Importance of "Financial Planning & Analysis"

What is FP&A?

There is no specific definition for FP&A at the moment. Wikipedia defines Financial Planning as “the task of determining how a business will afford to achieve its strategic goals and objectives.”

FP&A provides decision support to the management in visualizing short term and long term objectives, assessing their viability and ensuring their fulfillment through continuous monitoring. FP&A is the function that helps management take important decisions pertaining to the profitability and other financial health of the organization. It also provides sufficient information to the management in envisioning the future.

Elements of FP&A:

The basic elements of FP&A are forecasting, budgeting, reporting and analysis. But it could also include other areas such as resource allocation, IT support, Operations support and HR support. Each of the individual elements is a subject in itself. However, let’s attempt to understand the core elements in brief with day-to-day examples.

Forecasting:

All of us have some amount of savings and we want to invest it somewhere. What do we do as the first step? We shortlist some companies based on their past performances, extrapolate their past performance and see what is the amount that we can make out of the money invested. This is akin to Forecasting – an integral part of FP&A.

In the context of a corporation, forecasting can be defined as the periodic prediction of future trends considering the current internal and external factors. Usually, this is done by analyzing and extrapolating the past results and applying known anomalies to past trends.

Budgeting:

We all budget our expenses. At the beginning of every month, we draw up our expense statements and determine the amount we can afford to spend what we’d like to save.

In a corporate scenario, budgeting involves drawing out a detailed financial plan and establishing a goal for the future period. It usually details the various financial elements and its drivers considering the capabilities of the business. This activity is done before the beginning of the year and is drawn out by month.

Reporting:

At periodic intervals, we all get appraisals at our workplace or we get to attend the PTA meetings at our child’s school. What we get to hear is a summary of past performances and our standing with respect to expectations.

In a corporate scenario, we engage in reporting to measure the events in a particular period. Reporting can be defined as providing of information at periodic intervals to various stake-holders that enables them to take important decisions. Stake-holders include management, business partners, investors, creditors and debtors. Information could be related to past performance, future plan, strategy, objective and market standing among others.

Analysis:

When we overspend, we try to see where we are over-spending, what expenses can be controlled, and how we strayed from what we initially planned. This is essentially an analysis of household expenses.

In a corporate world, financial analysis can be defined as assessment of the financial aspects of an organization including deployment of funds, profitability, investor protection, business viability and market standing. It usually involves the understanding of ratios, comparisons with Budgets and Forecasts and detailed study of the financial statements. This activity not only helps understand the problems and provide decision support, but also visualizes opportunities and ensures better performance.

FP&A in Corporate World:

In a corporate scenario, FP&A function usually comes under the direct purview of the Chief Financial Officer or the Director - Finance. The activity involves liaison with various departments, understanding their functions, their impact on the Business and providing support to take important business decisions.

The core FP&A team caters to various departments like the Finance, Operations, HR, Corporate, Procurement, Quality, Sales and Marketing etc. In short, FP&A function is that thread of every organization that beads various departments together and ensures achievement of their common goal. In addition to providing timely reports and analysis, FP&A also provides support for redesigning the systems used for accounting, reporting etc.

FP&A is set up by every Product and Line of Business in an organization. In some cases, it is also sub-divided by function and areas in which the business is carried on. In fairly large organizations, there are different people sourcing to different sub-divisions and conversely, in small organizations, one person caters to all divisions.

Why FP&A?

To summarize the points discussed above, a few important reasons why FP&A is required in organizations:

FP&A aids in -

Envisioning the short-term and long-term objectives

Driving performance

Meeting and overachieving Internal and external expectations

Timely identification and correction of financial or operational concerns

Understanding the reasons for variances to expectations

Strategic analysis

Identifying opportunities and providing decision support to capitalize them

Outsourcing FP&A:

FP&A is now being outsourced to other countries and there are fairly large organizations that now have their FP&A setup in India. FP&A function requires being closely associated with the Business and also requires involvement with many departments. Hence, FP&A in India is now becoming a little more than an accounting job, unless reasonable analysis is involved.

To overcome this, it is very important for the offshore FP&A Analyst to allocate quality time to analysis and to ensure that we do not get too caught up between deadlines and mundane activities. It is also imperative for the offshore qnalyst to maintain contacts with the business as proximity will be a challenge. Regular visits to the business concern, wherever possible, will help.

The advantages of having an offshore FP&A are numerous. Offshore FP&A activities not only ensure cost savings but also help in standardization. The assumptions underlying the financial reports are standard across all products and regions. Also, Forecasting and Budgeting are processes involving assumptions about future events. Catering to these requirements in a unified manner ensures that all the assumptions are standard.

FP&A is a very dynamic and interesting function of finance. It requires the analyst to be deeply involved with the business and to understand not only the numbers, but also the science of running the business. It is therefore, very important for the analysts to understand the business before jumping into the numbers in order to keep the essence of “A” in FP&A alive.

Schedule VI of Companies Act under revision

The government has decided to revise schedule VI to the Companies Act, which stipulates the manner in which every company prepares and presents its balance sheet and profit and loss account. The revision aims to harmonise and synchronise the general disclosure requirements under schedule VI with those prescribed in International Financial Reporting Standards (IFRS), which India will adopt from April 1, 2011. The draft of the revised schedule VI is available at the web site of the Ministry of Corporate Affairs (http://www.mca.gov.in/).

The extant schedule VI does not require companies to classify assets and liabilities into current and non-current categories. As a result, some items of assets, which should be classified as non-current asset, are included in current assets. Examples are deposits which the company does not expect to realise within 12 months after the balance sheet date, that part of loans and advances that will be recovered after 12 months from the balance sheet date and those items of raw materials and components which are not expected to be consumed within the normal operating cycle. Similarly, non-current provisions and current provisions are clubbed together. At present the total amount of the provision is clubbed together with current liabilities. The draft revised schedule VI requires companies to classify assets and liabilities into current and non-current categories. This will definitely improve the usefulness of the balance sheet.

Conventionally, current asset to current liabilities ratio (current ratio) is calculated to evaluate the liquidity of the company. In absence of proper classification of assets and liabilities into current and non-current categories, this ratio gets distorted. Disclosure in the revised schedule VI will remove this distortion.

It is expected that the Companies Act will be revised to enable companies to classify redeemable preference shares as debt (loan fund). At present redeemable preference shares are classified as equity. IFRS requires that companies should classify redeemable preference shares as debt because a company has no discretion but to repay the capital. Therefore, redeemable preference shares represent an obligation present at the balance sheet date. Accordingly, it should be classified as debt. This classification will improve the analysis of financial statement. Provision in the Companies Act relating to preference shares, including provisions related to redemption of preference shares will require change.

Another important revision is the requirement to present accumulated loss as a negative amount under reserves and surplus. The proposed revision of schedule VI to the Companies Act 1956 stipulates multi-step format for the presentation of profit and loss account. It requires companies to disclose gross profit in the profit and loss account. It also requires allocation of operating expenses into selling and marketing expenses and administrative expenses. This will bring a significant change in the current structure of profit and loss account. This will require a company to apportion common expenses to different functions/activities. Companies should apply the Cost Accounting Standards, wherever applicable.

The disclosure of gross profit by companies will be useful in analysing financial statements. Gross profit is the difference between the amount of net sales (that is sales less excise duty) and the cost of goods sold. Revised schedule VI uses the term cost of sales instead of the term cost of goods sold. In a merchandising business the cost of goods sold is the total of costs incurred to bring the goods to the location and condition of sale. Thus, it includes expenses on inward logistics. For a manufacturing company cost of goods sold is total of costs incurred to manufacture the goods sold and the costs to bring the goods to the location of sale. Analysts use the gross profit ratio to evaluate the manufacturing efficiency of a manufacturing business and the efficiency of procurement and inward logistics of a merchandising business. However, the ratio is less relevant for a company that has significant operating expenses. The reason is that the gross profit ratio may be improved by improving sales through advertising and product promotion expenses and expenses on improving the efficiency and effectiveness of the distribution channel. Sales promotion and similar expenses are included in operating expenses and not in cost of goods sold. Therefore, gross profit ratio might be misleading.

The next level of profit is the operating profit. This is the difference between the gross profit and selling and marketing expenses and administrative expenses. Operating profit to sales ration measure the operating efficiency of the company. Operating expenses to sales ratio (operating ratio) is complementary to the operating profit to sales ratio. Certain expenses which do not have a direct cause and effect relationship with the revenue for the year are called discretionary expenses. Examples of discretionary expenses are training expense and research expense. The proposed schedule VI does not provide guidance on whether they should be included in cost of goods sold or in general and administrative expenses. If they are included in cost of goods sold, the amount of gross profit will be distorted. Therefore, they should be included in general and administrative expenses. The final revised schedule VI should provide adequate guidance on this issue.

Sometime analysts calculate earnings before interest, tax, depreciation and amortisation (EBITDA) to sales ratio to evaluate the profitability. The ratio is called cash profit ratio. This ratio is useful to calculate the margin over current expenses, particularly in capital intensive industries like the telecommunication industry. Profit and loss account provides information required to calculate EBITDA.

Revision of schedule VI is due for a long period. The government has taken it up now because of the compulsion to bring it in conformity with the requirement of IFRS. It is true that the format and requirements for the preparation of financial statements cannot be revised frequently. Frequent revision has the potential to confuse the investors. Therefore, after this revision, the next revision will wait for long. Therefore, the government should take this opportunity to make it mandatory for companies to disclose the amount of economic value added (EVA), in addition to the disclosure of earning per share.

EVA is calculated as follows: Invested capital × (ROIC - WACC). ROIC is the return on invested capital and WACC is the weighted average cost of capital. If a company fails to earn return on investment higher than the WACC, it destroys value. If a company earns return on investment higher than the WACC, it creates value. When a company's return on investment is just equal to WACC, it neither creates value nor destroys value.

EVA cannot capture the total value created by a company that creates value by managing intangibles because most intangible assets are not recognised in the balance sheet. EVA is being considered the most relevant measure to assess the operating efficiency in a particular year. Many companies disclose EVA voluntarily.

India will adopt IFRS from April 1, 2011. It is the time to speed up the changes in the regulatory environment for seamless implementation of IFRS.

P&L A/C IS NOT FACT: IT CAN BE MANIPULATED

The Comptroller and Auditor General's ( CAG) estimates of government losses and corporate gains have stirred much controversy. Supreme Court Chief Justice S H Kapadia attempted to elucidate valuation principles in a recent speech. He reportedly said, "Today, a number of controversies on valuation are discussed but the basic principle of valuation is that loss is a matter of fact and profit or gain is a matter of opinion. Please apply this test to the controversies going on. I do not want to discuss anything further. Loss is a matter of fact and profit and gain is a matter of opinion. So, if you understand these principles, we will be able to judge." 
I cannot make sense of this. I know of no principle in economics or audit that says losses are real but profits are not. One principle actually enunciated widely is "cash is a fact, but profit and loss are opinions". That's very different from the Chief Justice's claim. 
In 1975, the Press Club asked me to explain a puzzle. Its accounts showed a profit, but it had no money in the bank. Where had the profit gone? I soon found the answer. The accounts showed all receivables as 'income'. But many members had not paid their bills, so the receivables had not been received! There was a paper profit, but a cash deficit. This was no error: audit rules specifically permitted this. This accounting practice was widely used by the biggest corporations. Some showed huge profits, but showed even bigger sums owed to the company by 'sundry debtors'. Such companies had a big paper profit, and even paid taxes on this profit, yet had a cash deficit. 
Beyond a point, treating receivables as profits becomes sheer pretence: the sums should be written off as unpayable. Some companies do writeoffs honestly, but others resort to 'ever-greening' dud loans, quite legally. Given such accounting flexibility, loss and profit are clearly matters of opinion, and can be manipulated to suit the company's strategy. Again, a company's balance sheet may not show all assets and liabilities: some can legally be kept off balance sheet. This enables companies to hide enormous liabilities off the books, showing a very healthy but misleading picture on their books. A classic example of this was Enron, which looked highly profitable, but accumulated such huge debts offbalance sheet that these ultimately sank the company. Citibank's off-balance sheet activities helped sink it in the 2008 collapse.
Profit is not a clean, unclut-tered concept. Operational profit is income minus expenses. But after that you have to deduct interest on loans, amortisation of old loans, depreciation and taxes. Here again, much flexibility is legally permissible, allowing a company to show profits or losses as it chooses. Contrary to Kapadia's claim, all losses are not a fact. Back in the 1980s and 1990s, India had many large companies (notably Reliance) that paid no corporate tax.

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FOREIGN WORDS FREQUENTLY USED IN LAW

ab initio: 

 from the beginning.

locus standi: 

signifies a right to be heard.

ad hoc:

for particular purpose, pertaining to or for the purpose of, this case only.

mens rea:

a guilty mind.

ad interim :

in the meantime

mesne profits:

intermediate profits, the profits which a person in wrongful possession of the property actually received or might with ordinary diligence have received therefrom together with interest on such profits excluding the profits due to improvement made by the person in wrongful possession.

amicus curiae:

friend of the court; one who voluntarily or on invitation of the court, and not on the instructions of any party, helps the court in any judicial proceedings. 

modus operandi:

mode of operating; the way in which a thing, cause etc. operates.

audi alteram:

hear the other side. Both sides should be heard before a decision is arrived at.

mutatis mutandis:

with the necessary changes in points of detail, with such change as may be necessary.

caveat emptor:

let the purchaser beware. A maxim implying that the buyer must be cautious, as the risk is his and not that of the seller.

nexus:

bond, link or connection.

cestui que trust: 

a beneficiary under a trust, the person for whose benefit a trust is created.

non obstante:

"notwithstanding clause." A legislative device which is usually employed to give overriding effect to certain provisions over some contrary provision that may be found either in the same enactment, or some other enactment, that is to say, to avoid the operation and defect of all contrary provisions.

de facto:

in fact : an expression indicating the actual state of circumstances independently of any question of right or title.

de jure:

in law : independent of what obtains in fact.

obiter dictum:

an opinion of law not necessary to the decision. An expression of opinion (formed) by a judge on a question immaterial to the ratio decidendi, and unnecessary for the decision of the particular case. It is no way binding on any court, but may receive attention as being an opinion of high authority.

dehors:

outside of : unconnected with, unrelated to; 

pendente lite:

during litigation.

de novo:

anew.

per incuriam:

through carelessness, through inadvertence. A decision of the court is not binding precedent if given per incuriam, that is, without the court's attention having been drawn to the relevant authorities, or statutes.

ejusdem generis: 

of the same kind or nature. Where a list of specific items is followed by general concluding clause, this is deemed to be limited to things of the same kind as those specified.

pro tanto:

to that extent, for so much, for as much as may be.

ex gratia:

as a matter of grace or favour.

quid pro quo:

the giving of one thing of value for another thing of value; one for the other; thing given as compensation.

ex officio: 

by virtue of an office.

ratio decidendi:

reasons for deciding, the grounds of decision.

ex parte:

expression used to signify something done or said by one person not in the presence of his opponent.

res integra:

an untouched matter; a point without a precedent; a case of novel impression.

fait accompli:

an accomplished act.

res judicata:

a case or suit already decided.

in limine:

at the outset.

rule nisi:

a rule to show cause why a party should not do a certain act, or why the object of the rule should not be enforced.

in pari materia:

upon the same matter or subject

rule absolute:

when, having heard counsels, court directs the performance of that act forthwith.

in personam:

against the person; an act or proceeding done or directed against or with reference to a specific person.

sine die:

without day.

in rem:

an act/proceeding done or directed with reference to no specific person or with reference to all whom it might concern.

sine qua non:

an indispensable requisite.

inter alia:

amongst other things.

stare decisis: 

to stand by things decided; to abide by precedents where the same points come again in litigation.

inter vivos:

between living persons

status quo:

existing condition.

intestate:

a person is deemed to die intestate in respect of property of which he or she has not made a testamentary disposition ("will") capable of taking effect. 

sub judice:

before a judge or court, pending decision of a competent count.

intra vires:

within the powers; within the authority given by law.

ultra vires:

beyond one's powers.

ipse dixit:

he himself said it; there is no other authority for it.

ipso facto: 

by the mere fact, automatically

ipso jure:

by the law itself; by the mere operation of law.

lis pendens:

a pending suit.

Walter's model VS Market price of the share

Walter model was developed by the professor James E. Walter. He indicates in his model that the choice of appropriate dividend policy affects the value of the enterprise.In a sense,it implies that dividend affects the value of enterprise. He also studied the significance of the relationship between the firm’s internal rate of return (r) and cost of capital (ke) in determining such dividend policy which will accumulate the wealth of the shareholders.

He throws some assumption while dealing with it. These are-  1-Retained earnings should be source of finance which means a company doesn’t depend on external funds.

 2-The business risk should not change with additional investment undertaken that implies cost of capital and internal rate of return are constant.

 3-Earnings per share (E) and dividend per share (D) should be constant as assumed.

4-The firm has long and infinite life.

 Walter’s model for market price per share (p) computation-

P                   = D/ke+[r/Ke(E-D)]/Ke

He draws following conclusion out of the Walter model. These are-

When r> Ke

The value of share is inversely related to dividend payout ratio. As dividend ratio increases, the value of shares decline. if firms retained its earning entirely which will increase the market value of the shares. Here, the optimum payout ratio is zero.

When r<Ke

Dividend payout ratio and value of shares are positively co-related. As the dividend payout ratio increases, the market price of the shares increase. Then dividend payout ratio is hundred percent.

When r=Ke

The market value of shares are constant irrespective to optimum payout ratio.

VALUE ANALYSIS

When company, all of sudden, add or remove any feature of the product making the product even much better in same or some reduced price bring us at a point of confusion. Not even this, product’s sale is also picked up and product stands more competitive. All this happens since the value analysis pioneered. Here, we would get resolved from these confusions and get answered the questions which are blowing our mind.

Since the topic is value analysis which implies that we analyze the value of something i.e. Product or service. But before digging deeper we need to understand that how many ways a value can be defined or classified. Now, we get enough freedom of defining the value which turns the definition of the value in many folds. If we define it as a cost value, it indicates the summation of material, labour, overheads and some other cost to produce the product. But as a consumer, we can value the product by its characteristics, quality and durability. In the market, there are some other products which attract us and create the desire to purchase, having some special characteristics, even though are not useful. They can be called a product’s Esteem value. Sometimes, when product is outdated, even then, some people find it attractive enough and product gets pushed for resale in the market which is called to be an exchange value.

However, one thing has been cleared above that value analysis increases the value of an article or product. But the second thing is blurring that why does it come with the cost reduction? It can be better understood when we would go about the value analysis process even deeper.

In the value analysis process, it is first to find out the scope of the product, and then, problems are given to be emphasized. Once the scope is found, functions of the product and their items are derived as they are of paramount importance that they create the value of the product. Function is further classified as basic and secondary function. Basic function is for what product is being launched in the market. However, secondary function is to make the product more competitive in the market through adding several features. For example, today the cheapest mobile has all the features like camera, mp3, video player, radio and etc. are the secondary functions which make it more competitive in the market. But the basic function is just communication. Without this single function product can lose its identity in the market.

Value analysis matrix plays vital role to identify the high cost function ratio (which means causing high cost) as opportunity for further investigation and improvements. These improvement opportunities are then brainstormed, analyzed and selected. Value analysis matrix finds the cost contribution of each element in the function of the product which guides the team or analyst in selecting function for further improvements. Therefore, value analysis is of two folds, one is, it increases the value of the product, and second, it helps in cost reduction as well.

Target Costing

 It is not very difficult to understand the meaning of the target costing. As a layman, we can easily guess what the target costing is? So far as the meaning of target costing, it is a cost  where target is already set . But it’s not sufficient enough for it. We need to dig down even more deeply.

It was originated in Japan in late 1960s and remained secret for many years. But later in 1980s, it was started gaining popularity among the Japanese companies. And gradually, it then found the way to western countries. Since then many large companies adopted the target costing method and enhanced their cost and management system.

Akio Morita is the first person who has been credited with pioneering this cost approach when he led the development of Walkman as portable, pocket able and affordable musical gadget.

 Target costing is actually based on a philosophy that what customer wants and how much he is willing to pay for. Therefore, the price of the product is found from the market and then deducts the desired profit margin out from it and arrives at the target cost. For example Rattan Tata’s NANO for which a initial price was fixed Rs. 1, 00,000. Then the engineers were worked back on this targeted cost and launched the dream car NANO. It is a “price-led costing” called by Peter Drucker.

Target cost = target price (price customer willing to pay for) - profit margin

Above it was understood that what target costing is. But the real question is that how it is developed? Basically, there are some steps involved in developing the target cost. Here we go,

·         customer requirements

·         product planning

·         Concept design

·         Basic design

·         Detailed design

·         Manufacturing preparation

Customer requirements: At this first step, we try to find out the perception of the customer for the product characteristics and his expectations about the quality, price, performance and technology of the product.

Product Planning: At this step, we try to discover and plan that how the product is marketed, manufactured and what would be the primary performance specifications. We also plan that what would be the cost target, profitability, and volume of the product.

Concept design: At this stage, we design the basic concept of the product and assign the cost targets accordingly. We also evaluate whether the basic concept of the product which has been drawn fit the cost target or not.

Basic design: At this step, we construct the general design of the product keeping in mind the cost targets and evaluate whether this general design is fit with the cost target or not on the basis of some rough cost estimation.

Detailed design: At this step, we would move little bit manufacturing specification of the product on the basis of above concept design and basic design. The emphasis is given for the most to the cost targets. Then the drawing of manufacturing specification comes under its way.

Manufacturing preparation: At this final stage, we design the manufacturing system for the product which include tools, production methods to be adopted and processes for the product while cost targets are kept in mind and compared at every bit of additional workings.

Therefore, the target costing is a new way of understanding the customer demands and translates them into products. It has opened new doors for manufacturing companies to combat the competitiveness. Not even companies, but also customers are getting the products according to their specification that they really looking for. Thus,  Target costing has left the traditional method of manufacturing far behind.