Cost centers are established logically to collect spending at the functional department level and are assigned to a manager who is responsible for budgetary spending control.  To facilitate cost reporting and analysis, separate functional cost centers must be used to properly segregate costs by function, more than one function should not be captured within the same cost center.

 

Functional costs are categorized into five major categories:

Compensation and Benefits

• Salaries, Wages, Benefits, and Rewards & Recognition

 

Other Employee Related

• Educational Assistance, Training, Travel & Entertainment, Relocation, and Recruiting

 

Purchased Services

• Outside Services – Non-Professional, Professional Fees, Consulting, Computers & Data Processing, Service Agreement
• Outside services – Non-Professional Includes to temporary, contract employees

 

Overhead / Other

• Contributions, Subscriptions, Memberships, Operating Supplies, Building & Equipment maintenance and repair, Rentals / Leasing, Depreciation / Amortization, Insurance, and Miscellaneous Operating Expenses
• Direct bills from certain Corporate functions

 

Shared Services Billings (SS, GCTS and GTS)

• All Shared Services Billings except GTS pass-throughs (also referred to as GTS variable charges)
• SBG’s should report Shared Services Billings according to the billing information provided by SS, GCTS and GTS

 

Specific Rules for FT Reporting:

 

• Functional census / cost directly associated with generating revenueis not included in FT reporting.  Example – IT cost associated with development of the ERPTM software application within  business.
• Factory overhead supporting plant operations is included in FT reporting.
• Administrative / secretarial support of functional executives is included within the  respective functions.
• Payroll processing, administration and master data maintenance is included under the HR function.
• Payroll accounting and taxes is included under the Finance function.
• Project administrators (with < 50% accounting / finance job content) are included under the Business Management function which is not tracked under FT efforts.
• Corporate billing for outside legal counsel and patent administration are excluded.
• implementation cost for SBG’s are excluded from total functional cost to ensure compatibility with 2004 baseline costs.
• Restatements for prior year functional costs are required for major acquisitions and divestiture activities and for major reorganizations.

 

Definitions of Functional Transformation (FT) Functions

 

This section describes the key processes performed within each function.

 

Finance – primarily responsible for the recording and accounting of business transactions in accordance with generally accepted accounting principles, budgeting, forecasting, and analyzing financial performance.  Listed below are typical Finance processes:

 

• Transaction Processing

-       Cash disbursements

-       Revenue cycle

-       General accounting and external reporting

 

 

• Compliance & Risk Management

-       Tax management

-       Treasury management

-       Compliance management

 

• Planning & Analysis

-       Planning and performance management

-       Business analysis

 

• Management & Administration

-       Management and administration – performance improvement

-       Management and administration – general

 

Information Technology (IT)– primarily responsible for the use of technology infrastructure and software application to support business processes.  Listed below are typical IT processes:

• Technology Infrastructure

-       Developing and supporting functions

-       End-user support and training

 

• Application Management

-       Application maintenance

-       Application implementation

-       Project management

 

• Planning & Strategy

-       IT support of business planning

-       IT strategy development

-       Technology research

-       Enterprise architecture

 

• Management & Administration

-       Management and administration – general

-       Management reporting

-       IT financial management

-       Supplier and resource management

 

Human Resources– primarily responsible for the management of employee human capital in areas such as hiring, training, career development, compensation and benefits and labor relations.  Listed below are typical HR processes:

 

• Transactional

-       Total rewards administration

-       Payroll services

-       Data management, reporting and compliance

 

• Employee Life Cycle

-       Staffing services

-       Workforce development services

-       Labor relations

-       Organization effectiveness services

 

• Strategy

-       Total rewards planning

-       Strategic workforce planning

 

• HR Operations

-       Management and administration – supplier management

-       Management and administration – general

 

Law/Contracts– primarily responsible for providing legal counsel to operating management in areas of contract negotiations, patent filings, and defending and pursuit of legal cases.

 

Procurement – primarily responsible for the sourcing of direct and indirect materials, and supplier management and development.  Procurement resources are a sub-set of the Integrated Supply Chain organization.  Listed below are typical Procurement processes:

 

• Procurement Operations

-       Sourcing execution

-       Purchase order processing

-       Scheduling

-       Supply data management

-       Receipt processing

 

• Risk Management

-       Compliance management

-       Supplier management and development

 

• Decision Support

-       Sourcing strategy and analysis

-       Product development support

 

• Management & Administration

-       Management and administration – general

General and Administrative Expense Report

 

The General and Administrative expense (G&A) report provides quarterly and Year-to-Date (YTD) cost walk for the SBGs and Corporate departments.  Prior Year (PY) costs are the baseline and the Current Year Actuals (or AOP or Forecast) are the ending point. Current year Annual Operating Plan (AOP) data and G&A as % of Revenue is also displayed.

 

The six major categories of the G&A cost walk are:

 

• Inflation – the primary inflationary drivers on G&A costs are merit increases and employee benefit cost (i.e., medical) increases, but also include period over period purchase price changes for goods and services.
• Foreign Exchange – cost changes due to changes in foreign exchange rates.
• Investments – cost changes to major investments (i.e., ERP implementations) or additional costs incurred to expand into Emerging Markets.

 

• Productivity – cost changes, generally decreases, driven by various productivity programs (i.e., Functional Transformation, SBU consolidation, site closures, procurement projects.)
• Acquisitions / Divestitures – cost changes due to acquisitions and divestiture activities to include incremental expenses incurred during integration efforts.
• Other / One Time Costs – this category is reserved to account for unusual and significant cost drivers (i.e., medical refund, vendor credits, changes in incentive compensation accruals)  Additionally, journal entry errors, timing differences and accounting changes are captured under this category.

 

 

The report is prepared four times per year – AOP, Major Forecasts (5+7, 8+4), and at Year-end.  At the discretion of senior management, the report may be requested on a more frequent basis.

Key Financial Metric(s):

G&A as % of Revenue

For both G&A expenses and Net Sales & Operating Revenues – External, certain adjustments are periodically made to adjust (recast) financial data for acquisitions & divestitures, significant Corporate one-time adjustments and incremental ERP expenses.

Indirect Spend Report

 

 

The Indirect Spend Report provides the total indirect spending for the Full Year (FY), Quarter to Date (QTD) and the Year to Date (YTD) by category and in total. The report highlights variances versus, prior year (VPY), AOP (V AOP) and the 2007 Target (V 2007 Target).  Additionally, the report highlights sales and percent of sales for the said periods as well as the associated variances.

 

The report is prepared monthly and distributed to the Senior VPs and the CPO and distributed quarterly to the CEO, Corporate Senior VPs, CPO and the SBG Presidents.

 

Conversion Cost (Definition)

in the Integrated Supply Chain.  Cost improvement would result in conversion cost reductions across all Company manufacturing plants.  Conversion cost is a component of Cost of Goods Sold (COGS) consisting of Variable costs and Fixed costs.  The following table lists the Corporate approved major cost categories of conversion cost:

 

Each cost category is classified as Indirect, Production or Non-production spending.  The Indirect classification is aligned with the Corporate approved definition of Indirect Spend.   The Production classification identifies conversion costs that are directly related with the production process within a plant.  Direct materials are not considered conversion costs while it is a major cost component of Cost of Goods Sold (COGS).  The Non-production classification identifies conversion costs that are indirectly related to the production process, however, not considered Indirect according to the Indirect Spend definition.

In addition to the three classifications previously explained, the conversion cost categories are also classified as controllable or uncontrollable costs. Controllable costs are defined as costs that a plant manager has full discretion in reducing or increasing at any given moment.

 

The 10 major categories of conversion costs can be broken into 20 specific categories.  The following table contains the category description and classification of each:

 

 

IV.     Other Financial Metrics

Revenue / Operating Income Conversion %

 

This metric is primarily used to analyze period over period revenue conversion to operating income.  This metric is primarily used to review quarterly performance.

 

Compounded Average Growth Rate (CAGR) %

Current Period
Net Sales & Operating Revenue – External (FM 410000)

¸

Comparison Period
Net Sales & Operating Revenue – External (FM 410000)

 

This metric is primarily used in analyzing growth rates in revenues and income over multiple periods.  It is used primarily during the Strategic Planning (STRAP) process.

 

Average Annual Growth Rate (AAGR) %

 

This metric is primarily used in analyzing growth rates in revenues and income over multiple periods.

DuPont Analysis

As an extension of traditional ratio analysis, financial analysts have long sought to understand the interrelationship between different ratios and what they suggest about the way that a company is being managed and what is happening to the company overall. Analysts at DuPont have long been among the most creative and insightful reviewers of financial information and of a form of analysis that serves to integrate several ratios into a commentary on a company’s situation. Long ago they recognized the importance of Return on Equity (ROE) as a measure of the reward to the shareholder, but they recognized that Return on Equity was a consequence and not a predictor of company performance. They also recognized that looking at ROE in terms of other ratios would provide a different insight. Therefore, they looked at ROE much as we looked at relationships during our early school years. They suggested that ROE, presented as a ratio could be restated into component ratios in the following manner:

 

And that this relationship could be further analyzed as:

 

where the first ratio is now Return on Sales, the second is Total Asset Turnover, and the third is known as the Equity Multiplier. When decomposed into these three elements, Return on Equity can be analyzed for its cause or causes.

The level of return to the shareholders may be as a result of profitability on sales, or utilization of assets in generating sales, or the relative amounts of debt and equity making up the sources of financing for the company. By determining the cause of a business’s success or lack of success, an analyst is in a position to assess management performance or to make recommendations for future management actions.

 

Some of these ratios can predict what’s going to happen, even as they tell what has already happened. Though traditional ratio analysis groups ratios into several clearly defined categories, it focuses on explaining the current condition of the company. However, financial analysis is really useful in guiding management actions in the future, because, after all, we cannot change what has already happened. By regrouping the traditional ratios into those that are the consequence of prior decisions and those that are anticipatory or predictive of future results, Project Managers are able to focus more attention on actions that will improve future results. Those ratios that point to future results can be classified as causal rather than as consequent or effect ratios.

You can easily construct other ratios to tell you interesting information. Consider what you can learn by constructing a ratio such as Miscellaneous Assets to Net Worth, which may be very meaningful particularly in privately held companies.

Miscellaneous Assets are often those assets that make working for the company enjoyable but do not return any income to the Corporation Based Projects . They often include such things as loans to officers, loans to employees, recreation facilities for employees (such as a boat or a racquetball court), fine art for the company headquarters lobby, and investments (often in companies unrelated to the business).

These assets generally do not earn a return on their investment. In other words, sooner or later such nonprofitable investments can be expected to affect overall financial performance negatively. In addition, they have diverted funds, and possibly management attention, away from productive use by the company.

When we think about analyzing financial statements, we start with the chart of accounts, the systematic listing of categories into which we separate all financial information. If we set up the chart of accounts so that it is easily grouped into the sequential lines of the financial statements—by tradition the Balance Sheet comes first, followed by the Income Statement—the routine recognition of activities and obligations will almost automatically produce appropriate financial statements. Furthermore, the user of the financial statements, generally an owner or Project Manager, will know exactly where to get additional detail whenever a particular account or financial statement line item raises questions, either favorable or unfavorable.

We begin this analysis by looking at the Income Statement, followed by the Balance Sheet. Interestingly, we tend to look at financial statements by focusing first on the Income Statement, the report of performance, before looking at the Balance Sheet, the results of performance, even though the Chart of Accounts starts with the balance sheet accounts. This is because performance leads to the changes in the Balance Sheet accounts, rather than the other way around. We then consider a variety of financial ratios grouped in a different way, tied to the source of the information or to links to other measures. Unlike ratios grouped by liquidity, activity, profitability, and debt management, looking at these ratios in the context of th

About the Author

GAUTAM KOPPALA, With over   a decade, track record of successful leadership, excellent results through strategic skills in driving revenue and profit growth. Demonstrated ability to identify and trouble shoot critical issues impacting productivity, cost, distribution, marketing, Strategic positioning, sales and financial operations, with innate ability to build and maintain strong client relationships in operations. Expert in distilling and managing processes, enhancing internal structures, and promoting multi-skilled team competencies via nurturing mentorship and inspirational leadership. Engagements have spanned operational, strategic, technological and change management roles. Academically, I am a cum laude graduate with a Bachelor of Technology degree in Electrical and Electronics Engineering (B-Tech E.E.E.) and a post graduate in Masters in Human Resources Management (M.H.R.M.) and Masters of Foreign Trade (M.F.T.). As you will see my Post Graduation’s were been studied part-time, as well as working full-time as an Engineer. I feel that this demonstrates my ability to maintain dedication, motivation and enthusiasm for a project management over a long period of time. In addition, balancing full-time work with study has perfected my time-management and organizational skills. I believe that my college degrees and gamut certifications in combination with my extensive broad-based work experience along with my drive, resourcefulness and determination, would make me an excellent candidate for a senior management position with any company. Highlights of my background include Operations related Commercial, Supply chain, Sales with a magnificent experience in Project management, technically oriented towards Automation and Security Systems in Industrial and Building sectors. Presently, writing a book on Projects and Operations Management (comprise of 12 volumes, 6K pages), and awaited for the reputed publications. These books can be checked in Google books and other search engines too.

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