Wednesday, 11 March 2009

Finance 101

(Sometimes when I start writing a post, it ends up in a totally different place to where I envisaged it going. This started off on Wednesday as a rant about cash flow.)

One of the courses I taught, back when I was a Trainer, was on project finance. The aim was to explain to a room full of (mainly) engineers how our company accounted for its projects. Each project had its own Project Summary Report: a project specific Profit & Loss Account and mini Balance Sheet. Relatively early in the day, I'd introduce some accounting principles and basic concepts to help prepare them for the sessions on the PSR.

Since it was highly unlikely that any of the engineers would ever be interested in accounting and finance, I used to make it personal and keep it personal for most of the session:

While we all know we need to "work for a living", most people don't view their efforts as selling their labour for cash or that the stuff we spend our money on is cutting into our personal bottom lines. Think about it for a minute. If you view your Cost of Sales as your essential living expenses, then everything else you spend your money on eats into your personal profit. If you can cut your Cost of Sales down further, then that too will make you a bigger profit. Of course, if you spend more than you earn, you will make a loss, going into debt to fund your lifestyle.

After the P&L came the Balance Sheet and then a discussion on cash flow.

(Here, I'm showing them the other way around, cash flow first. I set that slide up so that the smiley face danced across the page, whilst the frowny face bounced "splat" into place.)

In business, poor cash flow isn't indicative of making losses. However, if they can't get/keep cash within the business then no matter what the paper profits, the company will go bankrupt. It isn't what is earned that is the problem, it's running out of money to pay the bills and buy more supplies. Only very small businesses run on a purely cash basis - most offer credit to their clients, even if they don't realise it. You do the work, send out your invoice and wait to get paid. (Most employees do it, too. We work first, then get paid afterwards.) Running out of cash is the number 1 cause of bankruptcies.

A Balance Sheet is a business' Net Worth Statement. Continuing the concept of personalisation, in class, I'd use this example to explain the main headings:

I'd tell my trainees that Current Assets are things which you can harvest readily for cash - in most companies that'd be debtors, stock and work-in-progress. Current Liabilities are things which need to be paid fairly immediately (i.e. suppliers of your materials), or things which could be cancelled almost overnight like overdraft facilities.

We'd pull apart the example, concluding that this person has a positive net worth, but their finance situation isn't that rosy:
  • They have a lot* of credit card debt.
  • They have very little in the bank and no investments.
  • Their car has depreciated to a point where it is worth far less than the loan used to finance it's purchase (something that happens within 2-3 years on a brand new car).
  • To have chattels worth £5,000, they must have spent closer to £50,000. Chattels are personal possessions: furniture, clothes, household goods; again things which depreciate massively from the moment they are purchased. Think about it for a second: how many top of the range electrical goods are next year's old junkers? Technology changes very fast. (That got the guys thinking.) So does fashion - if you had to sell the clothes in your wardrobe, how much do you think they'd fetch compared to what you paid? (That got the girls thinking.)

In class, there would always be a few "light bulb moments" when the above sunk home. Inevitably someone would grab me at the break with questions about personal budgeting. Depending on how receptive I thought they'd be, I'd either recommend they check out the discussion boards at the Motley Fool or read the Tightwad Gazette.

- Pam

* All things are relative. When I created the example, the average British salary was £27,000.

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