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CHAPTER 1 - BASICS

The ratios show the connections that exist between different parts of the business. The
manager will, of course, understand that the financial numbers are only a reflection of
what is actually happening and that it is the reality not the ratios that must be
managed.

All commercial enterprises use money as a raw material which they must pay for.
Accordingly, they have to earn a return sufficient to meet these payments. Enterprises
that continue to earn a return sufficient to pay the market rate for funds usually prosper.
Those enterprises that fail over a considerable period to meet this going market rate
usually do not survive – at least in the same form and under the same ownership.

The big issues in business are:


_ assets
_ profits
_ growth
_ cash flow.

These four variables have interconnecting links. There is a balance that can be
maintained between them and, from this balance, will come corporate value. It is
corporate value that is the reason for most business activity and, for this reason, this
book focuses on the business ratios that determine corporate value.

CHAPTER 2 – FINANCIAL STATEMENTS

In finance, there are three – and only three – documents from which we obtain the raw
data for our analysis.

1. The balance sheet (B/S)

It is simply an instant ‘snapshot’ of the assets used by the company and of the funds
that are related to those assets. It is a static document relating to one point in time. We
therefore take repeated ‘snapshots’ at fixed intervals – months, quarters, years – to see
how the assets and funds change with the passage of time.
A balance sheet of a given mass of assets must produce a minimum level of
profit to be efficient.

The ‘Assets’ column contains, simply, a list of items of value owned by the business.

The ‘Liabilities’ column lists amounts due to parties external to the company, including the
owners.

The ‘Assets’ column is a list of items of value at their present cost to the company. It can be
looked on as a list of items of continuing value on which money has been used or spent. The
‘Liabilities’ column simply lists the various sources of this same sum of money. The amounts in
these columns of course add up to the same total, because the company must identify exactly
where funds were obtained from to acquire the assets.

All cash brought into the business is a source of funds, while all cash paid out is a use of
funds. A balance sheet can, therefore, be looked on from this angle – as a statement of
sources and uses of funds.
2. The profit and loss (P/L) account

The profit and loss account measures the gains or losses from both normal and abnormal
operations over a period of time. It measures total income and deducts total cost. The
profit and loss account quantifies and explains the gains or losses of the company over
the period of time bounded by the two balance sheets. It derives some values from both
balance sheets. Therefore, it is not independent of them. It is not possible to alter a
value in the profit and loss account without some corresponding adjustment to the
balance sheet. In this way the profit and loss account and balance sheet support one
another.

3. Cash flow (C/F) statement

The statement of cash flow is a very powerful document. Cash flows into the company
when cheques are received and it flows out when cheques are issued, but an
understanding of the factors that cause these flows is fundamental.

The cash flow statement depends on the two balance sheets and the profit and
loss account.

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