You are on page 1of 497

1

Kanaka maha lakshmi Thalli

Be bold when you loose and be calm when you


win.

"Changing the Face" can change nothing.


POME’
POME’07
But "Facing the Change" can change everything.

1
2
2
KANAKA MAHA LAKSHMI THALLI
THIS BOOK IS DEDICATED TO THE ALMIGHTY, WHO
ALWAYS SHOWERS HER BLESSINGS ON HER
CHILDREN.
3
2007, POME, Gautam_Koppala, All Rights Reserved
PROJECTS AND OPERATIONS
MANAGEMENT EXPOSED
(POME)
Part “PROJECT’S ACCOUNTING”
A COLLECTION AMELIORATED BY
GAUTAM KOPPALA V.T.
4
2007, POME, Gautam_Koppala, All Rights Reserved
5
2007, POME, Gautam_Koppala, All Rights Reserved
6

6
You are the only person who can revolutionise your life.
You are the only person who can influence your happiness,
your realisation and your success.
You are the only person who can help yourself.
Your life does not change, when your boss changes,
when your friends change, when your parents change,
when your partner changes, when your company changes.
Your life changes when YOU change,
when you go beyond your limiting beliefs,
when you realize that you are the only one responsible for your life.

2007, POME, Gautam_Koppala, All Rights Reserved


Copyright © 2007 POME
All rights reserved. No part of this product may be reproduced or utilized in any form or by
any means, electronic or mechanical, including photocopy, recording, broadcasting, or by any
information storage or retrieval system, without permission in writing from the author
Gautam Koppala.
All knowledge in POME book is service marks and/or trademarks of the author Gautam
Koppala.
Except as otherwise specified, names, marks, logos and the like used in the
educational/teaching content of these materials are intended to be, and to the best of
Licensor’s [Gautam Koppala’s] knowledge and belief are, fictitious. None of the names,
marks, or logos used herein is intended to depict any past or present individual or entity, or
any trademark, service mark, or other protectable mark of any individual or entity. Any
likeness, similarity or sameness between any name, mark, or logo used herein by Licensor
and the name, mark, or logo of any individual or entity, past or present, is merely
coincidental and unintentional. Any such names, marks, and logos used in the
educational/teaching content of these materials are used only to provide examples for
purposes of teaching the educational content of the materials, and are in no way intended to
be used in any trademark sense or manner.
The names of actual past or present individuals, entities, trademarks, service marks, logos
and the like (other than those of Licensor used in the educational/teaching content of these
materials are used only to provide examples (including in some instances actual case studies
based upon factual events or circumstances involving the individuals, entities, marks, or
logos) for purposes of teaching the educational content of the materials. Any such names,
marks, and logos used in the educational/teaching content of these materials are intended
and used solely for the purpose of providing examples and case studies, and are in no way
intended to be used in any trademark sense or manner.
VITA: FROM THE AUTHOR:
Academically, I am a cum laude graduate with a Bachelor of Technology degree in Electrical
9
2007, POME, Gautam_Koppala, All Rights Reserved
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.), all from India.
My engineering completed in a remote village in India, Srikakulam, and it’s been a long
journey from there, and journey still continues….I feel this book demonstrates my ability to
maintain dedication, motivation and enthusiasm for a project management over a long period
of time. I believe that in combination with my extensive broad-based operations work
experience along with my drive, resourcefulness and determination would make this book, an
excellent opportunity for any juvenile/experienced one in Projects industry.
I started my career as a small time engineer and gradually still developing in the Operations
Domain.
With over nine years of Professional Experience, am a well-rounded functional Manager with
excellent, documented record of accomplishment and success in the electronic Security and
Building Systems Technology Field.
The reason behind writing this book, is that when am new to this field, I don’t have any one
to say, what is all about the projects, what to do, and when to do? Hence, the detailed
information that I gained through the ages, thought to put in an orderly fashion, so that it
would be vitally milked by future successful managers, avoiding the time lags.
Highlights of my background include Supply chain, Commercial with a magnificent experience
in Project and Operations management, technically oriented towards Automation and
Security Systems in Industrial and Building sectors.
My success in the past has stemmed from my strong commitment and sense of
professionalism. I keep high standards for my work and am known for my persistent nature
and ability to follow through.
If this book facilitates you in getting adjusted and grow in this domain. I would feel really
successful.
GAUTAM KOPPALA VT
10
2007, POME, Gautam_Koppala, All Rights Reserved
POME Contents
Finance Basics ........................................................................................................ 14
Accounting Basics: ................................................................................................. 29
Financial Planning .................................................................................................. 37
Cash Flows: ............................................................................................................ 51
Evaluating Capital Investment Projects .................................................................. 85
Invoicing for Projects: ............................................................................................ 91
Income Statements: ............................................................................................. 107
Working Capital .................................................................................................... 116
Balance Sheet:...................................................................................................... 137
Control of Project Cash Flows ............................................................................... 149
Managing Liabilities.............................................................................................. 173
Banking Industry for Bank Guarantees: ............................................................... 192
Insurance Management: ....................................................................................... 209
The Structure of Business and the Impact of Financial Statements ...................... 220
Taxation: .............................................................................................................. 232
Linking Departmental functions............................................................................ 244
Performance ......................................................................................................... 244
Linking Departmental functions through Financial Performance in Projects......... 245
Corporate Financial Reporting .............................................................................. 254
Corporate Governance .......................................................................................... 345
The Asset Management ........................................................................................ 362
Shares, Bonds and Securities: .............................................................................. 383
Accounting Schedules: ......................................................................................... 411
11
2007, POME, Gautam_Koppala, All Rights Reserved
12
2007, POME, Gautam_Koppala, All Rights Reserved
FINANCE BASICS
13
2007, POME, Gautam_Koppala, All Rights Reserved
Finance Basics
Change is a given in business today, and Project Managers are expected to do more and
understand more than they ever had to in the past. How often have you heard statements
just like these—often from your own Project Managers?
Finance Functions
Corporate Finance
Accounting &
Control
Financial Cost Management
Accounting Accounting Accounting
Act like you own the business.
Everyone is self-employed.
If what you’re doing isn’t adding value to the business, then stop what you’re doing.
To begin this discussion and concentrate on the process of financial analysis, consider this
question: What is the purpose of business?
To define the purpose of business, consider the relationships among business elements. Here
are some possibilities:
1. Is it to maximize sales? If so, how would we do it?
2. Is it to maximize profits? If so, how would we do it?
14
2007, POME, Gautam_Koppala, All Rights Reserved
3. Is it to maximize the wealth of the shareholders? If so, how would we do it?
As we develop our response to these questions, we will look at the techniques of financial
analysis and the tools of financial management. First, however, we develop answers to these
questions in the context of a small company.
Consider a very small business—the company of you. You have an income and expenses,
assets and liabilities. Therefore, an examination of your business may shed some light on this
whole area. If we recast these questions, we can extrapolate easily from your personal
business to a company of any size.
What is the purpose of your business? . . . Really?
Is it to maximize sales? You might then have to work extraordinary hours to maximize your
revenue. If you worked that many hours, you would not have time to enjoy your wealth and
you might burn yourself out without achieving your objective.
Is it to maximize your profits? You might choose to increase your profits by depriving
yourself of everything but the barest of necessities, reducing your expenses to the minimum
and increasing your savings. However, this option is also not very attractive, certainly over a
long time period.
It should be obvious from this simple example that the superficial answers really do not yield
the most attractive results. In reality, we work to achieve long-term goals. These long-term
goals are not really described in a revenues context, yet they may appear to involve profits
or accumulated profits. However, if the profits are accumulated at too great a sacrifice, that’s
not it either. The sacrifice detracts from our satisfaction, or wealth, which on a personal level
is more than just financial. Our personal business objective is to maximize the wealth, from a
satisfaction perspective, of the shareholder, our self.
We can easily extrapolate this analogy to a more general purpose of business, to maximize
the wealth of the shareholders and to do so over the long run. To accomplish this, we must
manage efficiently and effectively, making our resources, including people, productive. This,
in turn, requires that we support and compensate the workers so that they can and want to
be successful. Therefore, there is no conflict between the long-term objectives of the owners
(shareholders) and the workers.
Financial analysis allows us to measure a business’s success in achieving the wealth
maximization goal. Wealth maximization is measured by the net worth of the company, and
15
2007, POME, Gautam_Koppala, All Rights Reserved
more specifically, by the net worth of the company per share. There is a general belief that,
for a public company, successful performance over time makes the company’s stock
attractive in the market. That is, strong operating performance is directly related to strong
stock market performance, assuring that the market will reward shareholders, regardless of
when they acquire their stock, appropriately.
At this point it is appropriate to consider the stock market and what it means. After all,
shares of common stock represent ownership, and the equity on the balance sheet, when
divided by the number of shares, should equal the value of the shares. In fact, this
calculation determines the book value of the shares.
However, the price of the stock in the market is generally different from the book value,
frequently much higher. POME discusses the time value of money and explains that the price
of a financial asset, for example, a share of stock, is equal to the present value of future cash
flows, the sum of dividends and sale price to be received in the future, discounted to current
value. If a company is profitable, the profits belong to the shareholders, so the accumulated
value of those profits to be earned in the future, when discounted, will be valued in the stock
market at a share price higher than the current book value of the stock.
Finance and accounting give you tools that you can use to understand how the decisions you
make and the jobs you perform affect the long-term success of the entire organization.
Understanding the language of finance and accounting allows you to present your ideas
persuasively and precisely in Projects, and to be more comfortable when discussing results or
forecasts with your financial staff or outside investors. It helps you understand the financial
news and how financial markets can affect your own firm. And it helps you make better
decisions about your personal finances and investments.
Accounting has been called “the language of business.” Finance is the application of that
language to business activities and decisions. This POME Chapter introduces the basic
terminology and concepts of financial management. You’ll see how these terms and concepts
relate to your everyday responsibilities, and you’ll look at the basic financial statements,
which provide a starting point for everything that follows.
POME Case Study:
Are You a Financial Project Manager?
16
2007, POME, Gautam_Koppala, All Rights Reserved
Bob had recently been hired as the controller of a small, semi-autonomous division of a
publicly held company that was experiencing severe growing pains. Rapid expansion strained
the cash resources of the company as well as its human resources. Bob decided to introduce
open-book management to the employees, but he knew he’d have to give people some basic
tools before the company’s financial information would make much sense to them.
He called the first group together and asked, “How many of you are financial Project
Managers?” Every hand stayed down. Then he asked, “How many of you have a checking
account?” Most of the hands went up. “How many of you make mortgage or car payments?”
Again, most of the group had loans they were paying off. When he asked, “How many of you
have MasterCard or VISA cards?” nearly everyone raised their hand.
Bob pointed out that the Project Managers in the group were managing cash, making
investments and incurring loans, handling credit, and looking out for their own financial well-
being. They all had plenty of experience that they could use as they analyzed the financial
results of the company. When he asked the group, “How many of you really are financial
Project Managers?” nearly everyone responded affirmatively.
How would you have responded to these questions? Many Project Managers, even those in
senior positions, do not realize how much financial management they understand and how
much financial management they practice. Nearly everything that goes on in a business has
financial consequences.
Finance is, broadly, about two things: one is what happens to decisions within firms in terms
of how much value they create – decisions regarding corporate governance, capital
budgeting, and investment; the other is how the capital market reacts to these decisions and
how risk gets priced in the market.
By assessing rate of return on a project, Projects management is able to evaluate the
contribution that such an investment will make to overall performance. Many companies
undertake formal investment evaluation programs that identify the amount of investment
required, including working capital, and the cash flows that will result. The comparison of the
present value of the cash flows to be received and the amount of the investment enables
management to assess the acceptability of the project. Computing the payback period tells
management how long it will take to return the investment funds committed. Calculating the
net present value of the project using the Projects’s cost of capital as a discount rate enables
management to identify acceptable projects. Computing the internal rate of return in projects
17
2007, POME, Gautam_Koppala, All Rights Reserved
enables the Projects to rank projects of dissimilar size and life. However, the internal rate of
return computation is more complicated and many companies, particularly smaller ones, do
not use the technique. Later in POMEwe detail the specific computational procedures.
Capital investments involve:
 large amounts of money
 long periods of time
 delayed receipt of income
 complex tax treatments
 careful planning
The investment analysis process we have just discussed provides an introduction to the
whole area of business investment decision making and the management of long-term
assets, considered in more depth in Chapter 8. As a starting point let’s consider the reasons
for making capital investment decisions. These choices lead to an assessment of the risks
involved as well as to the modification of required rates of return.
In terms of what happens within the firm, the basic principles to remember are that if you
want to use finance to create value, the first thing you need is a good strategy. The second
thing you need is a good internal resource allocation system so that capital is flowing to the
highest-value project. The third thing you need is the right performance metrics with which
to judge people so that you maximize shareholder value on a day-to-day basis. Finally, you
need the right corporate culture within the organization to make sure the implicit rules by
which people are being judged and rewarded make sense.
From the external perspective, capital will flow to the highest- value user. The firms that will
be valued more highly are the ones that are making positive net present value investments.
The market will demand a higher risk premium for investing in firms that are riskier. If you
are an investor and you hold a diversified portfolio, you don’t really have to care so much
about what is happening in the firm because the capital market at an aggregate level is
taking care of allocating resources to the best users. You have to make sure you hold a
diversified portfolio so that if one out of the 200 firms in your portfolio disappoints, the whole
portfolio doesn’t go down.
Finance is not a foreign language, understood only by those who have studied it for years.
Everyone who functions in today’s Projects has a basic understanding of the principles of
18
2007, POME, Gautam_Koppala, All Rights Reserved
finance. The daily transactions of comparing prices, writing checks to pay for purchases,
using credit cards, and maintaining a bank account are all financial management activities.
Understanding and managing the financial activities of a business are a logical extension of
understanding and managing your personal financial activities.
Financial management comprises the tools and capabilities used to produce monetary
resources and the management of those monetary resources. The language of finance allows
different businesses to compare monetary results. Whether the business makes cars or sells
hamburgers, people can describe the results in monetary terms. In order to take part in this
discussion, it’s important to understand the words and concepts that people use. Throughout
this course we employ the vocabulary of finance. New terms are highlighted and defined.
You’ll find all of the definitions in the Glossary at the back of this text.
In its simplest definition, finance is managing money. What else can we say about the tasks
and the focus of finance and financial management?
1. Finance, whether personal or business, is managing money on behalf of owners and
creditors.
2. Managing money includes attracting it and spending it or investing it according to a
plan of action.
3. Financial management is the management of that plan.
We can apply this definition of financial management this way:
 Business finance is the managing of money for a business
 Personal finance is the managing of money for oneself
The rules and practices of managing money are essentially the same, regardless of whose
money is being managed. Exhibit 1–1 demonstrates just how close the business definitions
and personal definitions of several important words and concepts are. It should be clear from
these comparisons that the definitions of these terms are very similar whether viewed in a
business or a personal context. You already know more than you may think, and you should
feel confident that you will be able to understand and use the terms and concepts of financial
management effectively.
POME describes four basic elements of finance:
1. Bookkeeping—the accurate and timely recording of transactions, providing the
reader with clear financial information
19
2007, POME, Gautam_Koppala, All Rights Reserved
2. Accounting—analysis and evaluation of past events and results, showing how we
arrived at the current financial position
3. Planning—building on the past to direct the future, permitting the Project Manager to
manage proactively rather than simply reacting
4. Cash Management—concentrated attention on a scarce essential resource, assuring
that the available resource can be managed effectively
Exhibit: Representative Terminology
As we describe each of these elements in depth, the basic structure of financial information
will become clearer.
Bookkeeping is the accurate and timely recording of transactions. This definition of
bookkeeping is what most people mean when they talk about “accounting.”
Without a sound bookkeeping system, all of finance is really only guesswork. No financial
planning can take place if the books and records from which information is drawn are not
reliable. If the systems and procedures that provide financial information are not dependable,
the first step must be to correct the data and assure that future reporting is sound and
timely. But the information gathered in the accounting process is too detailed in its raw form
to be very useful for decision making. The data are used to generate financial statements,
which follow set rules to provide consistent information to the people who use them—Project
Managers within the business, vendors and customers who do business with the business,
and investors. Generating financial statements is really only the last step of the bookkeeping
responsibility.
20
2007, POME, Gautam_Koppala, All Rights Reserved
The production of these statements must follow a logical process, must conform to
generally accepted accounting principles (GAAP), and must be timely. They must follow
a logical process to ensure completeness. They must follow generally accepted accounting
principles so that everyone who needs to understand them will be able to analyze and
interpret them in a meaningful way. This is particularly important in the case of publicly
owned companies, whose financial statements must be understandable by investors,
analysts, and many other people. GAAP. Statements must be timely so that management can
take action effectively. When Project Managers make good use of the financial information
provided by the accounting system, they can achieve continuous improvement of financial
performance by maintaining and enhancing positive results and correcting negative or
unsatisfactory results.
Accounting is the analysis and evaluation of past events and results.
Accounting’s primary focus is determining what really happened and why. The purpose of the
accounting function is neither to affix responsibility nor to give credit for success or blame for
shortfalls. Accounting has the absolutely crucial responsibility of understanding what
happened that caused the financial results reported through the financial statements.
Once financial statements have been prepared, the accounting staff and others evaluate
them. This look at historical performance—whether for the most recent month, for the prior
month, or for some prior year—establishes relationships that provide a starting point for
forecasting financial performance.
The accounting analysis, as part of regular reporting, explains how or why the company
achieved the financial results it did. In accounting analysis, Project Managers and analysts
examine the results reported in the financial statements and identify the actions or activities
that caused or contributed significantly to the results reported. To be most valuable, they
must perform this analysis while the operating circumstances are still fresh. Analysis of old
results cannot contribute nearly as much to future success as can analysis performed while
the situation is still clearly in focus. And since corrective action is not possible until Project
Managers have analyzed the results, failure to act quickly allows problems to continue longer
than they should. We examine the techniques of financial analysis, the interpretation of
financial results, and positions to guide the future actions of the company in more depth.
21
2007, POME, Gautam_Koppala, All Rights Reserved
In addition to helping management understand the recent past, this analysis, this
accounting, provides the basis for judging forecasts of future performance. If the forecasts
prepared as part of the planning process differ from the results that would be expected based
on the past, the accounting function must be able to explain why the projected differences
are valid.
Otherwise, the forecasts are flawed and will yield unrealistic performance projections.
Planning is building on the past to direct the future.
Planning starts from the understanding of what happened in the past and uses forecasts and
estimates to project the future. If the results of the past were satisfactory, then Project
Managers develop a plan that will perpetuate past practices to reach the goals for the future.
If, however, the results of the past were less than satisfactory, management must use its
understanding of what happened to identify what must be changed in order to arrive at a
more desirable future result.
Planning uses the analysis of what has happened in the past to guide the future. It answers
the questions:
 Do we like the results of the past?
 What can we do to improve them?
In reality, the past is the starting point in developing a projection of future performance. If
the Project Manager and the organization feel that the past performance was satisfactory or
exemplary, then they build on that to build for the future. If, on the other hand, the
performance was not satisfactory, they must incorporate significant change into the
projection. In a properly prepared plan, the projected results must identify those factors that
will make the result differ from the past.
Cash management is concentrated attention on a scarce, essential resource.
Cash is the focus of much of the public discussion of financial issues. Because cash is
considered a scarce but essential resource, people believe it requires special treatment and
attention.The essence of good cash management may be described as:
 Collect it as quickly as you can.
22
2007, POME, Gautam_Koppala, All Rights Reserved
 Hold it as long as you can.
 Release it as slowly as you can.
 Have little or none on hand.
Often included in a discussion of cash management are a number of specific responsibilities
that fit into the treasury responsibility. These functions include: managing the relationship
between the company and its bank so that necessary financing and bank services will be
available, risk management so that the company is insured for casualty losses, and
investment management to assure that the company earns a proper return on its excess
cash.
The process of cash management is different from all other aspects of finance and requires a
particular understanding. Specifically, the idea that we should have little or no cash requires
an explanation.
A business holds cash (whether in currency or in a checking account) to facilitate
transactions. However, cash held earns little or no interest. Therefore, the prudent Project
Project Manager would prefer to invest the cash where it will earn a greater return. The
Project Manager can’t invest or use too much of the cash, however, or the business will not
have enough on hand to make purchases, pay bills, pay salaries, or pay taxes. The business
must find just the right amount of cash to keep on hand. This is not as hard as it sounds,
because most people and most businesses have predictable, and reasonably consistent, cash
flows. It is not necessary to hold large amounts of cash because the account at the bank is
being replenished continuously.
All but the smallest businesses prepare financial statements. People inside the business use
the statements to analyze their results. How is the business doing? Are there any warning
flags that require changes? Is the business growing faster or slower than its competitors?
What can it do better? Investors use financial statements to see whether their money is
invested wisely. Are they getting the kind of return that they expected for the money they’ve
invested? Would they do better to invest elsewhere? Should they work for a change in
management? Is the company a likely target for acquisition? Vendors use the financial
statements to determine whether the company is a good credit risk. Can the business pay its
bills? Customers use financial statements to evaluate whether the company is likely to be
around to provide services and support in the future.
23
2007, POME, Gautam_Koppala, All Rights Reserved
How can one set of financial statements provide so much information about so many
businesses to so many people?
Long ago authors and theorists broke financial management information into two accounting
equations—essential relationships that have been used to describe financial management.
These two equations, which provide the basis for the first two financial statements, are:
1. ASSETS = LIABILITIES + EQUITY—the basis for the Balance Sheet
2. REVENUES – EXPENSES = PROFIT—the basis for the Income Statement
The first of these accounting equations
ASSETS = LIABILITIES + EQUITY
is also referred to by some as the “fundamental accounting equation.” Using basic algebra,
this equation may also be written as
ASSETS – LIABILITIES = NET WORTH
This equality may be described more simply as:
What you have = What you owe + What you own
What you have – What you owe = What you own
Who Performs Financial Analysis?
Almost anyone can be a financial analyst. Different analysts look at financial information from
different perspectives and make assessments based on the following criteria, criteria relevant
to their individual focus. Exhibit below lists several different analysts and what they look for.
Exhibit: What Financial Analysts Look For
24
2007, POME, Gautam_Koppala, All Rights Reserved
The analysis of financial information provides a window into the success of a business.
Whereas the analysis of financial statements starts with some straightforward calculations, it
is really based on answering the same questions we were all taught to ask when we were in
grade school:
Who?
What?
Why?
When?
Where?
How?
How much?
When we apply the tools of financial analysis to financial statements and information of
outside firms, we ask ourselves, “What did they do? What should they have done? What will
the consequences of what they did be?” When we apply these same tools to the financial
statements of our own Projects, the questions become more personal. “What did we do?
What should we have done? What do we do now? What should I do?” This POME Chapter
draws on the information and tools presented to consider these questions from inside the
Projects. Using some of the ratios introduced, we identify issues facing an organization,
indicating where to concentrate management attention. This POME Chapter draws on
financial analysis techniques to tell the Project Manager where to respond as well as to
predict what will happen, or more specifically, to predict what will happen if something is not
done.
POME considers both the Income Statement and the Balance Sheet, with particular emphasis
on where Project Managers have impact. This discussion also ties the Income Statement to
the various parts of the Balance Sheet, facilitating the establishment of logical links between
operating performance and financial condition. Inclusion of interactive examples will make
this information transparent to the reader and enable each student to draw on personal
experience to strengthen his or her understanding of the material.
We can relate financial analysis to operating action in many ways.We described planning as
“building on the past to direct the future.” Before we can move the Projects in the right
25
2007, POME, Gautam_Koppala, All Rights Reserved
direction, we must understand what has already happened. The interpretive analysis of
financial information leads to the action decisions we concentrate on in this POME Chapter.
The field of finance deals with allocating scarce resources, and people should always view
financial decision-making with a clear sense of fiduciary responsibility, recognizing that they
are using the funds they have acquired from someone to do something. They always need to
keep in mind that they should make the best possible use of those dollars, taking into
consideration the finance issues, as well as ethical considerations, stakeholder concerns, and
so on.
We make decisions on an incremental basis. That is, we look at the changes and the
marginal effects of our decisions. We need to think of all the consequences of our decision-
making, including possible impacts that may not appear in our immediate focus.
We must never forget that money has a time value, and the dollars of different time periods
are different. In multi-period decisions, we try to draw a timeline that will show all the
impacts of the decision and when those impacts will occur. Financial decisions have to be
made in the context of other issues besides finance (ethics, regulatory issues, and so on), so
every decision must be related to the impact on shareholder value. Notice that I didn’t say
shareholder value must be maximized, but the impact must be recognized. Shareholder
value should not be maximized to the disadvantage of other important stakeholders.
POME Case Study:
Having an Impact
“Hi, Koppala. Well, my group looked at some areas where we can exert some direct control.
We compared inventory turnover for the past three years, and we were pretty surprised by
some of what we learned. Even though sales are rising pretty dramatically, this ratio is
getting worse. We asked two of the people in your group if they could help us identify what
was causing this.
“It seems we’ve been buying more materials for the A600 product line to make certain that
we won’t run short when we get hit with big new orders. In addition, the inventory of A200s
is rising. Those sales aren’t keeping up with the other increases. A couple of us met with the
plant Project Manager and then got together with Jan and Les in purchasing. Two of our
machinists can convert one of the machines from the A200 to the A600 products in half a day
26
2007, POME, Gautam_Koppala, All Rights Reserved
and we’re going to try to negotiate a better delivery schedule with our main supplier for A600
parts.”
“That’s terrific. When we have everybody looking at the numbers to see how we can improve
performance, we can come up with great solutions.”
POME Prescribe:
27
2007, POME, Gautam_Koppala, All Rights Reserved
ACCOUNTING
BASICS
28
2007, POME, Gautam_Koppala, All Rights Reserved
Accounting Basics:
Accounting is different from finance and this POME Chapter explains the differences. The
definition and demonstration of basic accounting tools provide you with the understanding
you need to participate in discussions of financial matters with others.
You will be introduced to some basic accounting principles and other accounting basics
in an easy-to-understand format. Some of the vocabulary words may be new to you,
but once you become familiar with some of the terms of basic accounting, you will feel
comfortable navigating through any of the topics in Accounting of daily operations.
Some of the basic accounting terms that you will learn in accounting basics are
revenues, expenses, assets, liabilities, and the balance sheet for your Projects.
You will become familiar with accounting debits and credits as we show you how to
record transactions for your Projects. You will also see why two basic accounting
principles, the revenue recognition principle and the matching principle, assure that a
Project's income statement reports a Project's profitability.
The Accounting System
The accounting system is the bookkeeping portion of financial management. It defines
what goes in what category on the Income Statement or the Balance Sheet. In addition, an
accounting system accomplishes the following functions:
 Identifies and records all transactions. The accounting system needs to handle
and control all transactional documentation quickly and correctly: incoming and outgoing
invoices, incoming and outgoing payments, orders, payroll items, and all other business
activities.
29
2007, POME, Gautam_Koppala, All Rights Reserved
 Describes accounting events on a timely basis. As we noted earlier, immediately
recording and recognizing financial effects allows organizations to respond effectively and
quickly to challenges or opportunities.
 Measures the value of transactions properly. The accounting system must assign
appropriate values to transactions, particularly those for which the value is not obvious,
such as the inventory value and, therefore, cost of product produced or held for sale. The
accurate valuation helps assure accuracy, which is necessary if an organization is to
manage effectively.
 Ensures recording in the proper time period(s). Financial reporting is most
valuable when it provides an accurate assessment of the status of the business. By
recording transactions in the appropriate time period, plans and forecasts as well as
operations themselves can be properly evaluated.
 Presents and discloses accounting events properly. Proper treatment permits
outsiders to evaluate the success of the business, whether they are the board of
directors, investors, lenders, vendors, customers, or anyone else. Timely reporting and
disclosure increases the value of everything about the business.
Who Uses Accounting Information?
Accounting information is valuable to everyone included in a list of company stakeholders,
the various people and organizations that have an interest in the company. Among the
stakeholders are
 The Board of Directors
 Management
 Employees
 Shareholders
 Bankers and other lenders
 Customers
 Vendors
 Competitors
 Various federal, state, and local governmental agencies that are interested in the
company, its industry, taxes, and regulatory compliance
 The community as a whole
 Anyone else with an interest in the company or its industry These different parties use
the information produced from the accounting records of the company, but, obviously, all
of them have different interests and perspectives to apply to this information. With all
30
2007, POME, Gautam_Koppala, All Rights Reserved
these different concerns, the quality of the accounting information becomes paramount.
The accounting system and the processes followed require special attention.
In preparing the financial statements the bookkeepers and accountants must be aware of the
needs and expectations of the various stakeholders. Consider the examples of the different
stakeholders that follow.
The Board of Directors makes policy decisions and develops the future plan for the company
based on the financial performance and condition of the company as reflected in the
statements. It also takes into account the financial performance of the company’s
competition. The importance of accuracy and timeliness is obvious.
Similarly, company management makes current and shorter-term decisions using the same
information. Its decisions often respond to the signals found in the statements and in the
changes in results from period to period. It also responds to the financial activities of
customers, vendors, and competitors.
In turn, customers, vendors, and competitors analyze financial information for indications of
financial strength or weakness, improved or deteriorated performance, and prospects. They
make buying, selling, or market response decisions based on their interpretation of financial
results. The analysis of financial statements provides a real window into business operations.
Employees and prospective employees look at financial information as they make personal
decisions as to employment and personal financial expectations. In today’s competitive
employment marketplace it is very common for a prospective employee, before committing
to a job offer, to request copies of company financial statements to analyze.
The regulatory agencies of the federal, state, and local governments and the community as a
whole are interested in the performance of the company and how it fits into the overall
financial picture the viewer is concerned with.
Investors examine financial information of the company before making, retaining, or
disposing of investments in the company. In some cases they rely on the analysis of financial
analysts employed by securities brokers and dealers to provide guidance for their investment
decisions.
Bankers and other lenders analyze financial information before deciding to make loans to the
company. Then they examine the periodic financial statements to determine the appropriate
actions with regard to the loans they have already made. If they see a weakening
31
2007, POME, Gautam_Koppala, All Rights Reserved
performance, they will be more apt to take protective action to assure that their loans are
secure. If they see strengthening of the financial performance of the company, they will be
more likely to extend further credit and make more money available. As we will see, this
improvement in performance that facilitates further borrowing is important to a company,
because in many cases, business growth creates the need for additional outside funding.
Accounting Is Not Just Cash
Koppala, an opearations accountant welcomed the group and let them know that he
appreciated how hectic it was around the plant these days. “I know a lot of you have been
putting in a lot of extra hours, so I really appreciate the effort you’re making to get
together.” Koppala asked how many of the group had looked at the company financial
statements on the intranet. Only a few hands went up.
“We’ve just started talking about accounting and finance, so those statements will still be
hard to understand. Even so, the sooner you start looking at them, the sooner you’ll start to
see the story they can tell you. After you begin to get familiar with our financial statements,
you might go to the Internet and look up some of the publicly traded companies we compete
against to see what their financial statements look like . . . Chris, I see you’ve got a
question.”
“Koppala, I did take a look at our statements and I don’t see why it has to be so complicated.
At home, I pay all my bills, pay my mortgage, and put a little bit away. When I balance my
checkbook at the end of the month, I can look at what’s left and see how I did. Why can’t we
just check the company’s cash balance? We’re growing, right? And we have plenty of new
orders. Why do we need all that other information?”
“Because we’re growing so fast right now, just looking at the cash we have in the bank at the
end of the month could give a lot of people the wrong idea about the company. Our sales are
increasing quite rapidly, but we don’t get the cash for those sales at the same time we get
the orders. We’re buying larger quantities of raw materials every month lately, and we’re
running extra shifts—which means we’re spending more on labor. We have to lay out that
cash before we get the revenue for the new sales. The accounting system, by recording
transactions in the proper period, lets me see how much cash we’re going to need—and
explain to the bank why we need to increase our credit line. It’s not because we’re managing
badly; it’s because we’re growing fast.
32
2007, POME, Gautam_Koppala, All Rights Reserved
“That’s why I want every Project Manager in this company to understand what’s happening
around here and what kind of impact it will have on the results we share with the board of
directors, our creditors, and the bank. That kind of understanding will help you explain to
your people why we have to be so careful about controlling costs.”
The Purpose of Accounting
The American Institute of Certified Public Accountants (AICPA) described in 1970 the purpose
of accounting: “To provide quantitative information, primarily financial in nature, about
economic entities that is intended to be useful in making economic decisions.” The key word
here is “useful.” If the information is not useful, there is no sense in going through the effort.
The following pages look at the accounting information and identify its usefulness.
If we handle like transactions or activities in the same way all the time, it is easy for us to
interpret the transactions and understand what is happening to our business. Accounting
provides the structure that enables us to process business transactions in a way that permits
consistent treatment, reporting, and interpretation. Whereas this portion of financial
management was labeled bookkeeping in the first POME Chapter, it is generally known as the
accounting system.
Starting Up a New Business:
George Gautam is a savvy man—for quite some time he's been noticing the need for
an efficient Project sub contractor in his customers Projects, and he's been toying with
the idea of starting up such a business himself. George does some background
research, prepares a business plan, and is pleased to see that he is on the right
track—the business plan verifies that his sub contractor service for his customers
Projects would save money for clients while at the same time be profitable within a
year.
George knows he will sleep better at night if he takes steps to protect his personal
assets (his second home and his investments) from any unforeseen lawsuits related to
his new business. By forming a corporation, GG Org, Incorporated (or "Inc.") he limits
his liability to only those assets owned by his corporation. In other words, if someone
successfully sues GG Org, Inc., it is possible that the loss would be limited to the value
of GG Org's assets; George's personal assets might be safe. George continues with the
33
2007, POME, Gautam_Koppala, All Rights Reserved
start-up process by obtaining the permits and state and federal identification numbers
for his new business. So, George want to start a Business implementation Project.
George is a hard worker and a smart man, but he admits that he is not that
comfortable with matters of accounting. In order to have the level of control in his sub
contracting Projects that he wants over his costs and profits for is personal
Operations, he knows he will have some type of accounting. However; he wants to
learn more about accounting. George asks his friend Koppala, an Operations
accountant, to explain the basics of accounting to him before he appoints an
accountant for all his Projects and cumulatively for his Operations and opens for
business. Here is what Koppala tells George—
Types of accounting and accounting information users
Accounting:
One of the great things about accounting is that it can record all of the financial
transactions of GG Org, Inc. George seems puzzled by the term "transaction", so
Koppala gives him five examples of the types of transactions GG Org might make:
1. George will no doubt start his business Project by putting some of his own personal
money into it. In effect, he is buying shares of GG Org's common stock.
34
2007, POME, Gautam_Koppala, All Rights Reserved
2. GG Org will need to buy a sturdy, dependable delivery vehicle.
3. The business will begin earning fees and billing clients for delivering their parcels.
4. The business will be collecting the fees that were earned.
5. The business will incur expenses in operating the business, such as a salary for
George, expenses associated with the delivery vehicle, advertising, etc.
There may be thousands of such transactions made in a given year, and this is why
George is smart to start using accounting software right from the beginning—the
software will keep the business's transactions organized and accessible. Accounting
software will generate sales invoices and accounting entries simultaneously, prepare
statements for customers with no additional work, write checks, automatically update
accounting records, etc.
By getting into the habit of entering all of the day's business transactions into his
computer, George will be rewarded with fast and easy access to the specific
information he will need to make sound business decisions. Koppala tells George that
accounting's "transaction approach" is useful, reliable, and informative.
He has worked with other small Project Managers who think it is enough to simply
"know" their Project made $30,000 during the year (based only on the fact that it
owns $30,000 more than it did on January 1). Those are the people who start off on
the wrong foot and end up in Koppala's office looking for financial advice.
If George enters all of GG Org's transactions into his computer on a routine basis,
good accounting software will allow George to print out his financial reports with the
click of a button.
Koppala will explain the purposes of the three main reports that George will be using:
1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows
35
2007, POME, Gautam_Koppala, All Rights Reserved
FINANACE
PLANNING
36
2007, POME, Gautam_Koppala, All Rights Reserved
Financial Planning
POME puts the financial management information previously presented into the context of
business financial planning. The structure of the planning continuum, from the business plan
to the strategic plan to the operative plan to the detailed components of the departmental
budget, is discussed. The chapter includes specific discussion of departmental budgeting and
relating the departmental budget to the larger entities of which the department is a part.
POME clarifies the entire integrated planning process and identifies the roles and
responsibilities of all Project Managers, both at the operating and at the senior levels. It also
recognizes the effect departments and projects have on the Projects results.
Before beginning the discussion of specific aspects of planning, a brief look at the different
types of plans and planning is appropriate. A Projects’ planning includes several parts, some
major and some less so. The major parts are the business plan—an overview of the
Projects, its vision, people, products, markets, customers, and competitors; the strategic
plan—the long-range view of the Projects; the annual budget—a detailed prediction of
revenues, expenses, and results; the capital budget—the identification and evaluation of
major investments in equipment and resources; and the cash budget—the prediction of
cash flows and cash needs, including magnitude and timing.
POME Case Study:
Planning and Replanning
“Good morning, Koppala. How’s it going?”
“Things are great. I just want to remind you that it’s time to update the strategic plan and to
confirm this year’s budget.”
“Why do we have to confirm the budget, Koppala? We’ve been analyzing our results—and our
financial statements—all year long. Everything should be under control.”
“We’ve all kept our eyes on a number of financial measures this year, Pat. But when we pull
together all of the information for the strategic plan, we may find that something in the
environment has changed. If it has, we should revise our thinking as early as possible to
avoid any nasty surprises. Don’t you remember earlier in the year when we put together the
proposal for a new machine for the A600s? We hadn’t accurately forecast how much capacity
we’d need to keep up with orders when we prepared last year’s budget. It’s always a good
idea to reconfirm the plan at the beginning of the year.”
37
2007, POME, Gautam_Koppala, All Rights Reserved
“Will we be using the same forms we used in the past, Koppala?” “No. We revised the forms
this year. You’ll get a call from the budget department and one of the analysts will set up an
appointment to meet with you. After all you’ve learned about our accounting system and
financial analysis over the past year, you shouldn’t have too many questions.”
The Essence of Financial Planning
Every Project does some planning because, even if there is nothing formal, the Project
Manager or Project Managers have a reasonable idea what to expect in the months to come.
However, if there is no formal planning and budgeting process, the projected results for next
year are only “guesstimates” and little can be done to assure that the expected results will
become real.
A business, any business that intends to be successful, is too important to leave to chance.
Planning and budgeting permit management to control the results, to avoid surprises. In a
well-managed business there will be no surprises. Planning enables business management to
anticipate what the business will do and to identify the resources necessary to assure that
what is desired is possible.
Consider the numerous popular sayings that relate to planning. Here are a few, all of which
convey the same message.
 Failure to plan is planning to fail.
 If you don’t care where you are going, it doesn’t matter which road you take.
 Plan your work and work your plan.
A plan provides the means to differentiate between managing and reacting. To help put the
planning process into perspective,
Business Planning—A Continuous Process
Planning and budgeting can be described as the coordination of information inside the
business to predict future results. POME describes briefly a continuous planning process that
keeps planning current rather than letting it become a once-a-year interruption to be
completed as quickly as possible, often without regard for validity or congruence with
corporate objectives. Planning should be continuous, current, and comprehensive—involving
all levels and all functions of the organization. The process depends on the commitment of
the people who have to deliver the results if the Projects is to meet its objectives.
38
2007, POME, Gautam_Koppala, All Rights Reserved
Strategic planning and operational budgeting are not difficult, per se, but many companies
do not do a particularly effective job of either. As a result, their planning documents do not
provide accurate plans, and this, in turn, discredits the process and leads to the deterioration
of subsequent efforts.
The most effective planning system is a comprehensive planning process involving people at
all levels that converts the planning effort from a once-a-year interruption of business
activity to a continuous update of what’s going on. As a result, planning and budgeting
becomes an integral part of the management of the business.
Therefore, the soundest source of sales forecast information is the sales-people, as long as
they understand the purpose of the information. Similarly, the staffing and expenditure
requirements to deliver the projected products, revenues, and profits are best predicted by
those who have to deliver the results. The people who are continuously in the market should
generate the best competitive information. In a similar vein, the sales force, the people in
the organization closest to the marketplace, often identify the new products most likely to
succeed.
Roles of the Key Players
In the planning process within Projects, everyone has roles and responsibilities. Most
important, the Project Manager who coordinates the budgeting and planning activities, often
a financial Project Manager, is not responsible for, nor does he or she do the budget or plan.
Rather, the budget Project Manager’s role is to facilitate and coordinate.
Top management sets the rules for the planning, defines the overall strategy; and
establishes the overall objectives. It also approves the budgets and plans and retains overall
responsibility for the process and its results.
Operating Project Managers are responsible for the specifics related to their areas. They
provide the detail, determine what actions are to be taken, identify what resources they need
in order to be successful, and communicate, often through the budget Project Manager, to
the other parts of the Projects the needs and expectations as well as their contributions to
the operations of other Project Managers.
The budget Project Manager oversees the process and provides the interface that assures
that all Project Managers receive the information they need. Among the budget Project
Manager’s duties are the setting of the timetable, development of the planning assumptions,
39
2007, POME, Gautam_Koppala, All Rights Reserved
coordinating organizational communications, assuring the avoidance of conflicts between
departments and disciplines, and assurance that the final plan document, whether it is the
budget or the strategic plan update, is internally consistent and clear in its projections and
requirements. However, the budget Project Manager does not do the budget.
Overview of the Financial Planning Process
It’s easy to incorporate a comprehensive financial planning program into the regular activities
and responsibilities of the various functions within a Projects. By doing so, the Project
Managers of the Projects recognize the integrated relationship between historic experience,
current activity, and future growth and success. The most knowledgeable people regarding
any aspect of the business operations are the people who have to perform in the function.
The integrated nature of business operation means that business planning and financial
planning are virtually synonymous.
Planning Sequence
Because business planning information builds on the information that precedes it, Projects
that follows a comprehensive planning process will develop its plans from the general to the
specific, from the longest range to progressively shorter time periods, taking advantage of
the accumulated knowledge.
Therefore, after the closing of the financial books for a year, early in the new fiscal year, the
planning for the next cycle begins. Bear in mind that plans already exist for the current fiscal
year. We assume for this discussion that the fiscal year and the calendar year coincide,
although, obviously, there is no need for that to be true.
The first step is to review the business plan that is already in existence to be sure that it still
applies. If it does, that is good. If it does not, management should confirm the Projects vision
and its mission statement or modify them as required. Management then updates the other
sections of the business plan, delineated in the next section, to reflect the new or revised
corporate direction.
The updated or confirmed business plan serves as the starting point for the strategic plan,
the five-year guide to business development that defines the expectations for each of the five
years and the steps necessary to reach the strategic goals established. The strategic plan is
updated every year: the first year of the plan drops off, as it is history; each succeeding year
is updated; and a new fifth year is added.
40
2007, POME, Gautam_Koppala, All Rights Reserved
This updating usually occurs in the first half of the year. The capital budget is generally
initiated in conjunction with the strategic plan and sometimes adjusted as part of the annual
budget when, during the assessment of capacity, other near-term investment needs are
identified. The capital budget decisions are incorporated into the cash budget. The cash
budget focuses attention on the availability of the cash resources needed to meet the
business’s requirements.
The Business Planning Process
There are five primary parts to the planning process: Business Plan, Strategic Plan, Operative
Plan or Budget, Capital Plan, and Cash Plan. These planning activities are linked together to
assure management’s overall control over the business. Other planning elements are of
lesser importance and are really components of the other plans. For example, the advertising
budget and the media plan detail the timing and the costs of the year’s advertising program,
one element of the annual budget. The advertising program may also be an important part of
the strategic plan and may significantly affect the cash budget, particularly with regard to
timing. Similarly, the product development plan is an integral part of the strategic plan and
also has an effect on the annual budget and the cash budget. It could also contribute to the
capital budget.
Note that once it is prepared and approved, the budget remains in place for the entire year.
If management chooses to update or revise the budget as the year progresses, doing so
creates another comparison basis, but does not replace the “original” budget.
As a structure for this chapter, we look at each of the major planning types and tasks,
beginning with the business plan.
Business Plan
The business plan is frequently prepared as an overview of the Projects, often as a basis for
attracting financing. And it is often the first effort at planning because it provides a good
starting point and usually exists even for entities that have no formal planning process.
Business plans should be reviewed and updated or confirmed annually, most easily at the
time the strategic plan is prepared. Because some of the information and some of the
structure of the business plan differ from the strategic plan, keeping the business plan
current should be a separately assigned task.
41
2007, POME, Gautam_Koppala, All Rights Reserved
In today’s marketplace there is a great deal of talk about business plans. Most companies
seeking financing must submit a business plan. Many prospective employees ask to see the
business plan before deciding whether to join an organization. Vendors and customers, asked
to become parts of a strategic alliance, ask for a copy of the business plan. There are many,
many books and pamphlets on how to write a business plan. The American Management
Association offers seminars and self-study courses on how to write a business plan.
A business plan is the first step to formalized strategic planning. As noted earlier, it describes
the Projects, its people, its products, its markets, its customers, and its competitors. Most of
the time a business plan is written to satisfy a specific purpose and, therefore, very
specifically addresses the requirements of the audience to whom it is directed.
A business plan can also serve the business itself well. As such, perhaps it should be written
first with the internal organization in mind as its audience and then edited to satisfy an
outsider. When management looks at the business plan as a necessary evil, they write it for
the outsider; when management looks at the business plan as the first guide to internal
development, they write it to satisfy the inside organization. With either audience, the
structure of the business plan is basically the same. In the annotated outline that follows,
drawn from requirements presented by a venture capital provider, a plan organization is
suggested that will serve any audience.
Obviously, the business plan, often originally written to attract financing, serves as a very
thorough starting point for the continued strategic and operative planning that follow from it.
Keeping the business plan up-to-date is a part of the strategic planning effort that the
Projects should be pursuing. In Exhibit below the critical topics of a business plan are
presented in a logical sequence. Other topics may be added and the sequence may be
modified, but well-crafted business plans address these topics.
42
2007, POME, Gautam_Koppala, All Rights Reserved
43
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: A Business Plan Outline
Strategic Plan
The strategic planning process is the long-range look at the Projects’ future. The most
commonly used time frame is five years, but it really should be reflective of the product life
cycle for the business. For this reason, the strategic planning period for an aircraft
manufacturer would be significantly longer than five years and for a software developer
significantly shorter.
The strategic plan is updated annually, removing the year just completed, adjusting and
modifying the remaining four years (including the year currently underway), and adding a
new fifth year. Thus, in the 2005 renewal period, January through June 2005, 2004 is
dropped off (it is now history), 2005–2008 are updated based on the 2004 experience, and
2009 is added. Note that the first period being updated, 2005, is the same period for which a
detailed budget has been prepared. Therefore, the strategic planning process provides an
initial confirmation of the budget and its achievability. Furthermore, the detailed expectations
of the first strategic plan year are known and form a well-constructed starting point for the
five-year plan.
If, perhaps, the business’ situation has changed, this is the first opportunity to revise the
plans and expectations. Many companies review their operations periodically and issue
revised estimates to keep management informed. Therefore, included in the update process
are review, reassessment, and revision of the action steps and benchmarks that make up the
essence of the strategic plan.
Defining Strategy
A Projects’ strategy is the basic business approach it follows to meet its goals. Strategy has
been described in many ways. Among them are:
 A plan of action intended to accomplish a specific goal.
 A carefully devised program for achievement of objectives.
 Skillful management to attain an end.
 Guidelines for making directional decisions.
The strategy defines the methodology for accomplishing goals, strategic objectives. The
tactics the Projects employs are chosen to move the Projects toward its goals while adhering
to the overall strategy. Often, the strategy of a Projects can be summarized in a single word
44
2007, POME, Gautam_Koppala, All Rights Reserved
or short phrase. Exercise 11–3 provides an opportunity to link strategies to companies that
you know.
The Difference between Strategy and Tactics
The terms used to define business strategy are generally drawn from military analogies.
Strategic objectives describe what we want to accomplish, the strategy itself defines the
approach we plan to take to achieve the objective, and the tactics are the explicitly
identified action steps that will be employed to succeed.
Therefore, to achieve $10 million in sales is not a strategic objective any more than to
destroy 10,000 enemy soldiers is a strategic objective. To be the recognized leader in the
industry based on product quality may be a valid strategic business objective in the same
way that controlling the entrance to a valley, or surrounding an enemy army on a particular
battlefield, may be a valid military objective.
To achieve such an objective the Projects undertakes action steps keyed to quality and
reliability. Steps targeting market share and lowest cost are not appropriate. The military
commander may undertake a flanking maneuver or rush the ridge overlooking the valley.
Damming a river running through the valley will not help the military leader succeed.
Carrying this analogy a little further, consider the following scenario.
Our strategic objective is to surround the enemy army, containing and capturing their large
force, while minimizing our casualties.
We will undertake a flanking strategy.
Therefore Unit 1 will circle to the east following the river. Unit 2 will circle to the west along
the ridge. Unit 3 will confront the enemy from the south to permit Units 1 and 2 to succeed.
If all units complete their action steps, the strategy will be successful and the strategic
objective will be accomplished. An examination of the strategy and the tactics employed by
the allied forces in the Gulf War in 1991 demonstrates the successful military implementation
of such a strategy and the related tactics.
The Operative Plan or Annual Budget
Consider this scenario:
45
2007, POME, Gautam_Koppala, All Rights Reserved
Tom has managed the specialty light production at Bright Brites for five years now. Every
year top management asks his unit to submit its budget figures for the next year—based on
sales projections provided by the Projects’s large sales force. It’s budget time again, and
Tom is meeting with his top people to finalize their budget figures.
Tom: Listen up, team. These figures are way too high. I’ve checked the sales
forecasts and this year’s production numbers. There’s no way that we’ll need to
spend this amount on inventory or on labor. What gives?
Janice: Well, I’ve been the business Project Manager here for three years now, and
every year we give management our best estimate . . . and every year they
come back to us and ask us to reduce the number. Usually they want us to give
back about 18 percent. I’m tired of having to cut corners when I see other units
getting more than enough in their budgets. I just bumped up all the numbers
by 20 percent.
Tom: I can see why that approach is tempting, Janice, but how can top
management—or any of the rest of us, really—get a good handle on what’s
going on if they don’t start with good numbers?
Do you think the behavior of top management at Bright Brites encourages Project Managers
to submit accurate budgets and plans? Or, is it more likely that Project Managers inflate their
needs so that they have the resources to meet their functional obligations? Is management’s
strategy an effective tool for getting everyone in the organization committed to striving for
the corporate objectives?
Long-range planning and annual budgeting enable management to establish goals and define
expectations. They also identify benchmarks for evaluating accomplishment in the financial
and measurement periods that follow.
By itself a strategic plan or a budget is nothing more than some papers containing words and
numbers. For the planning process to be successful, all members of the organization for
which the budget or plan is written must accept and acknowledge as valid the objectives
established. The achievement of this buy-in by the people who must deliver the results is one
of the most important points in this entire program. The active participation and commitment
by the operating organization is essential to the successful planning of the business and
achievement of the plans established.
46
2007, POME, Gautam_Koppala, All Rights Reserved
When we examine the process, the same conclusions apply whether we speak of the
strategic plan or the budget. For example, a strategic plan develops goals and expectations
both in financial and in operational terms. A well-constructed plan includes a clear set of
actions that, when completed, achieve the objectives. The same is true, in more detail, for
the annual budget.
The action steps in all planning activities must include time frames and criteria for
measurement. The result is a set of benchmarks, or evaluation points, that enable the
Project Manager to assess progress toward the goal.
Projecting the Financial Future
Planning uses the analysis of what has happened in the past to guide the projection of future
results. It helps answer questions like: Do we like the results of the past? What can we do to
improve them?
In the projection of future performance, the starting point is the past. If the Project Manager
and the organization feel that the past performance was satisfactory or exemplary; then it is
used as the basis for the next expectation.
If, on the other hand, the performance was not satisfactory; some significant change must
be incorporated into the projection. Planners must look at past performance to see how it
must be altered. In a properly prepared plan, the projected results, whether of some major
revenue or expenditure item or of a less important element, must identify those factors that
will make the result differ from the past.
Capital Budgets
The capital budget is a separate task for two reasons: it is affected by the strategic planning
effort and is confirmed and may be modified by the annual budgeting process, and it often
involves substantial funding, more than is available through normal business operations.
Cash Budgets
The operating budget just described focuses on operations. What we sold and what we made
are measured as current activities. However, as we all know, the activities of today do not
represent the cash flows of today. The cash picture may be entirely different from the daily
activity.
47
2007, POME, Gautam_Koppala, All Rights Reserved
The cash budget presents only cash activities, and it presents them as they are expected to
occur. For example, the raw material we need to manufacture our product may be purchased
several months before it is to be used.
Such a transaction in normal accrual accounting would appear as:
Inventory 1,000
Accounts Payable 1,000
This same transaction has, at the time it occurs, no cash effect at all. Although the Projects
has an obligation, there has been no effect on cash availability per se.
When the bill comes due and is paid 30 days later, there is another bookkeeping transaction:
Accounts Payable 1,000
Cash 1,000
This obviously has a cash effect that must be recognized. The important point here is that
the cash transaction, if planned, would be planned for 30 days after the inventory acquisition
date.
Similarly, when a sale is recorded, the transaction appears as:
Accounts Receivable 1,500
Sales 1,500
Again, no cash transaction has occurred, and no cash recognition takes place. When the
customer remits payment, the bookkeeping transaction is recorded as follows:
Cash 1,500
Accounts Receivable 1,500
As with the purchase above, if the cash transaction had been planned, it would have been
planned for a date significantly after the date of the sale.
When the bookkeeping transaction does not have any cash effect, it is not included in the
cash budget. Therefore, accruals, depreciation, and amortization entries, and other noncash
records do not enter into the cash budget.
48
2007, POME, Gautam_Koppala, All Rights Reserved
Cash inflows result from receipt of sales revenues, generally a significant time after sales
have been recorded and long after payments have been made to cover the costs of the
products or services have been sold. Other sources of cash inflows are financing actions,
recovery of prior year tax over-payments, and other similar nonrepetitive items.
To determine the appropriate schedule of cash receipts, the budget Project Manager refers to
prior years and develops a pattern of customer payments. The sales are then converted to
receipts following the pattern of the Projects’ experience in prior years. If management
decides to change its receivables management policy, perhaps increasing the collection effort
in order to improve the time of cash receipts, such a change can easily be accommodated.
49
2007, POME, Gautam_Koppala, All Rights Reserved
CASH FLOW’S
50
2007, POME, Gautam_Koppala, All Rights Reserved
Cash Flows:
A revenue or expense stream that changes a cash account over a given period in your
Project. Cash inflows usually arise from one of three activities - financing, operations or
investing - although this also occurs as a result of donations or gifts in the case of personal
finance. Cash outflows result from expenses or investments. This holds true for both Projects
and personal finance.
Because many people view cash as indicative of a business’s financial well-being, a great
deal of attention is directed toward cash, cash management, cash availability, and a range of
other issues surrounding cash and cash equivalents. The third major financial statement, the
Statement of Cash Flows, represents an effort to present the management of cash in a
manner that can be understood by the various interested parties.
Over the years this interest in cash has gone through an evolution, from a relatively simple
Sources and Uses of Cash statement to the Cash Flow Statement to today’s Statement of
Cash Flows in a form that addresses the interests of management, lenders, and investors in
the same document.
The Statement of Cash Flows summarizes the changes in the Balance Sheet during the
reporting period, separated into transactions reflecting operating activities, investing
activities, and financing activities. It identifies where the company got the funds it used and
51
2007, POME, Gautam_Koppala, All Rights Reserved
what it did with them, and it facilitates assessment of management’s effectiveness in
directing the business.
The results of the Statement of Cash Flows reflect the change in the cash balances of the
company. If an item, or a total, is negative, it represents cash outflow; if positive, it reflects
inflows. On the following pages we present and describe the basic elements of the Statement
of Cash Flows.
For internal management each contributor to cash flow may be computed separately as part
of an effort to track amounts and causes and consequences. This detailed approach is known
by some as the Direct Method Cash Flow Statement; the one presented in Exhibit below is
known as the Indirect Method Cash Flow Statement.
The simple structuring of cash flows in Exhibits below helps you recognize the double entry
nature of bookkeeping entries and the effect that a transaction has on cash resources. It
demonstrates clearly the relationship of cash to other accounts on the Balance Sheet and
permits you to test the effect of a transaction before you undertake it.
Exhibit: Statement of Changes in Financial Position (Cash Flow Statement)
If you include cash and cash equivalents in your generation of the table in Exhibit , the two
columns will be equal. If you exclude cash and cash equivalents, the difference in the two
52
2007, POME, Gautam_Koppala, All Rights Reserved
columns is the change in liquid assets. If this table is produced as part of the planning
process, the difference between the columns (and it will generally be negative) is the cash
generated (+) or the cash needed (–) for the period being projected.
Exhibit: Alternative View of Cash Flow Statement
An accounting statement called the "statement of cash flows", which shows the amount of
cash generated and used by a company in a given period. It is calculated by adding noncash
charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a
specific project, or to a business as a whole. Cash flow can be used as an indication of a
Projects financial strength.
In projects, as in personal finance, cash flows are essential to solvency. They can be
presented as a record of something that has happened in the past, such as the sale of a
particular product, or forecasted into the future, representing what a Projects or a person
expects to take in and to spend. Cash flow is crucial to an projects survival. Having ample
cash on hand will ensure that creditors, employees and others can be paid on time. If a
project or person does not have enough cash to support its operations, it is said to be
insolvent, and a likely candidate for bankruptcy should the insolvency continue.
The statement of a Project's cash flows is often used by analysts to gauge financial performance.
Companies with ample cash on hand are able to invest the cash back into the Project in order to
generate more cash and profit.
53
2007, POME, Gautam_Koppala, All Rights Reserved
Fig: Cash Flows
Cash Flow Per Share:
A measure of a firm's financial strength, calculated as follows:
Many analysts, as well as some of the greatest investors of all time, place more weight
on cash flow per share than earnings per share(EPS). Because EPS is more easily
manipulated, its reliability can at times be questionable. Cash, on the other hand, is
difficult - if not impossible - to fake. You either have cash or you don't. Therefore,
cash flow per share is a useful measure for the strength of a firm and the
sustainability of its business model.
Cash Flow Return on Investment (CFROI):
54
2007, POME, Gautam_Koppala, All Rights Reserved
A valuation model that assumes the stock market sets prices based on cash flow, not on
corporate / Projects/ Operations performance and earnings.
It's valuable to consider as many models as possible when looking at the stock
market. Financial theory is similar to scientific theory; no model can be entirely proved
or disproved, and a diversity of opinions is encouraged
The Essentials Of Cash Flow:
If operations reports earnings of $1 billion, does this mean it has this amount of cash in the
bank? Not necessarily. Financial statements are based on accrual accounting, which takes
into account non-cash items. It does this in an effort to best reflect the financial health of a
company. However, accrual accounting may create accounting noise, which sometimes needs
to be tuned out so that it's clear how much actual cash a company is generating. The
statement of cash flow provides this information, and here we look at what cash flow is and
how to read the cash flow statement.
Projects are all about trade, the exchange of value between two or more parties, and cash is
the asset needed for participation in the economic system. For this reason - while some
industries are more cash intensive than others - no Project can survive in the long run
without generating positive cash flow per share for its shareholders. To have a positive cash
flow, the company's long-term cash inflows need to exceed its long-term cash outflows.
An outflow of cash occurs when a project transfers funds to another party (either physically
or electronically). Such a transfer could be made to pay for employees, suppliers and
creditors, or to purchase long-term assets and investments, or even pay for legal expenses
and lawsuit settlements. It is important to note that legal transfers of value through debt - a
purchase made on credit - is not recorded as a cash outflow until the money actually leaves
the company's hands.
A cash inflow is of course the exact opposite; it is any transfer of money that comes into the
55
2007, POME, Gautam_Koppala, All Rights Reserved
Project's possession. Typically, the majority of Projects cash inflows are from customers,
lenders (such as banks or bondholders) and investors who purchase company equity from
the company. Occasionally cash flows come from sources like legal settlements or the sale of
Operations real estate or equipment.
Cash Flow vs Income
It is important to note the distinction between being profitable and having positive cash flow
transactions: just because a project is bringing in cash does not mean it is making a profit
(and vice versa).
For example, say a manufacturing company is experiencing low product demand and
therefore decides to sell off half its factory equipment at liquidation prices. It will receive
cash from the buyer for the used equipment, but the manufacturing company is definitely
losing money on the sale: it would prefer to use the equipment to manufacture products and
earn an operating profit. But since it cannot, the next best option is to sell off the equipment
at prices much lower than the company paid for it. In the year that it sold the equipment, the
company would end up with a strong positive cash flow, but its current and future earnings
potential would be fairly bleak. Because cash flow can be positive while profitability is
negative, investors should analyze income statements as well as cash flow statements, not
just one or the other.
What Is the Cash Flow Statement?
There are three important parts of a Project's financial statements: the balance sheet, the
income statement and the cash flow statement. The balance sheet gives a one-time snapshot
of a Project's assets and liabilities (see Reading the Balance Sheet). And the income
statement indicates the Project's profitability during a certain period (see Understanding The
Income Statement).
The cash flow statement differs from these other financial statements because it acts as a
kind of corporate checkbook that reconciles the other two statements. Simply put, the cash
flow statement records the company's cash transactions (the inflows and outflows) during
the given period. It shows whether all those lovely revenues booked on the income
statement have actually been collected. At the same time, however, remember that the cash
flow does not necessarily show all the company's expenses: not all expenses the company
accrues have to be paid right away. So even though the company may have incurred
56
2007, POME, Gautam_Koppala, All Rights Reserved
liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are
paid (see the section "What Cash Flow Doesn't Tell Us" below).
The following is a list of the various areas of the cash flow statement and what they mean:
• Cash flow from operating activities - This section measures the cash used or
provided by a Project's normal operations. It shows the Project's ability to generate
consistently positive cash flow from operations. Think of "normal operations" as the
core business of the Project. For example, Microsoft's normal operating activity is
selling software.
• Cash flows from investing activities - This area lists all the cash used or provided
by the purchase and sale of income-producing assets. If Microsoft, again our example,
bought or sold companies for a profit or loss, the resulting figures would be included
in this section of the cash flow statement.
• Cash flows from financing activities - This section measures the flow of cash
between a firm and its owners and creditors. Negative numbers can mean the Project
is servicing debt but can also mean the Project is making dividend payments and
stock repurchases, which investors might be glad to see.
When you look at a cash flow statement, the first thing you should look at is the bottom line
item that says something like "net increase/decrease in cash and cash equivalents", since
this line reports the overall change in the Project's cash and its equivalents (the assets that
can be immediately converted into cash) over the last period. If you check under current
assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you
take the difference between the current CCE and last year's or last quarter's, you'll get this
same number found at the bottom of the statement of cash flows.
In the sample Microsoft annual cash flow statement (from June 2004) shown below, we can
see that the business ended up with about $9.5 billion more cash at the end of its 2003/04
fiscal year than it had at the beginning of that fiscal year (see "Net Change in Cash and
Equivalents"). Digging a little deeper, we see that the Company had a negative cash outflow
of $2.7 billion from investment activities during the year (see "Net Cash from Investing
Activities"); this is likely from the purchase of long-term investments, which have the
potential to generate a profit in the future.Generally, a negative cash flow from investing
activities are difficult to judge as either good or bad - these cash outflows are investments in
57
2007, POME, Gautam_Koppala, All Rights Reserved
future operations of the Company (or another Company); the outcome plays out over the
long term.
The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6 billion in
positive cash flow from its usual business operations - a good sign. Notice the Project has
had similar levels of positive operating cash flow for several years. If this number were to
increase or decrease significantly in the upcoming year, it would be a signal of some
underlying change in the Project's ability to generate cash.
Digging Deeper into Cash Flow
All companies and its Projects provide cash flow statements as part of their financial
statements, but cash flow (net change in cash and equivalents) can also be calculated as net
income plus depreciation and other non-cash items.
58
2007, POME, Gautam_Koppala, All Rights Reserved
Generally, a Project's principal industry of operation determine what is considered proper
cash flow levels; comparing a Project's cash flow against its industry peers is a good way to
gauge the health of its cash flow situation. A Project not generating the same amount of cash
as competitors is bound to lose out when times get rough.
Even a Project that is shown to be profitable according to accounting standards can go under
if there isn't enough cash on hand to pay bills. Comparing amount of cash generated to
outstanding debt, known as the operating cash flow ratio, illustrates the Project's ability to
service its loans and interest payments. If a slight drop in a Project's quarterly cash flow
would jeopardize its loan payments, that Project carries more risk than a Project with
stronger cash flow levels. Hence, we always require a Project Manager with finance acumen.
Unlike reported earnings, cash flow allows little room for manipulation. Every Company of its
consolidated Project filing reports with the Securities and Exchange Commission (SEC) is
required to include a cash flow statement with its quarterly and annual reports. Unless
tainted by outright fraud, this statement tells the whole story of cash flow: either the Project
has cash or it doesn't.
What Cash Flow Doesn't Tell Us
Cash is one of the major lubricants of Project activity, but there are certain things that cash
flow doesn't shed light on. For example, as we explained above, it doesn't tell us the profit
earned or lost during a particular period: profitability is composed also of things that are not
cash based. This is true even for numbers on the cash flow statement like "cash increase
from sales minus expenses", which may sound like they are indication of profit but are not.
As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of
indicating the overall financial well-being of the Project. Sure, the statement of cash flow
indicates what the Project is doing with its cash and where cash is being generated, but
these do not reflect the Project's entire financial condition. The cash flow statement does not
account for liabilities and assets, which are recorded on the balance sheet. Furthermore
accounts receivable and accounts payable, each of which can be very large for a Project, are
also not reflected in the cash flow statement.
59
2007, POME, Gautam_Koppala, All Rights Reserved
In other words, the cash flow statement is a compressed version of the Project's checkbook
that includes a few other items that affect cash, like the financing section, which shows how
much the Project spent or collected from the repurchase or sale of stock, the amount of
issuance or retirement of debt and the amount the Project paid out in dividends.
Cash accounting:
An accounting method which reports expenditures and revenues when the actual cash
outflow or inflow has occurred.
Cash discount:
A reduction, usually expressed as a percentage, in the price of a product or the
amount of a bill if payment is made promptly and in cash.
Cash market:
The market in which commodities, treasury bills and other debt securities are traded
against cash, for immediate delivery.
Cash payment:
In international trade transactions, this refers to the portion paid by the importer prior
to shipment (usually 15% of the total sales price or invoice value). It is mandatory for
the extension of most medium and long-term guarantee/insurance and trade financing
facilities.
Cash price:
Spot price.
Cash with order (CWO):
A payment technique whereby the buyer pays for the goods when ordering them, with
the transaction being binding on both parties.
Concluded Note:
Like so much in the world of finance, the cash flow statement is not straightforward.
You must understand the extent to which a Project relies on the capital and the extent
to which it relies on the cash it has itself generated. No matter how profitable a Project
may be, if it doesn't have the cash to pay its bills, it will be in serious trouble.
60
2007, POME, Gautam_Koppala, All Rights Reserved
At the same time, while investing in a Project that shows positive cash flow is
desirable, there are also opportunities in companies that aren't yet cash-flow positive.
The cash flow statement is simply a piece of the puzzle. So, analyzing it together with
the other statements can give you a more overall look at a Project' financial health.
Remain diligent in your analysis of a Project's cash flow statement and you will be well
on your way to removing the risk of one of your stocks falling victim to a cash flow
crunch.
The flow of cash payments to or from a firm during a given period of time.
Expenditures are sometimes referred to as "negative" cash flows.
 Statement of Cash Flows
(Note: The Separate POME Chapter of Cash Flows illustrated more in detail about this)
The third financial statement that George needs to understand is the Statement of
Cash Flows. This statement shows how GG Org's cash amount has changed during the
time interval shown in the heading of the statement. George will be able to see at a
glance the cash generated and used by his company's operating activities, its
investing activities, and its financing activities. Much of the information on this
financial statement will come from GG Org's balance sheets and income statements.
The three financial reports that Koppala introduced to George—the income statement,
the balance sheet, and the statement of cash flows—represent one segment of the
valuable output that good accounting software can generate for business owners.
Koppala now explains to George the basics of getting started with recording his
transactions.
Double Entry System
The field of accounting—both the older manual systems and today's basic accounting
software—is based on the 500-year-old accounting procedure known as double
entry. Double entry is a simple yet powerful concept: each and every one of a
company's transactions will result in an amount recorded into at least two of the
accounts in the accounting system.
The Chart of Accounts
61
2007, POME, Gautam_Koppala, All Rights Reserved
People develop accounting systems to make it easier to process accounting transactions and
to generate financial statements and other financial information. To process the accounting
transactions such as those in the preceding section, accountants have developed a
systematic account numbering system that helps assure that transactions are properly
reflected in the financial statements.
Such a systematic numbering system, called the chart of accounts, provides a shorthand
entry control system for assuring that related transactions are accumulated together.
Properly constructed, the chart of accounts should lead directly to the production of financial
statements, making it easy to close the books each period, produce financial statements, and
provide consistent information for analysis and interpretation. Thus, the accounting system
and the processing of transactions contribute to the timely and effective management of the
operations.
The numbering system in a well-constructed chart of accounts reflects the same sequence as
appears in the financial statements, beginning with cash, the first Balance Sheet Asset
account, and continuing through taxes, an expense reflected at the bottom of the Income
Statement. The result of such a structure is that as the accountant closes the books for the
period, these basic financial statements will be automatically prepared.
A typical chart of accounts might be constructed like the one in Exhibit below As you can see,
the structure of the numbering system leads directly to the presentation of financial
statements.
 1000s are Assets
 2000s are Liabilities
 3000 are Equity accounts
 4000s are Revenues
 5000s are Cost of Sales accounts
 6000s are Operating Expenses
 7000s are Other Income and Expense accounts
 8000s are Taxes
This type of structure makes it very easy for the accountants and Project Managers to review
the results of the accounting period and report to management, and to other interested
parties, the summarized results and the reasons behind them.
62
2007, POME, Gautam_Koppala, All Rights Reserved
As a company becomes more complicated, with divisions or subsidiaries, with multiple
departments, or with other specialized reporting interests, the accounts within each category
may be expanded by inserting numbers or adding additional digits to permit reporting by
smaller or more specific units.
For example, Peachtree Accounting Software, an inexpensive PC-based accounting software
package, permits a chart of accounts numbering system of up to 15 characters, both letters
and numbers. Such a chart of accounts permits as much detail as any smaller business might
want or need.
In fact, the availability of 15 characters would permit such detail as would be needed to track
the costs of a specific project or activity within a department within a facility within a division
within a subsidiary within a company. At the same time, by sorting on specific digits within
the account code, management could determine how much was spent on a particular
expense category, such as Telephone or Delivery.
As an example of a 15-digit account number consider the following:
AAA = Company, subsidiary, division or affiliate
BBBB = Account number
CCC = Department or responsibility
DDDDD = Project, territory, class of trade
With this type of structure a company can identify spending activity in almost any
combination of ways to provide all Project Managers with the information they need to
manage their area and level of responsibility.
The Accounting Cycle
Accountants collect financial information as it occurs but report it based on predetermined
accounting time periods, generally months, quarters, and years. It could, however, be
reported for any time period that management or some interested party decided was
important.
Using Journal Entries to Record Transactions
During the specified time period, the transactions that occur are tracked using the same
journal entry structure discussed in the last section. All activity is recorded using debits and
63
2007, POME, Gautam_Koppala, All Rights Reserved
credits, preserving the balance that was established before, but changing totals to
incorporate the current activity. In the actual accounting system these journal entries are
often established with one side understood and calculated automatically, such as when a bill
is paid, the debit is recorded as an expense or a charge to Accounts Payable. The credit side
is automatically charged to Cash, to recognize the actual payment. Only when the credit is to
go to some other account is it necessary to record the credit entry. Nevertheless, the journal
entry balances and the basic accounting equality are preserved. A brief look at some of these
transactions will clarify this discussion. Then a series of exercises provides a little practice in
making journal entries and following the transactions into the financial statements.
Where:
Exhibit: Chart of Accounts
Consider a purchase of $1,000 of special widgets needed for a special project.
64
2007, POME, Gautam_Koppala, All Rights Reserved
The Project Manager would place an order with the local office of Specialty Widget
Corporation Based Projects for the supplies. This action would have no impact on the
accounting system.
When the supplies are shipped, Specialty Widget issues an invoice for $1,000. On Specialty
Widget’s books this transaction is recorded as:
Dr (Debit) Cr (Credit)
Sales $1,000.00
Accounts $1,000.00
Receivable
Cost of Sales 700.00
Inventory 700.00
You will recognize that Specialty Widget has achieved a $300 contribution to profit on this
transaction. The difference between sales and cost of sales is known as gross profit.
On the purchasing company’s books, the same transaction appears as:
Supplies $1,000.00
Expense
Accounts $1,000.00
Payable
The supplies are not generally treated as inventory because they are not for resale, are not
held for use in some future time period, and are not to be stored for use as part of the
product to be sold.
When the purchasing company pays for the supplies, after 30 days or whatever credit period
was determined in negotiation between the two companies, the respective entries are as
follows:
On the books of the purchasing company:
Accounts $1,000.00
Payable
65
2007, POME, Gautam_Koppala, All Rights Reserved
Cash $1,000.00
And on the books of the Specialty Widget Corporation Based Projects :
Cash $1,000.00
Accounts $1,000.00
Receivable
You can see from this example that each entry is balanced. Following these entries to the
financial statements highlights some additional important considerations.
On the books of Specialty Widget, the Sales exceed the Cost of Sales by an amount that,
were this the only transaction of the month, would result in a profit of $300. This profit,
when closed to Retained Earnings during the closing process, would assure that the Balance
Sheet balanced because the increase in assets of $300 (the absolute difference between the
increase in Accounts Receivable [later transferred to Cash] and the decrease in Inventory) is
equal to the increase in Retained Earnings.
On the books of the purchasing company, the $1,000.00 in Supplies Expense, were it the
only transaction of the month, would result in a reported loss of $1,000.00. This amount,
when closed to Retained Earnings at the end of the month, would result in balancing the
Balance Sheet, as the decrease in Cash of $1,000.00 would equal the decrease in Retained
Earnings of $1,000.00.
In traditional accounting education, each of these transactions would be recorded in an
appropriate journal, a book of transactions that would be summarized as the first steps in
the monthly closing process. In practice today, these journals are generally automatically
recorded and summarized within the computerized accounting system. Let’s see how this
would look for an ordinary individual. If you pay all your bills by check and record all
transactions in your checkbook, the checkbook is the journal, and you could prepare personal
financial statements every month using the checkbook as the basis for all your closing
entries.
If you analyze your business, you will recognize a series of journals that you can visualize as
the accounting system:
 Sales Journal—Records all sales orders.
66
2007, POME, Gautam_Koppala, All Rights Reserved
 Cash Receipts Journal—Records all cash receipts. The Cash Receipts Journal should
confirm deposit information appearing in the bank statement.
 Purchases Journal—Records all purchase orders that have been fulfilled. It records
obligations before they have been paid. Payments appear in the Cash Disbursements
Journal.
 Cash Disbursements Journal—Records all payments made. The difference between
the cash disbursements journal summary and the cash receipts journal summary is the
net entry to Cash on the Balance Sheet.
 Payroll Journal—Records all payroll transactions. The amounts entered into the
payroll journal also show up as transactions in the cash disbursements journal.
 General Journal—Records all adjusting entries, summary totals from the other
journals, and all transactions that do not affect cash receipts or cash disbursements. The
general journal provides the link to the financial statements for all accounting activities
that do not pass through the other journals or other detailed records of the company.
Because each accounting period is supposed to provide a complete and accurate summary of
financial transactions and financial conditions, it is sometimes necessary to recognize the
financial effects of transactions that have not yet happened or are not yet complete. Consider
the partial completion of some production. You would need to record the value of the work
completed to date, even though it is not yet finished. The accounting for value added to work
in process needs to be recorded, but for the next period, you need to undo, or reverse, this
entry in order to record the final value of the now completed product. Such an entry, and
there are many of them, is handled in the accounting system as a reversing journal entry,
that is, an entry that will be reversed in the next accounting period. Each period will then
have the right amounts in it. The first entry, in the first period, records the work completed
to date. The second set of entries, in the following period, will record a negative amount for
the work completed earlier and the full value of the completed product. The net of these two
parts equals the value added in the second period.
Therefore, reversing journal entries are part of the general journal and are normally recorded
separately, permitting their immediate (at the beginning of the next accounting period)
reversal, setting the stage for the next accounting cycle.
There are also some transactions that occur every accounting period. These can be
summarized in a series of standard journal entries that simplify the accounting process.
For example, the depreciation of Fixed Assets occurs every month, generally recognized as
67
2007, POME, Gautam_Koppala, All Rights Reserved
one-twelfth of the annual depreciation amount. (Sometimes a company recognizes
depreciation based on the number of days in a month or some other predictable amount.)
Therefore, also in the General Journal, standard journal entries are recorded every month,
providing a basis for the recognition of all relevant financial consequences in the appropriate
accounting period.
Closing Procedures
At the end of each accounting period, all the transactions for that period are entered, even if
the entry takes place after the last day of the accounting period. Accounting is more
interested in accuracy than in getting everything done as quickly as possible. This sometimes
creates conflicts between the accountants and the operating Project Managers. Operating
Project Managers want to know as soon as possible what the results were and what
happened. After all, it is easier to make corrections in practices if you know about the
problems soon enough. Think about training a puppy. To change a behavior, you must
educate the puppy while he still remembers what you are training him about.
To satisfy both the accountants and the Project Managers, a closing schedule is established
that brings most of the relevant accounting information to the accounting department
quickly. The few transactions that are missed are generally not material. That is, they do
not significantly affect the final results.
As soon as the last of the transactions are recorded, the accountants summarize the general
journal, perhaps automatically as part of the computerized accounting system, making
closing journal entries that bring the current period to a close. These entries bring the
Income Statement balances for the period back to zero by transferring the net amount to the
equity side of the Balance Sheet, creating a balance between the assets and the liabilities. At
this time, the system is ready to start the next period’s Income Statement.
To begin the process of setting up George's accounting system, he will need to make a
detailed listing of all the names of the accounts that GG Org, Inc. might find useful for
reporting transactions. This detailed listing is referred to as a chart of accounts.
Because of the double entry system all of GG Org's transactions will involve a
combination of two or more accounts from the balance sheet and/or the income
statement. Koppala lists out some sample accounts that George will probably need to
include on his chart of accounts:
Balance Sheet accounts:
68
2007, POME, Gautam_Koppala, All Rights Reserved
• Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)
• Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)
• Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)
Income Statement accounts:
• Revenue accounts (Examples: Service Revenues, Investment Revenues)
• Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation
Expense)
To help George really understand how this works, Koppala illustrates the double entry
with some sample transactions that George will likely encounter.
Sample Transactions #1:
On December 1, 2007 George starts his business GG Org, Inc. The first transaction
that George will record for his company is his personal investment of $20,000 in
exchange for 5,000 shares of GG Org's common stock. GG Org's accounting system
will show an increase in its account Cash from zero to $20,000, and an increase in its
stockholders' equity account Common Stock by $20,000. Both of these accounts are
balance sheet accounts. There are no revenues because no delivery fees were earned
by the company, and there were no expenses.
After George enters this transaction, GG Org's balance sheet will look like this:
GG Org, Inc.
Balance Sheet
December 1, 2006
Assets Liabilities & Stockholders' Equity
Cash $ 20,000 Liabilities
Stockholders' Equity
$
Common Stock
20,000
Total Assets $ 20,000 Total Liabilities & Stockholders' $
69
2007, POME, Gautam_Koppala, All Rights Reserved
Equity 20,000
Koppala asks George if he can see that the balance sheet is just that—in balance.
George looks at the total of $20,000 on the asset side, and looks at the $20,000 on
the right side, and says yes, of course, he can see that it is indeed in balance.
Koppala shows George something called the basic accounting equation, which, he
explains, is really the same concept as the balance sheet, it's just presented in an
equation format:
Assets = Liabilites + Stockholders' (or Owner's) Equity
$20,000 = $0 + $20,000
The accounting equation (and the balance sheet) should always be in balance.
Debits and Credits:
Did the first sample transaction follow the double entry system and affect two or more
accounts? George looks at the balance sheet again and answers yes, both Cash and
Common Stock were affected by the transaction.
Koppala introduces the next basic accounting concept: the double entry system
requires that the same dollar amount of the transaction must be entered on both the
left side of one account, and on the right side of another account. Instead of the word
left, accountants use the word debit; and instead of the word right, accountants use
the word credit. (The terms debit and credit are derived from Latin terms used 500
years ago.)
Debit means left.
Credit means right.
George asks Koppala how he will know which accounts he should debit—meaning he
should enter the numbers on the left side—and which accounts he should credit—
meaning he should enter the numbers on the right side. Koppala points back to the
basic accounting equation and tells George that if he memorizes this simple equation,
it will be easier to understand the debits and credits.
70
2007, POME, Gautam_Koppala, All Rights Reserved
Memorizing the simple accounting equation will
help you learn the debit and credit rules.
Let's take a look at the accounting equation again:
Stockholders' (or Owner's)
Assets = Liabilites +
Equity
Assets are on the left side (or debit side) of the accounting equation, so assets have
their account balances on the left side. To increase an asset's balance, you put more
on the left side of the asset account. In accounting jargon, you debit the asset
account. To decrease an asset you credit the account, that is, you enter the amount
on the right side.
Liabilities and stockholders' equity are on the right side (or credit side) of the
accounting equation, and liabilities and equity have their account balances on the right
side. To increase the balance in a liability or stockholders' equity account, you put
more on the right side. In accounting jargon, you credit the liability or the equity
account. To decrease a liability or equity, you debit the account, that is, you enter the
amount on the left side.
As with all rules, there are exceptions, but Koppala's advice of using the accounting
equation will be helpful with the majority of George's transactions.
Since many transactions involve cash, Koppala suggests that George memorize how
the Cash account is affected when a transaction involves cash: if GG Org receives
cash, the Cash account is debited; when GG Org pays cash, the Cash account is
credited.
When a company receives cash, the Cash account is debited.
When the company pays cash, the Cash account is credited.
Koppala refers to the example of December 1. Since GG Org received $20,000 in cash
from George in exchange for 5,000 shares of common stock, one of the accounts for
this transaction is Cash. Since cash was received, the Cash account will be debited.
In keeping with double entry, two (or more) accounts need to be involved. Because
the first account (Cash) was debited, the second account needs to be credited. All
71
2007, POME, Gautam_Koppala, All Rights Reserved
George needs to do is find the right account to credit. In this case, the second account
is Common Stock. Common stock is part of stockholders' equity, which is on the
right side of the accounting equation. As a result, it should have a credit balance, and
to increase its balance the account needs to be credited.
Accountants indicate accounts and amounts using the following format:
Account Name Debit Credit
Cash 20,000
Common Stock 20,000
Accountants usually first show the account and amount to be debited. On the next
line, the account to be credited is indented and the amount appears further to the
right than the debit amount shown in the line above. This entry format is referred to
as a general journal entry.
(With the decrease in the price of computers and accounting software, it is rare to find
a small business still using a manual system and making entries by hand.
Sample Transaction #2:
Koppala illustrates for George a second transaction. On December 2, GG Org
purchases a used Project van for $14,000 by writing a check for $14,000. The two
accounts involved are Cash and Vehicles (or Delivery Equipment). When the check
is written, the accounting software will automatically make the entry into these two
accounts.
Koppala explains to George what is happening within the software. Since the company
pays $14,000, the Cash account is credited. (Accountants consider the checking
account to be Cash, and the TIP you learned is that when cash is paid, you credit
Cash.) So we know that the Cash account will be credited for $14,000 and we know
the other account will have to be debited for $14,000. We need only identify the best
account to debit. In this case we choose Vehicles (or Delivery Equipment) and the
entry is:
72
2007, POME, Gautam_Koppala, All Rights Reserved
Account Name Debit Credit
Vehicles 14,000
Cash 14,000
The balance sheet will look like this after the vehicle transaction is recorded:
GG Org, Inc.
Balance Sheet
December 2, 2006
Assets Liabilities & Stockholders' Equity
Cash $ 6,000 Liabilities
Vehicles 14,000 Stockholders' Equity
$
Common Stock
20,000
Total Assets Total Liabilities & Stockholders' $
$ 20,000
Equity 20,000
The balance sheet and the accounting equation remain in balance:
Assets = Liabilites + Stockholders' (or Owner's) Equity
$20,000 = $0 + $20,000
73
2007, POME, Gautam_Koppala, All Rights Reserved
As you can see in the balance sheet, the asset Cash decreased by $14,000 and
another asset Vehicles increased by $14,000.
Liabilities and stockholders' equity were not involved and did not change.
Sample Transaction #3:
The third sample transaction also occurs on December 2 when George contacts an
insurance agent regarding insurance coverage for the vehicle GG Org just purchased.
The agent informs him that $1,200 will provide insurance protection for the next six
months. George immediately writes a check for $1,200 and mails it in.
Let's consider this transaction. Using double entry, we know there must be a minimum
of two accounts involved—one (or more) of the accounts must be debited, and one (or
more) must be credited.
Since a check is written, we know that one of the accounts involved is Cash. Since
cash was paid, the Cash account will be credited. (Take another look at the last TIP.)
While we have not yet identified the second account, what we do know for certain is
that the second account will have to be debited.
At this point we have most of the entry—all we are missing is the name of the account
to be debited:
Account Name Debit Credit
??? 1,200
Cash 1,200
We know the transaction involves insurance, and a quick look through the chart of
accounts reveals two possibilities:
Prepaid Insurance (an asset account reported on the balance sheet) and Insurance
Expense (an expense account reported on the income statement)
74
2007, POME, Gautam_Koppala, All Rights Reserved
Assets include costs that are not yet expired (not yet used up), while expenses are
costs that have expired (have been used up). Since the $1,200 payment is for an
expense that will not expire in its entirety within the current month, it would be logical
to debit the account Prepaid Insurance. (At the end of each month, when $200 has
expired, $200 will be moved from Prepaid Insurance to Insurance Expense.)
The entry in the general journal format is:
Account Name Debit Credit
Prepaid Insurance 1,200
Cash 1,200
After the first three transactions have been recorded, the balance sheet will look like
this:
GG Org, Inc.
Balance Sheet
December 2, 2006
Assets Liabilities & Stockholders' Equity
$
Cash Liabilities
4,800
Prepaid Insurance 1,200 Stockholders' Equity
$
Vehicles Common Stock
14,000 20,000
75
2007, POME, Gautam_Koppala, All Rights Reserved
Total Assets Total Liabilities & Stockholders' $
$ 20,000
Equity 20,000
Again, the balance sheet and the accounting equation are in balance and all of the
changes occurred on the asset/left/debit side of the accounting equation. Liabilities
and Stockholders' Equity were not affected by the insurance transaction.
Sample Transaction #4:
The fourth transaction occurs on December 3, when a customer gives GG Org a check for
$10 to deliver two parcels on that day. Because of double entry, we know there must be a
minimum of two accounts involved—one of the accounts must be debited, and one of the
accounts must be credited.
Because GG Org received $10, it must debit the account Cash. It must also credit a second
account for $10. The second account will be Service Revenues, an income statement
account. The reason Service Revenues is credited is because GG Org must report that it
earned $10 (not because it received $10). Recording revenues when they are earned results
from a basic accounting principle known as the revenue recognition principle. The following
tip reflects that principle.
Revenues accounts are credited when the company earns a fee (or sells merchandise)
regardless of whether cash is received at the time.
Here are the two parts of the transaction as they would look in the general journal format:
Account Name Debit Credit
Cash 10
76
2007, POME, Gautam_Koppala, All Rights Reserved
Service Revenues 10
Sample Transaction #5
Let's assume that on December 3 the company gets its second customer—a local company
that needs to have 5 work packages immediately. George's price of $250 is very appealing,
so George's company is hired to deliver the work packages. The customer tells George to
submit an invoice for the $250, and they will pay it within seven days.
George delivers the work packages on December 3 as agreed, meaning that on December 3
GG Org has earned $250. Hence the $250 is reported as revenues on December 3, even
though the company did not receive any cash on that day. The effort needed to complete the
job was done on December 3. (Depositing the check for $250 in the bank when it arrives
seven days later is not considered to take any effort.)
Let's identify the two accounts involved and determine which needs a debit and which needs
a credit.
Because GG Org has earned the fees, one account will be a revenues account, such as
Service Revenues. (If you refer back to the last TIP, you will read that revenue accounts —
such as Service Revenues—are usually credited, meaning the second account will need to be
debited.)
In the general journal format, here's what we have identified so far:
Account Name Debit Credit
77
2007, POME, Gautam_Koppala, All Rights Reserved
??? 250
Service Revenues 250
We know that the unnamed account cannot be Cash.
Account Name Debit Credit
Accounts Receivable 250
Service Revenues 250
Again, reporting revenues when they are earned results from the basic accounting principle
known as the revenue recognition principle.
Sample Transaction #6
For simplicity, let's assume that the only expense incurred by GG Org so far was a fee to a
temporary help agency for a person to help George in completing the work packages on
December 3. The temp agency fee is $80 and is due by December 12.
If a company does not pay cash immediately, you cannot credit Cash. But because the
company owes someone the money for its purchase, we say it has an obligation or liability
to pay. Most accounts involved with obligations have the word "payable" in their name, and
one of the most frequently used accounts is Accounts Payable. Also keep in mind that
expenses are almost always debited.
78
2007, POME, Gautam_Koppala, All Rights Reserved
The accounts and amounts for the temporary help are:
Account Name Debit Credit
Temporary Help Expense 80
Accounts Payable 80
Expenses are (almost) always debited.
If a company does not pay cash right away for an expense or for an asset, you cannot credit
Cash. Because the company owes someone the money for its purchase, we say it has an
obligation or liability to pay. The most likely liability account involved in business obligations
is Accounts Payable.
Revenues and expenses appear on the income statement as shown below:
GG Org, Inc.
Income Statement
For the Three Days Ended December 3,
2006
Service Revenue $ 260
Temporary Help Expense 80
Net Income $ 180
After the entries through December 3 have been recorded, the balance sheet will look like
this:
79
2007, POME, Gautam_Koppala, All Rights Reserved
GG Org, Inc.
Balance Sheet
December 3, 2006
Assets Liabilities & Stockholders' Equity
$
Cash Liabilities
4,810
$
Accounts Receivable 250 Accounts Payable
80
Prepaid Insurance 1,200 Stockholders' Equity
Vehicles 14,000 Common Stock 20,000
Retained Earnings
180
Total Stockholders' Equity 20,180
Total Assets Total Liabilities & Stockholders' Equity
$ 20,260 $ 20,260
Notice that the year-to-date net income (bottom line of the income statement) increased
Stockholders' Equity by the same amount, $180. This connection between the income
statement and balance sheet is important. For one, it keeps the balance sheet and the
accounting equation in balance. Secondly, it demonstrates that revenues will cause the
stockholders' equity to increase and expenses will cause stockholders' equity to decrease.
After the end of the year financial statements are prepared, you will see that the income
statement accounts (revenue accounts and expense accounts) will be closed or zeroed out
and their balances will be transferred into the Retained Earnings account. This will mean
the revenue and expense accounts will start the new year with zero balances—allowing the
company "to keep score" for the new year.
80
2007, POME, Gautam_Koppala, All Rights Reserved
Koppala suggested that perhaps this introduction was enough material for their first meeting.
She wrote out the following notes, summarizing for George the important points of their
discussion:
1. When a company pays cash for something, the company will credit Cash and will
have to debit a second account. Assuming that a company prepares monthly
financial statements—
 If the amount is used up or will expire in the current month, the account to be
debited will be an expense account. (Advertising Expense, Rent Expense, Wages
Expense are three examples.)
 If the amount is not used up or does not expire in the current month, the
account to be debited will be an asset account. (Examples are Prepaid Insurance,
Supplies, Prepaid Rent, Prepaid Advertising, Prepaid Association Dues, Land,
Buildings, and Equipment.)
 If the amount reduces a company's obligations, the account to be debited will
be a liability account. (Examples include Accounts Payable, Notes Payable, Wages
Payable, and Interest Payable.)
2. When a company receives cash, the company will debit Cash and will have to
credit another account. Assuming that a company will prepare monthly financial
statements—
 If the amount received is from a cash sale, or for a service that has just been
performed but has not yet been recorded, the account to be credited is a revenue account
such as Service Revenues or Fees Earned.
 If the amount received is an advance payment for a service that has not yet
been performed or earned, the account to be credited is Unearned Revenue.
 If the amount received is a payment from a customer for a sale or service
delivered earlier and has already been recorded as revenue, the account to be credited is
Accounts Receivable.
 If the amount received is the proceeds from the company signing a promissory
note, the account to be credited is Notes Payable.
81
2007, POME, Gautam_Koppala, All Rights Reserved
 If the amount received is an investment of additional money by the owner of
the corporation, a stockholders' equity account such as Common Stock is credited.
Determining the Cash Flows of a Project
For all of the years of the capital project evaluation, usually six or seven, all of the income
and expenses associated with the project activity need to be determined. The evaluation is
concerned only with the incremental activity, not the already existing fixed costs that will be
allocated to the sales and operations involved. The choice of a useful life limited to six or
seven years recognizes the difficulty of estimating results too far into the future. It also
recognizes that the present value interest factors beyond six or seven years are sufficiently
low that the present value of cash flows then is probably modest.
In many cases incremental revenues are easy to determine. The analyst needs to be
aggressive in seeking out the costs because they are much more difficult to identify.
This difficulty is compounded by the fact that the Project Manager who is recommending the
project is usually optimistic and positive about all aspects of the project; he or she may leave
out expenses and other costs, generally inadvertently. Nevertheless, determining the cash
flows associated with a project, and taking all elements into account, may be difficult. The
consequence will be optimistic projections of profits and cash flows resulting from the
investment.
For each year, the revenues and costs are computed and structured into an Income
Statement format, accounting for depreciation as an expense before computing the after-tax
profit associated with the project. The depreciation is then added back to the after-tax profit
because it is a non-cash expense and we are concerned with cash flows. These cash flows
are then adjusted for time in computing the return on investment, as we will see shortly.
Determining the Terminal Cash Flows
As noted above, the normal time frame for evaluation is generally six or seven years, even
though the equipment or other acquisition will last longer than that. The time value of cash
flows after the six or seven years, when the discount rate is applied, will be relatively small,
and the uncertainty that far out is substantial. Therefore, for evaluation purposes, the
assessment is terminated at the end of this time.
On termination of the investment, whenever it occurs, the Projects may incur removal and
disposal expenses. If the environment has been changed, there may be restoration costs.
82
2007, POME, Gautam_Koppala, All Rights Reserved
Additionally, there are salvage or sales values that may be significant and may involve
recovery of some portion of the original investment. And the working capital will be
recovered as well. All of these cash flows as well as the projected cash flows of this final year
must be taken into account in computing the terminal cash flow.
POME Prescribe
Z
Zero in on your
target and go for it!
POME Prescribe
83
2007, POME, Gautam_Koppala, All Rights Reserved
84
2007, POME, Gautam_Koppala, All Rights Reserved
Evaluating Capital Investment Projects
In order to evaluate the capital project, you must relate all of the costs and cash flows of the
project into an evaluation model so that management can judge the attractiveness of the
investment. Several methods are used to assess the attractiveness of a project. The most
frequently used are payback period, discounted payback period, net present value, internal
rate of return, and the modified internal rate of return.
Payback Period
Payback period is the time elapsed from the start of the project until the investment dollars
have been recovered by the project’s cash inflows. This method of evaluation is very easy to
calculate and to understand. As a result many companies use it, even though it does not
address the time value of money and does not take into account any cash flows subsequent
to the recovery of the initial investment. When someone proposes an investment, the first
question asked is often, “What’s the payback period?”
Though many textbooks suggest that there is no risk assessment in the payback method, in
fact, the sooner you recover your investment, the lower the risk. However, the payback
method is really not a good way to evaluate projects, particularly dissimilar ones competing
for limited investment funds.
To compute the payback period, deduct cash flow amounts from the original investment until
the entire initial investment has been recovered. The process is very simple and easy to
understand, but as with most things that are simple, payback period leaves out something
important. In this case, it is any consideration of the time value of money. This oversight is
addressed through the determination of the discounted payback period.
Discounted Payback Period
As noted, the payback period calculation does not pay any attention to the impact of time on
the value of money received. To remedy this problem, analysts have developed a process
called the discounted payback period. This method recognizes the time value of money by
discounting the cash flows from the project at the required rate of return and then calculating
when the cost of the project is recovered using the discounted cash flows. Obviously, the
discounted payback period will be longer than the original payback period calculation.
Net Present Value
85
2007, POME, Gautam_Koppala, All Rights Reserved
Net present value, like the discounted payback period, recognizes the time value of money
discussed in Chapter 6. In capital investment evaluation, the time value of money takes on
additional importance. Because the investment in the asset takes place and recovery of the
investment depends on future cash flows that have to not only recover the value of the
investment but also provide an acceptable return to the providers of the funding,
incorporating the time value into the assessment provides a much more realistic assessment
of the project.
The net present value methodology applies the present value factors to the annual cash
flows, comparing the present value of the future cash flows to the cost (where the present
value interest factor is 1) to determine whether the sum of the present values of the future
cash flows exceeds the investment cost.
The discount rate used to determine the factors is the required rate of return identified based
on the cost of capital, the adjustment for risk, and the adjustment for the nonprofitable
investments. If the sum of present values of the future cash flows exceeds the investment
cost, the investment is deemed acceptable. It provides a rate of return that exceeds that
required by the investors.
Computing the net present value is relatively easy, and many academic writers like it,
believing that it enables a Project Manager to assure the greatest dollar return to the
shareholders. However, because there are limited capital investment funds available, and
because businesses are more concerned with rate of return than absolute dollars, the net
present value calculation is less attractive to business analysts than to the academics. The
net present value computation makes it difficult to compare projects of different sizes. A
costly project that offers a few more dollars of net present value may not really be as
attractive as a less expensive project that leaves funds for other investments.
Internal Rate of Return
The internal rate of return (IRR) method of evaluating capital investment projects utilizes
the time value of money assessment tools to relate the cash flows to the original investment.
It determines that rate of return that exactly equates the present value of the future cash
flows with the cost of the investment, thereby determining the rate of return of the project.
Using this IRR method permits the analyst to rank projects based on their rate of return,
permitting the analyst to choose those projects that maximize the overall rate of return
offered to the shareholders. With IRR, projects of differing sizes may be effectively compared
and ranked.
86
2007, POME, Gautam_Koppala, All Rights Reserved
Before the arrival of financial calculators, computing IRR was difficult, requiring multiple
iterations to determine the right rate of return. Today, with more sophisticated and powerful
calculators and computers, computing the IRR is primarily a function of collecting the right
data and entering them correctly into the calculator. The calculator or computer applies the
time value of money factors, just as the manual process does, but it does it automatically,
arriving at the result very rapidly, even for the most complex projects.
One problem with IRR is that when the IRR is very high, it may be misleading because it
assumes that the cash flows in the early years are rein-vested at the same rate as is
determined overall. If the computed rate is high, it may not be possible to reinvest those
cash flows at comparable rates, resulting in a lower overall return rate. In most cases this is
not crucial, but if you recommend investment projects, it is information you should know.
Finance textbooks offer an alternative called the modified internal rate of return that
assumes reinvestment at the corporate cost of capital, a more conservative approach.
Modified Internal Rate of Return
The modified internal Rate of Return (MIRR) addresses two issues that have been raised
regarding the internal rate of return calculation. The more important issue is that IRR
assumes that all cash flows generated in the early years of an investment can be reinvested
at the IRR computed for the project. If a particular project has a very high IRR, this may not
be possible. The consequence is such a case would be that the Projects would fall short of its
expected return. The modified internal rate of return, although more complicated than IRR,
solves this issue. MIRR assumes that reinvestment of the early cash flows is at the required
rate of return (based on WACC) and not at the IRR. This assumption reduces the rate of
return, making the evaluation of the investment more conservative.
The MIRR process uses the same data as the IRR process, but it then calculates the future
value of each cash flow, using the required rate of return, taken to the end of the
investment. The future values so calculated are then summed and the interest rate that
equates this future value with the original investment is the modified internal rate of return.
The MIRR will always fall between the required rate of return and the IRR.
87
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit : Comparing Two Investments
The other issue related to IRR is that if during the life of the investment, one of the cash
flows is negative, that is, an outflow, calculating IRR will result in two rates. Although one of
the two rates so calculated is usually unreasonable and easily rejected, the MIRR solves that
problem as well.
Exhibit above presents a comparison of two alternative investments that accomplish the
same goal. Note that at a required rate of return of 10 percent, Investment B offers a higher
net present value, but at a required rate of return of 14 percent, Investment A offers a
positive NPV and is acceptable whereas Investment B’s NPV is negative and the investment is
not acceptable.
POME Prescribe:
About Bonding and Loving
 A healthy personal life translates to a well-balanced, healthy person. Make sure you are not
succeeding at the workplace at the cost of your family and loved ones. Given enough time, they
will learn to live without you around – without complaining about it. Tip: Pets are wonderful to
shower you with (unconditional) love when nobody else will.
88
2007, POME, Gautam_Koppala, All Rights Reserved
 No job in the world is worth neglecting your kids for. Your kids will outgrow their strong
dependence on you – the job will always be there (one or the other). If you are not there for them
when they need you the most, don’t count on their unconditional acceptance and love for you later
on.
Y
You are unique of all
God’s creations, nothing
can replace you.
POME Prescribe

89
2007, POME, Gautam_Koppala, All Rights Reserved
INVOICING
BASIC’S
90
2007, POME, Gautam_Koppala, All Rights Reserved
Invoicing for Projects:
Issue of Credit Notes
This Process is to ensure correct process is followed when raising a credit note, and to define
the Inputs, responsibilities and information flow for credit notes.
Ste Who Details
p#
1 Project If part or all of an
Managers & Invoice is disputed
Engineers the following steps
(Solutions); need to be taken:
Team
Leaders • Advise
(Service) Management and
Financial Administrator
immediately of any
dispute
• Plan for
resolution needs to be
put in place and worked
through with
Management and
Customer.
• Advise Credit
Controller (CTS) of any
disputes and action plans
to resolve.
Note: Ensure that Credit
91
2007, POME, Gautam_Koppala, All Rights Reserved
Controller is informed
throughout the cycle of
the dispute to ensure
alignment of the two
areas
2 Project If Credit Note
Managers & needs to be raised
Engineers ensure the
(Solutions); following steps are
Team followed:
Leaders
(Service) • Obtain verbal
Management approval
before commitment to
customer.
• Complete Credit
Note Request form and
obtain correct approval
per Approval Matrix.
• Prepare Credit
note ensuring that the
items in step 3 are
included
3 Project When raising a
Managers & Credit Note
Engineers include the
(Solutions); following:
Team
Leaders • Correct Customer
92
2007, POME, Gautam_Koppala, All Rights Reserved
(Service) Number
• Customer Order
Number
• Back Reference
Invoice being credited
• Reason for Credit
Note
• Reference to
Proposal or Contract,
where applicable
• Invoice Name,
Address and Contact
Name
• Your Contact
Name and Telephone
Number
• Special Customer
or Lease References,
where applicable
• Clear description
of items or services
being credited.
• Amount being
credited and correct
currency
• GST, where
applicable
• Account Code
allocation
4 Management Approve credit
Note in line with
93
2007, POME, Gautam_Koppala, All Rights Reserved
the / PROJECT
Approval Matrix.
5 Project Ensure Customer
Managers & is appropriately
Engineers informed of the
(Solutions); credit note.
Team
Leaders
(Service)
6 Financial Keep Financial
Administrator Controller
informed as part
of forecast and
month end
process.
7 Project When Credit Note
Managers & approved
Engineers complete the
(Solutions); following steps:
Team
Leaders • Send credit note
(Service) Original to Customer
with any other required
documents
• Copy to Project
file.
• Advise Credit
Controller when credit
raised.
94
2007, POME, Gautam_Koppala, All Rights Reserved
Credit Invoice Process:
To ensure the correct process is followed for the extension of credit facilities to a customer
and to define the Inputs, responsibilities and information flow for the extension of credit
facilities.
Step Who Details
#
1 Sales During the
Personnel prospect stage
determine if
the customer
exists as an
entity within
Company’s
financial
system by
contacting
Credit
Controller.
This will alert
Credit
Controller
(CTS) of
possible new
Customer and
allow for
preliminary
credit
worthiness
checks, where
applicable.
95
2007, POME, Gautam_Koppala, All Rights Reserved
2 All Alternate credit
terms should
not be
extended. If
alternate credit
terms are
required they
need to be
approved by
external
Management.
3 Sales If the
Personnel; customers
Project details are not
Managers/ incorporated
Engineers into the
(Solutions); Company
Teams Financial
Leaders system ensure
(Service) that the
following steps
are followed
prior to
commencement
of services:
• Ensure that the new
Customer completes
a Commercial Credit
Application form and
returns complete
form to Credit
96
2007, POME, Gautam_Koppala, All Rights Reserved
Controller (CTS)
• Submit Completed
Booking to Credit
Controller for credit
approval.
4 Sales Ensure new
Personnel: Customer
Project completes a
Managers/ Commercial
Engineers Credit
(Solutions); Application
Teams form including,
Leaders but not limited
(Service) to the
following:
• Company Name, ACN
and ABN Numbers
• Commencement Date
of Business and
Number of employees
• Nature of Business
• Structure
• Trading Name (if any)
• Registered Business
Name, address,
postal address
• Delivery address,
Telephone Number,
Fax Number, email,
web address
97
2007, POME, Gautam_Koppala, All Rights Reserved
• Accountant
• Bank, Branch, BSB,
Account Number
• Directors details
• Trade references
• Credit limit required
and anticipated
monthly purchase
• Balance sheet
information (assets,
liabilities, Profit and
Loss for previous 12
mths)
• Applicant/s
signature/s, name,
position, date
5 All • Ensure that
completed
Commercial Credit
application is
forwarded to Credit
Controller (CTS)
6 Credit • Process Commercial
Controller Credit application in
(CTS) line with Company
policy
• Assign Customer #
• Setup Customer in
Oracle
• Alert Project
98
2007, POME, Gautam_Koppala, All Rights Reserved
Manager/Team
Leader of Customer #
• Send notification
letter to Customer
including credit limit,
customer number,
account contact and
account terms
7 Project If Customer is
Managers/ an existing
Engineers Customer,
(Solutions); submit
Teams completed ERP
Leaders Prospect to
(Service) Credit
Controller for
credit approval
8 Credit • For existing
Controller Customers check ERP
(CTS) booking amount,
terms, etc against
existing Credit Limit
and where applicable
seek further credit
checks, clarification,
etc. in line with
Company policy
• Approve credit limit
for ERP Booking for
new or existing
99
2007, POME, Gautam_Koppala, All Rights Reserved
Customer
• Advise Originator of
approval
9 Credit If Credit
Controller application or
(CTS) credit limit are
rejected,
communicate
reasons to
Originator
immediately
10 Project Seek advice
Managers/ from
Engineers Management
(Solutions); and Finance
Teams Manager before
Leaders proceeding
(Service) further.
Disputed Invoices:
This Process is to ensure correct process is followed for disputed invoices. And to define the Inputs,
responsibilities and information flow for disputed invoices.
Step Who Details
#
100
2007, POME, Gautam_Koppala, All Rights Reserved
1 Project When part
Managers & or all of an
Engineers Invoice is
(Solutions); disputed the
Team following
Leaders steps need
(Service); to be taken:
Credit
Controller: • Credit Controller
Managers to identify who is
to resolve dispute
(eg. Project
Manager/Team
Leader, Manager,
etc.) and enter
into Receivables
• Receivables will
email resolver
requesting action
• Resolver to obtain
a clear
understanding of
the dispute from
the Customer (eg
Customer
Cashflow,
incorrect,
incomplete or
duplicate Invoice,
dispute with
deliverables, etc)
• Resolver to ensure
Management and
Credit Controller
101
2007, POME, Gautam_Koppala, All Rights Reserved
are informed
throughout the
lifecycle of the
dispute
• Resolver to track
dispute through
eReceivables
system and
adhere to requests
for information
and timing of
feedback.
• Resolver to
formulate a
resolution plan /
timeline and seek
approval from
Management
before presenting
to the Customer
• Resolver to work
through the
resolution plan
with Customer and
others, where
applicable
• Escalate to
Management if
resolution cannot
be sought or legal
intervention is
required
• If part or all of
resolution is to
102
2007, POME, Gautam_Koppala, All Rights Reserved
credit
2 Credit Credit
Controller Controller to
track the
dispute via
Receivables,
ensuring:
• Dispute is being
managed and
regular feedback
is forthcoming
• Ensure
Receivables
process is being
adhered to
• Ensuring at all
times the
adherence to the
Customers Credit
Limit. Escalate if
exceeded in
accordance with
Company Policy
• Stop Credit, if
applicable, until
dispute resolved
• Ensure Financial
Controller,
Management and
other parties,
where applicable,
are informed
103
2007, POME, Gautam_Koppala, All Rights Reserved
throughout the
lifecycle of the
dispute
• Initiate legal
advice or action,
or other recovery
path, where
applicable
• If the dispute is
resolved ensure
that there are firm
payment deadlines
in place and that
they are adhered
to.
3 Receivables If dispute is
not resolved
in a timely
manner
Receivables
will escalate
to
appropriate
Manager for
further
action
throughout
the lifecycle
of the
dispute.
4 Managers; Credit
Credit Controller
104
2007, POME, Gautam_Koppala, All Rights Reserved
Controller and/or
Manager to
seek legal
advice to
assess if
further
intervention,
arbitration
or other
path should
be sought
(ie write-off,
etc.) and
update
Receivables
of actions
taken
5 Project If dispute is
Managers / resolved
Engineers
(Solutions); • Update
Team Receivables
Leaders • Advise credit
(Service); controller,
Management; Manager or other
Others where to assist with the
applicable smooth collection
of debt

105
2007, POME, Gautam_Koppala, All Rights Reserved
INCOME
STATEMENTS
106
2007, POME, Gautam_Koppala, All Rights Reserved
Income Statements:
This section of the POME Chapter expands our understanding of the key financial statements,
from which analysts and Project Managers identify the areas of success within the company
and those that need improvement, and develop the understanding necessary to reach
conclusions and make decisions that will guide the business going forward. The essence of
financial management is gathering information, taking actions based on that information, and
then reviewing and reassessing before progressing again.
Exhibits below lay out the first two of the basic financial statements. These two statements
are the building blocks for all of the financial information Project Managers need to fulfill their
responsibilities.
These basic financial statements have already been introduced. Now we consider how the
information gets into these statements. To do so we must understand terms such as debits
and credits, revenues and expenses, assets and liabilities. Back in the fifteenth century a
Franciscan monk named Luca Pacioli, who first described the essentials of double-entry
bookkeeping, identified the most basic elements of today’s bookkeeping process.
He recognized that establishing a process of checks and balances enhanced information
control. We follow that premise today, reflected in the Balance Sheet, where Assets =
Liabilities + Equity. Using a basic principle of algebra, once established, the integrity of an
equality must be preserved. Therefore, whenever we make an entry to affect one side of the
equation, we must identify a companion transaction that either offsets that effect on the
same side of the equal sign or reflects a complementary effect on the other side.
From this we have developed the essence of debits and credits. In double-entry
bookkeeping, for every debit amount there must be an equal credit amount. Debits are used
to increase the assets or decrease the liabilities and equity, and credits are used to decrease
the assets or increase the liabilities and equity. In some cases the debits and credits reach
the balance sheet accounts through the Income Statement. In such cases the debits
decrease revenues or increase expenses and the credits increase revenues or decrease
expenses. We examine the Income Statement in detail in the next few pages.
The second accounting equation relates to ongoing activity.
REVENUES – EXPENSES = PROFIT
107
2007, POME, Gautam_Koppala, All Rights Reserved
Income – Outgo = Outcome
We measure our progress by comparing what we generate (revenues) with what it costs us
(expenses) and keep track of the difference (profit). We compare that result against targets
or objectives and get both absolute and relative measures of our success and achievement.
And we develop plans, programs, and actions that we expect will improve on our
performance, our results. Over the remainder of this course we examine some of these tools
and techniques and consider how to strengthen our basic financial management skills.
This second accounting equation reflects the second major financial statement, the Income
Statement. When the income statement, which is also known as the Profit and Loss
Statement, is presented, it is expressed as covering a period of time, with the beginning
and ending dates shown. Most frequently, this period is the accounting year, beginning on
the first day (e.g., January 1, XXXX) and ending on the last day (e.g., December 31, XXXX).
It summarizes all of the financial activity that took place during the period captioned. On the
following pages we present and describe the basic elements of the Income Statement. In the
next POME Chapter we describe the activities that are incorporated into the Income
Statement.
To understand the financial performance of a business, it is necessary to measure the
revenues and expenses and to compute the profit. To be successful, all businesses, even
those identified as “nonprofit” or “not-for-profit” need to make a profit. That is, their
revenues must exceed their expenses. Beginning with the Income Statement, we assess the
performance of the business. The next POME Chapter presents more detail, permitting you to
follow the Income Statement transactions, and see how they affect the Balance Sheet,
enabling you to evaluate the financial condition of the enterprise. In Exhibit below the normal
format for an Income Statement includes a line-by-line explanation of the key terms of this
important financial statement.
108
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: The Income Statement—Annotated
Many times, people talk about “the bottom line” when referring to the financial results of a
business. The bottom line refers to the Earnings after Taxes and is the primary focus of
people measuring a company’s performance. The Income Statement shown here includes
Dividends to demonstrate how the linkage is made to the Balance Sheet if a company issues
dividends. If it does not, then the Earnings after Taxes are equal to the Change in Retained
Earnings.
In an annual report of a public company these last segments (Dividends and Change in
Retained Earnings) may be presented as a separate reconciliation, called Statement of
Stockholders’ Equity or Statement of Retained Earnings. Conventions and regulations
determine how information is presented to external users. This often differs from the way
information is presented to internal Project Managers for internal decision-making.
109
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit The Balance Sheet
Exhibit: The Income Statement
Preparing Financial Statements
The final step in what is really the bookkeeping process (the accurate and timely recording of
transactions) is the preparation of financial statements. This is the summarization of the
recorded transactions into standard format for review and analysis. The next POME Chapter
focuses on the analysis and interpretation of these financial statements, which we referred to
as accounting in the last POME Chapter.
The Key Financial Statements
POME introduced the financial statements and this POME Chapter has described their
creation. The following exercises provide an opportunity to try your hand at preparing some
110
2007, POME, Gautam_Koppala, All Rights Reserved
financial statements and then to apply the journal entries described earlier to these
statements to see their effect.
Examining Your Company’s Income Statement
INSTRUCTIONS: Compare this Income Statement format with the one from your company or
another company whose financial statements you have access to. Identify the similarities and
differences between this generalized Income Statement and that of a specific company. As
with the Balance Sheet, ask someone in the accounting or finance department to clarify
anything that causes confusion.
For example, your company may show revenue from different sources separately or break
down expenses in more detail. Individual industries, such as banking and insurance, may
have some unique reporting practices that cause their statements to differ somewhat from
this format.
The Statement of Retained earnings, also known as the Statement of Stockholders’
Equity, is sometimes included in the financial statements of a public company when there
have been a number of transactions affecting the equity section of the Balance Sheet and
when it might be difficult for a reader to reconcile the equity section from one reporting
period to the next. This statement links the profit after tax on the income statement with the
retained earnings reported on the Balance Sheet. Among the transactions that could create
confusion would be the issuance or repurchase of common stock, distribution of dividends,
acquisition or disposition of a portion of the company, adjustments due to currency
translation or stock option activity. This statement is not really a financial statement, but
rather an effort to make part of the Balance Sheet more understandable.
Now coming to Koppala and george’s discussions
 Income Statement
Koppala points out that an income statement will show how profitable GG Org has
been during the time interval shown in the statement's heading. This period of time
might be a week, a month, three months, five weeks, or a year—George can choose
whatever time period he deems most useful.
111
2007, POME, Gautam_Koppala, All Rights Reserved
The reporting of profitability involves two things: the amount that was earned
(revenues) and the expenses necessary to earn the revenues. As you will see next,
the term revenues is not the same as receipts, and the term expenses involves more
than just writing a check to pay a bill.
A. Revenues
The main revenues for GG Org are the fees it earns for executing sub Projects. Under
the accrual basis of accounting (as opposed to the less-preferred cash method of
accounting), revenues are recorded when they are earned, not when the Project
receives the money. Recording revenues when they are earned is the result of one of
the basic accounting principles known as the revenue recognition principle.
For example, if George delivers 1,00 work packages in December for $40 per delivery,
he has technically earned fees totaling $4,000 for that month in that Project. He sends
invoices to his clients for these fees and his terms require that his clients must pay by
January 10. Even though his clients won't be paying GG Org until January 10, the
accrual basis of accounting requires that the $4,000 be recorded as December
revenues, since that is when the delivery work actually took place. After expenses are
matched with these revenues, the income statement for December will show just how
profitable the company was in delivering parcels in December.
When George receives the $4,000 worth of payment checks from his customers on
January 10, he will make an accounting entry to show the money was received. This
$4,000 of receipts will not be considered to be January revenues, since the revenues
were already reported as revenues in December when they were earned. This $4,000
of receipts will be recorded in January as a reduction in Accounts Receivable. (In
December George had made an entry to Accounts Receivable and to Sales.)
B. Expenses
Now Koppala turns to the second part of the income statement—expenses. The
December income statement should show expenses incurred during December
regardless of when the company actually paid for the expenses. For example, if
George hires someone to help him with December deliveries and George agrees to pay
him $500 on January 3, that $500 expense needs to be shown on the December
income statement. The actual date that the $500 is paid out doesn't matter—what
matters is when the work was done—when the expense was incurred—and in this
case, the work was done in December. The $500 expense is counted as a December
112
2007, POME, Gautam_Koppala, All Rights Reserved
expense even though the money will not be paid out until January 3. The recording of
expenses with the related revenues is associated with another basic accounting
principle known as the matching principle.
Koppala explains to George that showing the $500 of wages expense on the December
income statement will result in a matching of the cost of the labor used to deliver the
December work packages with the revenues from delivering the December parcels.
This matching principle is very important in measuring just how profitable a company
was during a given time period.
Koppala is delighted to see that George already has an intuitive grasp of this basic
accounting principle. In order to earn revenues in December, the company had to
incur some business expenses in December, even if the expenses won't be paid until
January. Other expenses to be matched with December's revenues would be such
things as expenses for the engineers and Project Vehicle..
George asks Koppala to provide another example of a cost that wouldn't be paid in
December, but would have to be shown/matched as an expense on December's
income statement.
Koppala uses the Interest Expense on borrowed money as an example. He asks
George to assume that on December 1 GG Org borrows $20,000 from George's aunt
and the company agrees to pay his aunt 6% per year in interest, or $1,200 per year.
This interest is to be paid in a lump sum each on December 1 of each year.
Now even though the interest is being paid out to his aunt only once per year as a
lump sum, George can see that in reality, a little bit of that interest expense is
incurred each and every day he's in business. If George is preparing monthly income
statements, George should report one month of Interest Expense on each month's
income statement. The amount that GG Org will incur as Interest Expense will be
$100 per month all year long ($20,000 x 6% ÷ 12). In other words, George needs to
match $100 of interest expense with each month's revenues. The interest expense is
considered a cost that is necessary to earn the revenues shown on the income
statements.
Koppala explains to George that the income statement is a bit more complicated than
what she just explained, but for now she just wants George to learn some basic
accounting concepts and some of the accounting terminology. Koppala does make
113
2007, POME, Gautam_Koppala, All Rights Reserved
sure, however, that George understands one simple yet important point: an income
statement, does not report the cash coming in—rather, its purpose it to
(1) Report the revenues earned by the company's efforts during the period, and
(2) Report the expenses incurred by the company during the same period.
The purpose of the income statement is to show a company's profitability during a
specific period of time. The difference (or "net") between the revenues and expenses
for GG Org is often referred to as the bottom line and it is labeled as either Net
Income or Net Loss.
114
2007, POME, Gautam_Koppala, All Rights Reserved
WORKING
CAPITAL
115
2007, POME, Gautam_Koppala, All Rights Reserved
Working Capital
What Is Working Capital?
A measure of both a Project's efficiency and its short-term financial health.
“Knowledge of men is the prime secret of business working capital.”
The working capital ratio is calculated as:
Working Capital= Current Assets- Current Liabilities
POME shall take a step-by-step tour of the Balance Sheet. You will learn how the operating
Project Manager affects these accounts and how the financial information reflected in these
accounts affects the operating Project Manager. This particular POME Chapter concentrates
on short-term assets, those that make up the working capital assets. These short-term
assets are often the most critical assets of a business, requiring a high degree of
management attention and careful understanding to assure that these resources are properly
utilized. POME talks about proper management as well as the consequences of improper
management of these important financial resources.
The management of short-term assets, also known as working capital assets, is a very, very
important management function. As we will see, mismanagement of these assets,
particularly inventories and accounts receivable, can consume resources that would
otherwise be used to support and strengthen the business. It is important to recognize that
management of these assets is a comprehensive function. One cannot focus on only one of
these asset categories at a time.
We will also see that there is a direct relationship between the management of short-term
assets and the management of short-term liabilities. As we noted earlier, financial
transactions that affect one part of the Balance Sheet ultimately affect another part, because
the Balance Sheet always balances. Understanding the other side of the Balance Sheet effect
helps us understand the impact of management actions
POME concentrates on cash, accounts receivable, and inventories. The other current assets
are generally relatively small and have little impact on the operations or the financial
116
2007, POME, Gautam_Koppala, All Rights Reserved
strength of the business. In those companies where these assets are important or significant,
the Project Manager whose function required the expenditure often holds specific
responsibility for the prepaid expense or deposit.
POME Case Study:
Attention and Improvement
“It’s been a while since we’ve gotten together. I thought we could revisit some of the
initiatives you put in place already. Pat, has the customer service group continued to follow
the ACP (Average Collection Period, also known as Days’ Sales Outstanding) ratio?”
“We have, Koppala. And Accounts Receivable began some initiatives of their own. Mary said
that by collecting sooner, we’ve got cash coming in faster and we’ve been able to invest it in
more raw materials for our fastest growing lines. This means we’ve had enough stock on
hand to fill orders promptly—and my group is noticing a difference in the phone calls we’re
getting. Almost no complaints about late deliveries. That’s helped the morale in customer
service—as has knowing that our ideas for improving the ACP had a measurable effect on
another department and overall performance.”
117
2007, POME, Gautam_Koppala, All Rights Reserved
The Balance-Sheet Model of the Project
The Net Working Capital Investment Decision
(Financial Decision)
Current
Current Liabilities
Assets Net
Working Long-Term
Capital Debt
Fixed Assets
1 Tangible Shareholders’
2 Intangible Equity
Positive working capital means that the Project is able to pay off its short-term
liabilities. Negative working capital means that a Project currently is unable to meet its short-
term liabilities with its current assets (cash, accounts receivable and inventory).
Also known as "net working capital".
If a Project's current assets do not exceed its current liabilities, then it may run into trouble
paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining
working capital ratio over a longer time period could also be a red flag that warrants further
analysis. For example, it could be that the company's sales volumes are decreasing and, as a
result, its accounts receivables number continues to get smaller and smaller.
Working capital also gives investors an idea of the Project's underlying operational efficiency.
Money that is tied up in inventory or money that customers still owe to the Project cannot be
118
2007, POME, Gautam_Koppala, All Rights Reserved
used to pay off any of the company's obligations. So, if a Project is not operating in the most
efficient manner (slow collection), it will show up as an increase in the working capital. This
can be seen by comparing the working capital from one period to another; slow collection
may signal an underlying problem in the Project's operations.
Everyone knows what cash is. We also know, from our personal experience, what it is used
for. Here we are less concerned with its uses than with the consequences of the choice of use
we select. Cash is the most liquid asset, immediately available for use. As such it carries the
least risk to its owner. However, if cash is not managed properly, several measurements
used to assess the business may be adversely affected.
we looked at several ratios and other measurements that analysts use to evaluate the
business and its management. Large cash balances affect these measurements and lead to
conclusions about the Projects. For example, if cash balances are high, the current ratio may
be high, suggesting that the Projects has not used its cash to generate income for the
Projects and return for the shareholders. If the cash balance is high and the current ratio is
not, then it may be that the Projects has more interest-bearing debt than it should, reducing
the income of the Projects and penalizing the return that the shareholders receive.
If we have a large cash balance, we must consider the alternative uses for cash that
management has chosen not to employ. Suppose management decides to hold cash instead
of paying down a note payable. Management may have recognized that if the Projects had
paid the balance, it might not have been able to borrow that same amount at a later date.
Therefore, management may have made the choice to retain the cash and incur the interest
expense in order to retain the flexibility that the cash provides for a future time. As we study
the financial statements, we may see this as an indication that management must
renegotiate the arrangement with the lender to permit a revolving loan rather than a term
loan. And if we have extended credit to this Projects in the past, we may want to take a hard
look at the situation before we extend any more.
Another possibility is that the retention of cash in a liquid form, generally in a checking
account, provides management with a sense of security. After all, having cash makes a
Project Manager comfortable that, whatever may occur, there is a resource to take care of it.
This is a very conservative approach. However, the very existence of that cash, if substantial,
may make the Projects attractive for a takeover. An aggressive Project Manager may
recognize that same cash as an underutilized resource, capable of earning a significant return
119
2007, POME, Gautam_Koppala, All Rights Reserved
and may attempt to gain control of the Projects in order to take advantage of that resource.
This belies the security that the earlier Project Manager felt.
Hence, Working Capital refers to the cash a Project requires for day-to-day operations, or,
more specifically, for financing the conversion of raw materials into finished goods, which the
company sells for payment. Among the most important items of working capital are levels of
inventory, accounts receivable, and accounts payable. Analysts look at these items for signs
of a Project's efficiency and financial strength.
Take a simplistic case: a spaghetti sauce company uses $100 to build up its inventory of
tomatoes, onions, garlic, spices, etc. A week later, the company assembles the ingredients
into sauce and ships it out. A week after the checks arrives from customers. That $100,
which has been tied up for two weeks, is the company's working capital. The quicker the
company sells the spaghetti sauce, the quicker the company can go out and buy new
ingredients, which will be made into more sauce sold at a profit. If the ingredients sit in
inventory for a month, company cash stays tied-up and can't be used to grow the spaghetti
business. Even worse, the company can be left strapped for cash when it needs to pay its
bills and make investments. Working capital also gets trapped when customers do not pay
their invoices on time or suppliers get paid too quickly or not fast enough.
The better a Project manages its working capital, the less the Project needs to borrow. Even
companies with cash surpluses need to manage working capital to ensure that those
surpluses are invested in ways that will generate suitable returns for investors.
120
2007, POME, Gautam_Koppala, All Rights Reserved
DOI Days of inventory
DSO Days sales outstanding
DPO Days payable outstanding
DWC Days of working capital
DOC Days of cash
Fig:Operations and Cash Cycles
Not All Companies Are the Same
Some companies are inherently better placed than others. Insurance companies, for
instance, receive premium payments up front before having to make any payments;
121
2007, POME, Gautam_Koppala, All Rights Reserved
however, insurance companies do have unpredictable outgoings as claims come in.
Normally a big retailer like BIG BAZAAR, India has little to worry about when it comes to
accounts receivable: customers pay for goods on the spot. Inventories represent the biggest
problem for retailers, who must perform rigorous inventory forecasting or they risk being out
of Projects in a short time.
Timing and lumpiness of payments can pose serious troubles. Manufacturing companies, for
example, incur substantial up-front costs for materials and labor before receiving payment.
Much of the time they eat more cash than they generate.
Evaluating Companies
Investors should favor companies that place emphasis on supply-chain management to
ensure that trade terms are optimized. Days-sales outstanding, or DSO for short, is a good
indication of working capital management practices. DSO provides a rough guide to the
number of days that a Project takes to collect payment after making a sale. Here is the
simple formula:
Receivables/ annual sales/365 days
Rising DSO is sign of trouble since it shows that a Project is taking longer to collect its
payments. It suggests that the Project is not going to have enough cash to fund short-term
obligations because the cash cycle is lengthening. A spike in DSO is even more worrisome,
especially for companies that are already low on cash.
The inventory turnover ratio offers another good instrument for assessing the effectiveness
of WCM. The inventory ratio shows how fast/often companies are able to get their goods
completely off the shelves. The inventory ratio looks like this:
Cost of goods sold (COGS)/Inventory
Broadly speaking, a high inventory turnover ratio is good for business. Products that sit on
the shelf are not making money. Granted, an increase in the ratio can be a positive sign,
122
2007, POME, Gautam_Koppala, All Rights Reserved
indicating that management, expecting sales to increase, is building up inventory ahead of
time.
For investors, a company's inventory turnover ratio is best seen in light of its competitors. In
a given sector where, say, it is normal for a company to completely sell out and re-stock six
times a year, a company that achieves a turnover ratio of four is an underperformer.
Computer giant and stock market champion, Dell, recognized early that a good way to
bolster shareholder value was to notch up working capital management. The company's
world-class supply-chain management system ensures that DSO stays low. Improvements in
inventory turnover increased cash flow, all but eliminating liquidity risk, leaving Dell with
more cash on the balance sheet to distribute to shareholders or fund growth plans.
GE's exceptional WCM certainly exceeds those of the top executives who do not worry
enough about the nitty-gritty of working capital management. Some CEOs frequently see
borrowing and raising equity as the only way to boost cash flow. Other times, when faced
with a cash crunch, instead of setting straight inventory turnover levels and reducing DSO,
these management teams pursue rampant cost cutting and restructuring that may later
aggravate problems.
Cash is king, especially at a time when fund raising is harder than ever. Letting it slip away is
an oversight that investors should not forgive us.
The diagram below illustrates the working capital cycle for a manufacturing operations
123
2007, POME, Gautam_Koppala, All Rights Reserved
The upper portion of the diagram above shows in a simplified form the chain of events
in a manufacturing firm. Each of the boxes in the upper part of the diagram can be
seen as a tank through which funds flow. These tanks, which are concerned with day-
to-day activities, have funds constantly flowing into and out of them.
• The chain starts with the firm buying raw materials on credit.
• In due course this stock will be used in production, work will be carried out on
the stock, and it will become part of the firm’s work in progress (WIP)
• Work will continue on the WIP until it eventually emerges as the finished
product
• As production progresses, labour costs and overheads will need to be met
• Of course at some stage trade creditors will need to be paid
• When the finished goods are sold on credit, debtors are increased
• They will eventually pay, so that cash will be injected into the firm
Each of the areas – stocks (raw materials, work in progress and finished goods), trade
debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into
and from which funds flow.
124
2007, POME, Gautam_Koppala, All Rights Reserved
Working capital is clearly not the only aspect of a business that affects the amount of
cash:
• The business will have to make payments to government for taxation
• Fixed assets will be purchased and sold
• Lessors of fixed assets will be paid their rent
• Shareholders (existing or new) may provide new funds in the form of cash
• Some shares may be redeemed for cash
• Dividends may be paid
• Long-term loan creditors (existing or new) may provide loan finance, loans
will need to be repaid from time to time, and
• Interest obligations will have to be met by the business.
Unlike movements in the working capital items, most of these ‘non-working capital’
cash transactions are not everyday events. Some of them are annual events (e.g. tax
payments, lease payments, dividends, interest and, possibly, fixed asset purchases
and sales). Others (e.g. new equity and loan finance and redemption of old equity and
loan finance) would typically be rarer events.
Working Capital Report
The monthly Working Capital (WC) Report shows overall working capital performance for
each SBG as well as total Company (excluding working capital balances from Corporate).
The report includes:
• Graphical summaries of Working Capital balances, WC metrics (working capital turns,
DSO, DOS and DPP) and WC components (Inventory, Receivables and Payables &
Advances). Comparisons are shown versus latest forecast, AOP and PY.
• Working Capital balances and WC components (Inventory, Receivables and Payables &
Advances) in absolute values for the current month. Comparisons are shown versus
latest forecast, AOP and PY.
The components of Working Capital are direct extracts from FM Balance Sheet accounts but
do require some POME Chapter adjustments. Since Working Capital performance focuses on
the cash producing activities of the operations, adjustments identified as Cash Flow Blocks
125
2007, POME, Gautam_Koppala, All Rights Reserved
are made to capture the impact of certain events such as acquisitions, divestitures and inter-
company Balance Sheet transfers. These events may have a favorable or unfavorable impact
to cash that inaccurately reflects the real cash generation capacity of the business unit
operations. For example, in the case of an acquisition where the purchase price includes
working capital balances, an adjustment is made to recognize the cash outflows as investing
activities instead of a use of cash flow from operations.
For the purposes of evaluating WC, 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.
For more detailed descriptions of the FM Balance Sheet accounts mentioned in the following
paragraphs, the COA can be reference on the Corporate Controller’s web-site via the
intranet.
Key Financial Metric(s):
Working Capital
+ Working Capital Receivables
+ Inventories
– Accounts Payables & Customer Advances
= Working Capital
126
2007, POME, Gautam_Koppala, All Rights Reserved
Within this metric calculation, Working Capital Receivables is a calculation of the following FM
Balance Sheet accounts:
+ Current Receivables
– Discounted Trade Accounts Receivables
– Discounted Trade Notes Receivables
– Legacy Receivables - Current
– Income Taxes Receivable – Current
– Long Term Financing Receivables
– Financing Receivables
+ Long Term Receivables
– Long Term Legacy Receivables
= Working Capital Receivables
Accounts Payables & Customer Advances is the summation of the following FM Balance Sheet
accounts:
+ Trade Payables
+ Customer Advances and Deferred Income
= Accounts Payables & Customer Advances
Working Capital Turns 13 Point Average (FM 924110)
Recent 12 months External Sales
÷
Working Capital 13 Months Average
The Recent 12 Months External Sales is the summation of the last 12 months of external
sales captured in the Income Statement within Net Sales & Operating Revenue – External
account. The Working Capital 13 Months Average is calculated by taking the last 13 months
ending Working Capital balances and dividing by 13.
Days Sales Outstanding (DSO)
127
2007, POME, Gautam_Koppala, All Rights Reserved
Days Sales Outstanding (DSO) is an operational metric that designates the number of days
invoices remain in the receivables balance. DSO is calculated using the “back out” method.
There is a current month calculation as well as a three-month average which is the last
three months divided by three. Both metrics are calculated but only the 3-month average
metric is used for management reporting purposes.
The following is an example of the DSO calculation for December month end:
There are three DSO metrics that are used to measure Working Capital Receivables month
end performance:
• Days Sales Outstanding with Unbilled
• Days Sales Outstanding without Unbilled
• DSO Cash In
The corresponding 3-month average DSO metrics are:
• DSO With Unbilled 3mo Avg.
• DSO Without Unbilled 3mo Avg.
• DSO Cash In 3mo Avg.
128
2007, POME, Gautam_Koppala, All Rights Reserved
Days Sales Outstanding with Unbilled
This metric measures the healthiness of receivables driven by sales of both short cycle and
long cycle businesses.
The components are Adjusted Trade Receivables with Unbilled and Adjusted External Sales
for DSO
Adjusted Trade Receivables with Unbilled is calculated as follows within FM:
+ Trade & Note Receivables - Current
– Discounted Trade Accounts Receivables
– Discounted Trade Notes Receivables
= Adjusted Trade Receivables with Unbilled
Adjusted External Sales for DSO captures the true up to sales for VAT (Value Added Tax)
taxes, since the receivable balances captures this tax for businesses that sell in regions and
countries where VAT is imposed. Sales reported in the Income Statement excludes VAT
taxes. The following calculation is performed within FM for Adjusted External Sales for DSO:
+ Net Sales & Operating Revenue – External
+ Ext Sales Adjustments for DSO
= Adjusted External Sales for DSO
Days Sales Outstanding without Unbilled
This metric measures the healthiness of trade receivables primarily driven by sales of short
cycle businesses excluding the impact of unbilled revenues driven by long cycle businesses.
The components are Receivables W/O Unbilled and Discounted and Adjusted External Sales
for DSO as described previously.
Receivables W/O Unbilled and Discounted is calculated as follows within FM:
+ Trade & Note Receivables - Current
129
2007, POME, Gautam_Koppala, All Rights Reserved
– Discounted Trade Accounts Receivables
– Discounted Trade Notes Receivables
– Unbilled Receivables
= Receivables W/O Unbilled and Discounted
DSO Cash In
This metric measures the overall cash generating capacity of the business by capturing the
cash collected through customer cash advances/deferred income and netting these amounts
against trade receivables and unbilled balances to determine the overall “cash in” position of
the company. This DSO metric is more aligned with Customer-to-Cash strategies by focusing
cash collection efforts on initiatives that have a greater net cash impact to the business.
The components are Adjusted Trade Receivables Cash In (w Unbilled and Advances) and
Adjusted External Sales for DSO as described previously.
Adjusted Trade Receivables Cash In (w Unbilled and Advances) is calculated as follows within
FM:
+ Trade & Note Receivables – Current
– Discounted Trade Accounts Receivables
– Discounted Trade Notes Receivables
– Customer Advances and Deferred Income
= Adjusted Trade Receivables Cash In (w Unbilled and Advances)
Past Due Receivables
+ Receivable Past Due 1-30
+ Receivable Past Due 31-60
+ Receivable Past Due 61-90
+ Receivable Past Due 91-180
+ Receivable Past Due 181-365
– Receivable Past Due 365+
= Past Due Receivables
130
2007, POME, Gautam_Koppala, All Rights Reserved
Past Due Receivables are those receivables that customers have not paid on time.
Past Due Receivables %
Past Due Receivables
÷
Trade Receivables without Unbilled and Discounted
Trade Receivable without Unbilled and Discounted is a calculation of the following FM Balance
Sheet accounts:
+ Trade & Note Receivables – Current
– Discounted Trade Accounts Receivables
– Discounted Trade Notes Receivables
– Unbilled Receivables
= Trade Receivables without Unbilled and Discounted
Days of Supply (DOS)
Days of Supply (DOS) is an operational metric that designates the number of days products
remain in the inventory balance. DOS is calculated using the “back out” method. There is a
current month calculation as well as a three-month average which is the last three months
divided by three. Both metrics are calculated but only the 3-month average metric is used
for management reporting purposes.
The following is an example of the DOS calculation for December month end:
131
2007, POME, Gautam_Koppala, All Rights Reserved
The components of DOS are Product Gross Inventory and Cost of Goods Sold
The Product Gross Inventory is different than the Working Capital Inventory mainly due to
the exclusion of Rotable Inventories, Contracts in Progress – Engineering, Stores Inventory
and LIFO Pools. The following calculation is performed within FM for Product Gross
Inventory:
+ Inventories Related to Cost of Sales
– Progress Payments – Production Inventory
+ Contract Inventory
– Service Inventory: Progress Payments – Contracts
+ Inventory Other
– InterCo out of Balance Trade Rec/Pay
– Stores Inventory (History Only)
– Non-Product Related Inventory
+ Inventory Reserves
– Inventory Reserves – LIFO
= Product Gross Inventory
Cost of Goods Sold is an FM Income Statement account and is a summation of the following
accounts:
132
2007, POME, Gautam_Koppala, All Rights Reserved
+ Total Variable Cost of Goods Sales
+ Total Fixed Cost of Goods Sold
+ Other Manufacturing Costs
+ Distribution & Logistics Expense
+ Other Operating Expense
= Cost of Goods Sold
Days Purchases in Payables (DPP)
Days Purchases in Payables (DPP) is an operational metric that designates the number of
days supplier invoices remain in the payables balance. DPP is calculated using the “back out”
method. There is a current month calculation as well as a three-month average which is the
last three months divided by three. Both metrics are calculated but only the 3-month
average metric is used for management reporting purposes.
The following is an example of the DPP calculation for December month end:
The components of DPP are Trade Payables and Cost of Goods Sold.
Reasons for Holding Cash
College finance textbooks describe three purposes for holding cash: transactions,
emergencies, or opportunities. Most of the cash we have is used to pay bills in the normal
133
2007, POME, Gautam_Koppala, All Rights Reserved
course of business. However, with a prior arrangement, the bank will provide “overdraft”
protection for our checks, assuring that our check when presented will be honored, whether
we have available cash or not. Therefore, if we have arranged for overdraft protection, or a
revolving line of credit, we do not need to hold cash for transactions unless we are certain
that the cash flow that normally occurs will not be sufficient, even with the overdraft credit,
to meet our payment needs.
In the case of emergencies, unless we have extraordinary amounts on deposit, the cash
balance may not be sufficient. Additionally, if our business is well managed, such
emergencies should not be manageable only with cash. Here, too, a prior arrangement with
the bank will enable us to deal with the emergency without having to hold cash.
In the third instance, opportunities, we cannot know in advance how much cash we will need.
Therefore, it may be much more effective to establish the type of banking relationship that,
when appropriate, will give us access to the appropriate resource.
In all three of these situations, we have turned to the bank to cover our cash needs. Some
Project Managers do not like to use debt, but we all know that used properly, debt can
enhance wealth. The most obvious example is in the purchase of a home. There are very few
of us who can pay cash for a house. We borrow money, the mortgage, in order to be able to
buy an asset that we believe will improve our lifestyle, help control our costs, and ultimately
increase our wealth through the equity we build up as house prices rise and we pay down the
mortgage. Clearly, the use of other people’s money, in this case through the bank, is a
means of increasing our own wealth as well as providing a return for the lender and the
suppliers to the lender. It is the same way in business. The judicious use of other people’s
money increases our own ability to make money. Holding cash for comfort, or, “just in case,”
may not really be to our advantage.
POME Prescribe:
About Your clients and stakeholders
 Keep the stakeholders updated: Keep the sponsors and stakeholders posted about the progress.
This becomes more important when there are unforeseen problems or newer risks; like when there
are delays.
134
2007, POME, Gautam_Koppala, All Rights Reserved
 Understand the need: When working on the project, it helps if you understand what your project
need will fulfill. Sometimes (make that often) your client’s description the project will not match his
need. Ensure that what you are doing will serve the purpose that it is meant to serve.
 When to give in and when to hold your ground: Once a project has started, the client will almost
always want you to incorporate changes and add tasks. Sometimes requests are legitimate, and it
is possible to incorporate them without throwing the project off track. But when the client’s
demands require significant changes, you need to take a call. Michelangelo Buonarroti’s ceiling
of the Sistine chapel project is a classic case in point. The original project involved creating twelve
paintings. By the time the project was completed, over 300 paintings had been created, costing the
artist his health and youth.
 When stakeholders do not respond to information or do not respond in an expected manner;
create alternative, proactive communication mechanisms to avert trouble.
 Don’t forget to ask, “What does my client want to be able to do as a result of this project?”
Translated to real life situations, every time you work on something, ask yourself what you (or
someone else) hope to accomplish from that activity. The answer can be as simple as “feeling
refreshed and rejuvenated” to something as complex as “moving towards my dream of contributing
to a cleaner and healthier planet”.
POME Prescribe
X
Xcellerate your
efforts.
POME Prescribe

135
2007, POME, Gautam_Koppala, All Rights Reserved
BALANCE SHEET
136
2007, POME, Gautam_Koppala, All Rights Reserved
Balance Sheet:
The first accounting equation, whichever form it takes, establishes the essence of the
Balance Sheet, a financial statement that describes for a reader the financial condition of a
business (or an individual) at a point in time. You can think of it as a snapshot of an
organization’s financial position.
Clearly, then, your net worth—the equity you have in your personal assets or in your
business—is a function of the resources you have and how you acquire and use them. If you
can acquire those assets for less than they are worth or will generate, you will increase your
net worth, or owner’s equity. The objective of financial management is to increase what you
own, your equity.
If that is the point of financial management, you might wonder why businesses use debt. If
they didn’t owe anything, they wouldn’t have to subtract liabilities from assets. A quick look
at the way people operate shows that this is an oversimplified view. The wise use of other
people’s money will, after providing an appropriate return for its use, enhance your ability to
increase your own net worth. And we all understand that: if we can, we borrow funds to buy
a house because we expect that, over time, that home will increase in value beyond what we
paid for it and what we could have earned by investing the funds. Using borrowed funds to
make the purchase will, therefore, increase our equity. The same is true for any productive
or valuable asset that is properly chosen and managed.
The Balance Sheet is presented as of a specific date, most frequently the end of the financial
year, and recognizes the effects of all of the financial activity that took place up through the
Balance Sheet date. On the following pages we present and describe the basic elements of
the Balance Sheet.
The first presentation, in Exhibit Below, provides a line-by-line explanation of the key parts
of a Balance Sheet.
137
2007, POME, Gautam_Koppala, All Rights Reserved
138
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: The Balance Sheet—Annotated
In the Balance Sheet it would be reflected as:
Dr (Debit) Cr (Credit)
Cash $100.00
Inventory $100.00
The reason that the credit is reflected first in this example is that in our Balance Sheet, cash
comes before inventory.
If we had purchased the inventory on credit, promising to pay for it at a later date, it would
appear as:
Debit Inventory (an Asset) for $100.00 to reflect the value of the inventory acquired.
Credit Accounts Payable (a Liability) for $100.00 to reflect the value of the inventory that we
now owe to the vendor.
In the Balance Sheet it would be reflected as:
Dr (Debit) Cr (Credit)
Inventory $100.00
Accounts Payable $100.00
To begin, bear in mind that the Income Statement reflects activities that are intended to
reward the shareholder; that is, to increase the wealth of the shareholders through the
generation of profit. The wealth of the shareholder is reflected in the Equity section of the
Balance Sheet. Recording credits to the Equity accounts, therefore, increases them.
Generally, except for the direct sale of stock, we only affect equity through transactions
reflected in the Income Statement.
Therefore, to ultimately increase Equity, we must show Revenues in the Income Statement
as credits, because if revenues exceed expenses, the result is profit that must reflect on the
Balance Sheet as an increase in—a credit to—Equity.
139
2007, POME, Gautam_Koppala, All Rights Reserved
If we show Sales as credits, then we must show Expenses as debits in order to generate
accurate accounting results. In its simplest terms then, we would show a sale of that
inventory on credit as follows:
Dr (Debit) Cr (Credit)
Sales (Revenue) $150.00
Accounts Receivable (Asset) $150.00
Cost of Sales (Expense) $100.00
Inventory (Asset) $100.00
These two transactions both balance, but the Balance Sheet no longer appears to be
balanced because we increased Assets by $150.00, but then decreased them only by
$100.00. However, the Income Statement now shows a profit of $50.00, the difference
between sales and expenses. This profit, at the end of the accounting period, is recognized
through a journal entry that closes out the period’s income statement by removing the profit
from the Income Statement through a debit and increasing the Equity on the Balance Sheet
through a credit. Now the Income Statement result has been zeroed out, making it ready for
the next accounting period, and the Balance Sheet has been balanced. Consider the
following:
Dr (Debit) Cr (Credit)
BS Accounts Receivable $150.00
BS Inventory $100.00
IS Sales $150.00
IS Cost of Sales $100.00
IS Profit $50.00
BS Retained Earnings (Equity) $50.00
Now the Balance Sheet (BS) balances and the Income Statement (IS) reflects the activity of
the period, closed out at the end of the period to the Balance Sheet.
Coming to Koppala and George conversation:
140
2007, POME, Gautam_Koppala, All Rights Reserved
 Balance Sheet – Assets
Koppala moves on to explain the balance sheet, a financial statement that reports the
amount of a company's (A) assets, (B) liabilities, and (C) stockholders' (or owner's)
equity at a specific point in time. Because the balance sheet reflects a specific point in
time rather than a period of time,
Koppala likes to refer to the balance sheet as a "snapshot" of a company's financial
position at a given moment. For example, if a balance sheet is dated December 31,
the amounts shown on the balance sheet are the balances in the accounts after all
transactions pertaining to December 31 have been recorded.
(A) Assets
Assets are things that a Project owns and are sometimes referred to as the resources
of the Project. George readily understands this—off the top of his head he names
things such as the company's vehicle, its cash in the bank, all of the supplies he has
on hand, and the dolly he uses to help move the miscellaneous material.
Koppala nods and shows George how these are reported in accounts called Vehicles,
Cash, Supplies, and Equipment. She mentions one asset George hadn't
considered—Accounts Receivable. If George delivers work packages, but isn't paid
immediately for the delivery, the amount owed to GG Org is an asset known as
Accounts Receivable.
Pre paids:
Koppala brings up another less obvious asset—the unexpired portion of prepaid
expenses. Suppose GG Org pays $1,200 on December 1 for a six-month insurance
premium on its Project vehicle. That divides out to be $200 per month ($1,200 ÷ 6
months). Between December 1 and December 31, $200 worth of insurance premium is
"used up" or "expires". The expired amount will be reported as Insurance Expense
on December's income statement. George asks Koppala where the remaining $1,000
of unexpired insurance premium would be reported. On the December 31 balance
sheet, Koppala tells him, in an asset account called Prepaid Insurance.
Other examples of things that might be paid for before they are used include supplies
and annual dues to a trade association. The portion that expires in the current
accounting period is listed as an expense on the income statement; the part that has
not yet expired is listed as an asset on the balance sheet.
141
2007, POME, Gautam_Koppala, All Rights Reserved
Koppala assures George that he will soon see a significant link between the income
statement and balance sheet, but for now she continues with her explanation of
assets.
Cost Principle and Conservatism
George learns that each of his company's assets was recorded at its original cost, and
even if the fair market value of an item increases, an accountant will not increase the
recorded amount of that asset on the balance sheet. This is the result of another basic
accounting principle known as the cost principle.
Although accountants generally do not increase the value of an asset, they might
decrease its value as a result of a concept known as conservatism. For example,
after a few months in business, George may decide that he can help out some
customers—as well as earn additional revenues—by carrying an inventory of packing
boxes to sell. Let's say that GG Org purchased 100 boxes wholesale for $1.00 each.
Since the time when George bought them, however, the wholesale price of boxes has
been cut by 40% and at today's price he could purchase them for $0.60 each. Because
the replacement cost of his inventory ($60) is less than the original recorded cost
($100), the principle of conservatism directs the accountant to report the lower
amount ($60) as the asset's value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than
cost, while conservatism might require assets to be reported at less then their cost.
Depreciation
George also needs to know that the reported amounts on his balance sheet for assets
such as equipment, vehicles, and buildings are routinely reduced by depreciation.
Depreciation is required by the basic accounting principle known as the matching
principle. Depreciation is used for assets whose life is not indefinite—equipment
wears out, vehicles become too old and costly to maintain, buildings age, and some
assets (like computers) become obsolete. Depreciation is the allocation of the cost of
the asset to Depreciation Expense on the income statement over its useful life.
As an example, assume that GG Org's van has a useful life of five years and was
purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5
years) of Depreciation Expense with each year's revenues for five years. Each year the
carrying amount of the van will be reduced by $4,000. (The carrying amount—or
"book value"—is reported on the balance sheet and it is the cost of the van minus the
142
2007, POME, Gautam_Koppala, All Rights Reserved
total depreciation since the van was acquired.) This means that after one year the
balance sheet will report the carrying amount of the delivery van as $16,000, after
two years the carrying amount will be $12,000, etc. After five years—the end of the
van's expected useful life—its carrying amount is zero.
George wants to be certain that he understands what Koppala is telling him regarding
the assets on the balance sheet, so he asks Koppala if the balance sheet is, in effect,
showing what the company's assets are worth. He is surprised to hear Koppala say
that the assets are not reported on the balance sheet at their worth (fair market
value). Long-term assets (such as buildings, equipment, and furnishings) are reported
at their cost minus the amounts already sent to the income statement as Depreciation
Expense. The result is that a building's market value may actually have increased
since it was acquired, but the amount on the balance sheet has been consistently
reduced as the accountant moved some of its cost to Depreciation Expense on the
income statement in order to achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller
than the carrying amount reported on the balance sheet. (Accountants view
depreciation as an allocation process—allocating the cost to expense in order to match
the costs with the revenues generated by the asset. Accountants do not consider
depreciation to be a valuation process.) The asset Land is not depreciated, so it will
appear at its original cost even if the land is now worth one hundred times more than
its cost.
Short-term (current) asset amounts are likely to be close to their market values, since
they tend to "turn over" in relatively short periods of time.
Koppala cautions George that the balance sheet reports only the assets acquired and
only at the cost reported in the transaction. This means that a company's reputation—
as excellent as it might be—will not be listed as an asset. It also means that Bill Gates
will not appear as an asset on Microsoft's balance sheet; Nike's logo will not appear as
an asset on its balance sheet; etc. George is surprised to hear this, since in his opinion
these items are perhaps the most valuable things those companies have.
Koppala tells George that he has just learned an important lesson that he should
remember when reading a balance sheet.
 Balance Sheet – Liabilities and Stockholders' Equity
143
2007, POME, Gautam_Koppala, All Rights Reserved
(B) Liabilities
The balance sheet reports GG Org's liabilities as of the date noted in the heading of
the balance sheet. Liabilities are obligations of the company; they are amounts owed
to others as of the balance sheet date. Koppala gives George some examples of
liabilities: the loan he received from his aunt (Notes Payable or Loan Payable), the
interest on the loan he owes to his aunt (Interest Payable), the amount he owes to
the hardware store for items purchased on credit (Accounts Payable), the wages he
owes an employee but hasn't yet paid to him (Wages Payable).
Another liability is money received in advance of actually earning the money. For
example, suppose that GG Org enters into an agreement with one of its customers
stipulating that the customer prepays $600 in return for the delivery of 3 work
packages every month for 6 months. Assume GG Org receives that $600 payment on
December 1 for deliveries to be made between December 1 and May 31. GG Org has a
cash receipt of $600 on December 1, but it does not have revenues of $600 at this
point. It will have revenues only when it earns them by delivering the parcels. On
December 1, GG Org will show that its asset Cash increased by $600, but it will also
have to show that it has a liability of $600. (It has the liability to deliver $600 of
parcels within 6 months, or return the money.)
The liability account involved in the $600 received on December 1 is Unearned
Revenue. Each month, as the 3 work packages are delivered, GG Org will be earning
$100, and as a result, each month $100 moves from the account Unearned Revenue
to Service Revenues. Each month GG Org's liability decreases by $100 as it fulfills
the agreement by delivering parcels and each month its revenues on the income
statement increase by $100.
(C) Stockholders' Equity
If the company is a corporation, the third section of a corporation's balance sheet is
Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as
Owner's Equity.) The amount of Stockholders' Equity is exactly the difference between
the asset amounts and the liability amounts. As a result accountants often refer to
Stockholders' Equity as the difference (or residual) of assets minus liabilities.
Stockholders' Equity is also the "book value" of the corporation.
Since the corporation's assets are shown at cost or lower (and not at their market
values) it is important that you do not associate the reported amount of Stockholders'
144
2007, POME, Gautam_Koppala, All Rights Reserved
Equity with the market value of the corporation. (Hence, it is a poor choice of words to
refer to Stockholders' Equity as the corporation's "net worth".) To find the market
value of a corporation, you should obtain the services of a professional familiar with
your businesses.
Within the Stockholders' Equity section you may see accounts such as Common
Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock,
Retained Earnings, and Current Year's Net Income.
The account Common Stock will be increased when the corporation issues shares of
stock in exchange for cash (or some other asset). Another account Retained
Earnings will increase when the corporation earns a profit. There will be a decrease
when the corporation has a net loss. This means that revenues will automatically
cause an increase in Stockholders' Equity and expenses will automatically cause a
decrease in Stockholders' Equity. This illustrates a link between a company's balance
sheet and income statement.
Examining Your Company’s Balance Sheet
INSTRUCTIONS: Get a copy of your company’s Balance Sheet or the Balance Sheet of
another company you are interested in. Compare the format of the Balance Sheet below with
the one you are looking at. Identify the similarities and differences between this generalized
Balance Sheet and that of a specific company. It is likely that your company’s presentation of
the Balance Sheet is similar to the one presented here. Different companies may alter the
presentation of the Balance Sheet to reflect the specifics of the company more clearly. For
example, you may see Fixed Assets described as Property, Plant, and Equipment. Your
company may break the classifications of assets and liabilities and equity into broader or
narrower subcategories. To the extent that the examination of your company’s financial
statements raises questions, ask someone in the accounting or finance department to clarify
what you have seen.
145
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: The Balance Sheet—An Alternative Presentation
Trial Balance
During the course of an accounting period, a company records many, many such
transactions, tracking every activity of the company through the financial records. When the
period ends, the accountants summarize all of the transactions, determining the amounts to
be recognized in each account. When all the accounts in the chart of accounts are listed with
their respective balances in a single, sequential statement, it is called a Trial Balance. There
may be several interim trial balances prepared before the books are closed, as the
accountants seek to be sure that everything has been accounted for. A properly completed
Trial Balance reflects everything that has occurred during the period and when added
together totals zero. That is, the debits equal the credits and since they are all added
together, they offset each other. Once this zero balance has been achieved, the accountants
recognize that by separating the Balance Sheet accounts from the Income Statement
accounts, they have prepared two financial statements which when added separately, reach
the same net amount, but with opposite signs, one positive and the other negative, one a
debit balance and the other a credit balance. If the company has made a profit, the Income
Statement has a total that reflects a net credit, and the Balance Sheet has more assets than
liabilities, by the amount of the net credit. The final entry made, then, is to clear the net
credit from the Income Statement and to add to the Retained Earnings account the profit for
the period, bringing the Balance Sheet back into balance. From here the formal preparation
and delivery of financial statements is only a function of printing the final results.
The Income Statement and Balance Sheet are the direct outcome of the accounting system
recording and reporting process. The preparation of the Statement of Cash Flows follows
146
2007, POME, Gautam_Koppala, All Rights Reserved
easily from the completion of the Balance Sheet. The Statement of Cash Flows, summarizes
information reflected on the Balance Sheet into a standardized structure, permitting analysts
to understand and interpret how the company handled its cash during the period. Since cash
and cash equivalents facilitate the completion of all business transactions, tracking the cash
flows provides the analysts with a window into the company. Similarly, the Statement of
Retained Earnings is also prepared after the preparation of the Balance Sheet and the
Income Statement, completing the financial statement package for the period.
POME Prescribe:
W
Want it more than
anything.
POME Prescribe
147
2007, POME, Gautam_Koppala, All Rights Reserved
CONTROL OF
PROJECT CASH
FLOW’S
148
2007, POME, Gautam_Koppala, All Rights Reserved
Control of Project Cash Flows
The development of information for the control of project costs with respect to the various
functional activities appearing in the project budget. Project managers also are involved with
assessment of the overall status of the project, including the status of activities, financing,
payments and receipts. These various items comprise the project and financing cash flows
described in earlier POME Chapters. These components include costs incurred (as described
above), billings and receipts for billings to End Users (for contractors), payable amounts to
suppliers and contractors, financing plan cash flows (for bonds or other financial
instruments), etc. Other short-term assets, including marketable securities, accounts
receivable, inventory, and prepaid expenses, are part of the Project’s cash flow. The rest of
POME describes the management issues for each of these assets.
As an example of cash flow control, consider the report shown in Table below. In this
case, costs are not divided into functional categories, such as labor, material, or
equipment. Table below represents a summary of the project status as viewed from
different components of the accounting system. Thus, the aggregation of different
kinds of cost exposure or cost commitment shown in Table 12-0 has not been
performed. The elements in Table below include:
• Costs
This is a summary of charges as reflected by the job cost accounts, including
expenditures and estimated costs. This row provides an aggregate summary of the
detailed activity cost information For this example, the total costs as of July 2 (7/02)
were $ 8,754,516, and the original cost estimate was $65,863,092, so the
approximate percentage complete was 8,754,516/65,863,092 or 13.292%. However,
the project manager now projects a cost of $66,545,263 for the project, representing
an increase of $682,171 over the original estimate. This new estimate would reflect
the actual percentage of work completed as well as other effects such as changes in
unit prices for labor or materials. Needless to say, this increase in expected costs is
not a welcome change to the project manager.
• Billings
This row summarizes the state of cash flows with respect to the owner of the facility;
this row would not be included for reports to End Users. The contract amount was
149
2007, POME, Gautam_Koppala, All Rights Reserved
$67,511,602, and a total of $9,276,621 or 13.741% of the contract has been billed.
The amount of allowable billing is specified under the terms of the contract between
an owner and an engineering, architect, or constructor. In this case, total billings have
exceeded the estimated project completion proportion. The final column includes the
currently projected net earnings of $966,339. This figure is calculated as the contract
amount less projected costs: 67,511,602 - 66,545,263 = $966,339. Note that this
profit figure does not reflect the time value of money or discounting.
• Payables
The Payables row summarizes the amount owed by the contractor to material
suppliers, labor or sub-contractors. At the time of this report, $6,719,103 had been
paid to subcontractors, material suppliers, and others. Invoices of $1,300,089 have
accumulated but have not yet been paid. A retention of $391,671 has been imposed
on subcontractors, and $343,653 in direct labor expenses have been occurred. The
total of payables is equal to the total project expenses shown in the first row of costs.
One of the principal ways that many companies generate sales is by offering to sell
their products on credit. This is particularly true when the Projects is selling to other
businesses. The sale on credit enables the purchasing Projects to use the product for
a period of time before paying for it. They may convert the purchased product into
some other product for ultimate sale, or they may resell the purchased product to
downstream customers, or they may consume the product themselves. In any event,
the payment for the purchase is delayed, enabling the buyer to retain its funds and
use them to generate income for the Projects.
The delay in receiving payment for your sale increases the risk to your Projects, risk
that you might not get paid at all, and risk because you need to borrow funds for the
time you wait, lowering the return that you can earn because you do not have the
money. Therefore, if you choose to sell on credit, it is important to manage your
receivables to assure that you receive the funds when you want and expect them.
Managing accounts receivable involves the assessment of credit risk, as well as
following up with customers to assure that they are satisfied with their purchase and
will, therefore, pay for it when payment is due. The management of accounts
receivable includes the maintenance of accurate and complete records of all sales and
payments, monitoring the status of all accounts, and undertaking the collection effort
150
2007, POME, Gautam_Koppala, All Rights Reserved
necessary to keep your investment in accounts receivable at the lowest level
consistent with your other management policies.
Most Project Managers do not like to call asking for money. Therefore, in many
companies, accounts receivable are not well managed and customers are allowed to
set their own schedule for payment. Because most companies, just as most people,
pay their bills on time, that is, within the terms set by the seller, the longer a
receivable remains unpaid, the riskier it is. Some companies borrow money, using
accounts receivable as security for the loan. The bank, in assessing the accounts
receivable, will limit the amounts that will be considered to those amounts that are
current or only a little past due. The lender knows that receivables unpaid more than
30 days past due fall into the problem category, because the customer either can’t
pay (doesn’t have the money) or won’t pay (has a problem with the product or
service). In either event the security for the loan is gone and the lender will not
consider such an account as valuable.
As part of managing accounts receivable, management assesses the probability of
collecting the amounts due. If there is some question as to whether the customer will
pay the amount due, a reserve may be established. It might even be reasonable to
create such a reserve based on the percentage of receivables, and therefore of sales,
that has historically been uncollectible. This reserve, created by recording a “Bad Debt
Expense” in the Income Statement and a “Reserve for Bad Debts” or an “Allowance
for Doubtful Accounts” on the Balance Sheet, reduces the profits for the period and
lowers the net balance of accounts receivable on the Balance Sheet. If a Projects
chooses not to recognize this probability, no adjustment to income or assets occurs.
As you can see, the evaluation of accounts receivable can change financial
performance.
In the past some companies adjusted their reported profits by manipulating this and
other reserves, raising and lowering profits according to management choice or
investor expectations. The Internal Revenue Service (IRS), Securities and Exchange
Commission (SEC), and the Financial Accounting Standards Board (FASB) all felt this
practice was sufficiently misleading that they established rules to limit the use of
reserves. Today, reserves for bad debts must be specific, that is, based on specific
accounts considered potentially uncollectible rather than on a percentage of
receivables. Other reserves, such as a reserve for inventory obsolescence, may no
longer be recorded on the Balance Sheet, but must be specifically identified and
151
2007, POME, Gautam_Koppala, All Rights Reserved
written off through the Income Statement, reducing the Balance Sheet balance. Any
inventory thus written off must be disposed of. It cannot be held, to be sold at a later
date, permitting the Projects to transfer the profits to the future.
POME considered the calculation of the Average Collection Period, a measure of the
effectiveness of the management of accounts receivable. This ratio tells us a lot about
the credit management and the overall management of the Projects, the quality of the
accounts receivable, and something about the future profitability of the business. As
such this ratio is one of the first computed when a Projects is being analyzed, whether
by an investor, a customer, or a competitor.
• Receivables
This row summarizes the cash flow of receipts from the owner. Note that the actual
receipts from the owner may differ from the amounts billed due to delayed payments
or retainage on the part of the owner. The net-billed equals the gross billed less
retention by the owner. In this case, gross billed is $9,276,621 (as shown in the
billings row), the net billed is $8,761,673 and the retention is $514,948.
Unfortunately, only $7,209,344 has been received from the owner, so the open
receivable amount is a (substantial!) $2,067,277 due from the owner.
• Inventory
For many companies, inventory is as important, or more important, as accounts
receivable. The money spent on inventory takes longer to convert to cash, because it
must be sold and the revenue collected, and is therefore more risky than accounts
receivable. Because in many cases inventory goes through stages, it is more
complicated to manage as well.
In a manufacturing Projects, inventory goes through three stages: raw material,
work-in-process, and finished goods. In these companies the management function is
more complex, requiring forecasts of requirements, an understanding of the
production process, and an estimate of end customer demand. In other companies,
ones that only handle the product after it is finished, the stages of inventory are not
important, but the forecasting is more critical because, although raw materials may
be used for several end products, and even work-in-process may be finished into a
number of different items, finished goods are not easily changed into something else.
152
2007, POME, Gautam_Koppala, All Rights Reserved
Because managing inventory is so critical, companies have developed complex
systems to control inventory and keep track of it. In recent years some of these
systems, drawing on the capabilities of computers and systems, have been expanded
to control all aspects of the manufacturing process. In the early years of
computerization, companies developed inventory control systems that tracked the
quantities, cost, and physical location of stocks held. Later these systems were
expanded to recognize ordered but not received materials as well as work-in-process
by stage of processing. These systems evolved into planning and forecasting tools
that took on the projection of materials requirements and the first Materials
Requirements Planning (MRP) systems were developed. Rapidly, MRP systems evolved
into Manufacturing Resource Planning (MRPII) tools, and from there to Enterprise
Resource Planning (ERP) systems. These have in recent years been further expanded
to recognize that the requirements for resources extend beyond the Projects to the
suppliers and their suppliers and to the customers and their customers. Today
companies are developing comprehensive computerized planning systems to tie the
needs of all the parts of the supply chain into an integrated planning system that will
provide status information about any stage of the entire processing chain from the
very beginning to the very end to anyone with a need to know.
The discussion of reserves in the last section is applicable here as well. Forecasts
guide management’s inventory decisions and forecasts can be wrong. However,
because of the potential for misuse, reserves for inventory may not be used for
financial or tax reporting. Any inventory considered unsalable, and therefore worthy of
write-off, must be disposed of, thereby assuring that the reduction in profits is not
just a “cookie jar” reserve, to be recovered in some future period when profits need a
boost. As you can see, regulators are continuously trying to assure that financial
results are meaningful and reliable.
The representative Manufacturing Cash Cycle presented in Exhibit below helps clarify
the importance of the planning as well as the interrelationships among the different
disciplines within a Projects. Think about the timing of actions within this example.
153
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: Manufacturing Cash Cycle
This gap between cash out and cash in, known as the cash conversion cycle, requires
the Projects to borrow funds or use equity resources to continue to operate during
this time period. In this example we have assumed that our Projects and our
customers pay their bills on time. If we delayed our payments, the amount of time
from cash out to cash in would be reduced. If our customers were at all delinquent
(and on the average companies’ collection periods are longer than the credit terms),
the period from cash out to cash in would be longer.
In this case the length of the conversion cycle is caused primarily by the need to hold
inventory, a need that is based on the difficulty of forecasting demand. It highlights
the importance of developing good forecasts and emphasizes the interrelationships
among forecasting, management of assets, and the cost of managing the Projects.
Consider the costs associated with carrying inventory in a Projects. The list of such
expenses is shown in Exhibit below.
Exhibit: Inventory Carrying Costs
154
2007, POME, Gautam_Koppala, All Rights Reserved
It is estimated that when all these costs are added together, they equal
approximately 30 percent of the value of the average annual inventory balance. This
amounts to a substantial percentage of Projects profits and excess inventory held
“just-in-case” severely impacts potential profitability. This is one reason for the “just-
in-time” emphasis on inventory management today.
• Cash Position
This row summarizes the cash position of the project as if all expenses and receipts
for the project were combined in a single account. The actual expenditures have been
$7,062,756 (calculated as the total costs of $8,754,516 less subcontractor retentions
of $391,671 and unpaid bills of $1,300,089) and $ 7,209,344 has been received from
the owner. As a result, a net cash balance of $146,588 exists which can be used in an
interest earning bank account or to finance deficits on other projects.
Each of the rows shown in Table 12-8 would be derived from different sets of financial
accounts. Additional reports could be prepared on the financing cash flows for bonds
or interest charges in an overdraft account.
TABLE: An Example of a Cash Flow Status Report
Costs Charges Estimated % Complete Projected Change
7/02 8,754,516 65,863,092 13.292 66,545,263 682,171
Billings Contract Gross Bill % Billed Profit
7/01 67,511,602 9,276,621 13.741 966,339
Payables Paid Open Retention Labor Total
7/01 6,719,103 1,300,089 391,671 343,653 8,754,516
Receivable Net Bill Received Retention Open
7/02 8,761,673 7,209,344 514,948 2,067,277
Cash Position Paid Received Position
7,062,756 7,209,344 146,588
155
2007, POME, Gautam_Koppala, All Rights Reserved
The overall status of the project requires synthesizing the different pieces of
information summarized in Table above Each of the different accounting systems
contributing to this table provides a different view of the status of the project. In this
example, the budget information indicates that costs are higher than expected, which
could be troubling. However, a profit is still expected for the project. A substantial
amount of money is due from the owner, and this could turn out to be a problem if the
owner continues to lag in payment. Finally, the positive cash position for the project is
highly desirable since financing charges can be avoided.
The job status reports illustrated in this and the previous sections provide a primary
tool for project cost control. Different reports with varying amounts of detail and item
reports would be prepared for different individuals involved in a project. Reports to
upper management would be summaries, reports to particular staff individuals would
emphasize their responsibilities (eg. purchasing, payroll, etc.), and detailed reports
would be provided to the individual project managers. Coupled with scheduling
reports, these reports provide a snapshot view of how a project is doing. Of course,
these schedule and cost reports would have to be tempered by the actual
accomplishments and problems occurring in the field. For example, if work already
completed is of sub-standard quality, these reports would not reveal such a problem.
Even though the reports indicated a project on time and on budget, the possibility of
re-work or inadequate facility performance due to quality problems would quickly
reverse that rosy situation.
Accounts Payable:
The purpose is to ensure vendor inoivces are processed and paid
Step Who Steps/Notes
Submission of Invoice to Company
Vendor generates invoice and references the
1 Vendor related Company purchase order number. .
a. Invoice must be submitted to the Bill To
Address as stipulated on the purchase
156
2007, POME, Gautam_Koppala, All Rights Reserved
order.
Invoice Received at Company
When the invoice is received, purchase order
number is validated by checking the following:
1. Purchase order number referenced on
invoice
Accounts
2
Payable If purchase order number is not referenced on
invoice, it is returned to the vendor with
standard explanation letter. A log is
maintained to record each instance of an
invoice being returned to vendor.
Scan Invoice into PMIS/ERP
Validated invoice is scanned into the ERP
Accounts system.
Payable
3
Once scanned into ERP, invoice is stamped
with the marking ‘file only’ to prevent duplicate
scans.
Matching of Invoice
Invoice is retrieved from ERP system and is
4 AP matched to purchase order. The agreed SLA is
retrieval within three (3) working days.
Variance reasons: not receipted (on hold),
157
2007, POME, Gautam_Koppala, All Rights Reserved
dispute (PO & invoice do not match).
Facilitation of Payment
Once invoice is matched to purchase order, the
three (3) way match applies.
PO number + Receipt + Invoice = Validated
5 AP
invoice
Once invoice is in validated status, payment is
calculated based upon the payment terms
assigned to the vendor account, based upon
his paymeny terms.
A Project Manager of cash in Projects recognizes that earning interest on cash on hand
increases the overall profits of a Projects. Therefore, many Project Managers take advantage
of the bank’s need for cash to maintain their levels of reserves. Project Managers contract
with the bank for the bank to use the cash the Projects has on deposit to increase the bank’s
overnight balances in return for interest. These repurchase certificates or securities
(Repos) provide a modest income for the Projects on funds that otherwise would not earn
anything at all. If the funds are not needed for longer than just overnight, longer agreements
will be established, and they will carry higher interest rates, to compensate for the longer
time. The differences in interest rates are very slight, but if the balances involved are
substantial, this may still result in some real income. If the funds will be available for longer,
weeks or months, other investment instruments may offer higher rates of return.
As part of this cash management process, companies with multiple locations will arrange to
bring the cash from all the locations into a central account where it can be managed and
invested more effectively. A Project Manager can earn more money if there are larger
amounts to invest as well as if the money can be invested for longer periods of time. The
sweeping of these funds into a concentration account gives the Project Manager more
opportunities to manage the funds effectively.
158
2007, POME, Gautam_Koppala, All Rights Reserved
Nevertheless, used properly, the techniques of cash management, getting money into a
central account and investing the funds intelligently, offer an opportunity to contribute
significantly to the financial success of a Projects. These funds are often invested in short-
term securities, known as marketable securities.
Managing Marketable Securities
Numerous instruments are available to the Projects treasurer to help generate income while
holding liquid assets. The list of such investments grows daily and includes instruments called
derivatives, whose value is “derived” from underlying assets or arrangements. One of the
most interesting aspects of the derivatives market is the flexibility of the instruments that
are being developed. Derivatives, which have received a lot of negative publicity in recent
years but which offer the ability to tailor investments to particular needs or situations, may
carry a level of risk inappropriate for liquid resources that a Projects will need in the near
future. A variety of short-term choices is listed in Exhibit below.
Exhibit: Short-Term Investment Choices
Clearly, the array of choices offers great flexibility at a broad range of risk levels. Common
stock is far riskier than savings accounts, but for the right situation it may offer the prospect
of sufficiently high return to make the risk worthwhile. It should also be apparent from the
breadth of the list in Exhibit that a short-term investment instrument can be constructed to
meet almost any need.
In any discussion of short-term investments, we must remember the effect of changes in
interest rates. In recent years the Federal Reserve, in its efforts to manage the economy and
control inflation, moved interest rates down, in a series of steps, as the economy slowed in
2001 and 2002, and then up, again in a series of steps, as the economy strengthened in
2004 and 2005. With each change in interest rates, specifically the short-term federal funds
rate, but, affecting all other rates through a reference to the prime interest rate, there
159
2007, POME, Gautam_Koppala, All Rights Reserved
was a ripple effect through all financial markets. As banks and businesses have become used
to the Federal Reserve rate-setting process, responses have become swift and predictable.
The federal funds rate is the rate that banks charge other banks for overnight loans. The
prime interest rate, approximately three percentage points higher than the federal funds
rate, generally moves in concert with the federal funds rate. The prime interest rate is the
short-term interest rate that banks charge their best (most creditworthy) customers.
Estimating Interest Rates
Using the preceding section as a guide, the formula for interest rates would be:
I = BR + DP + IP + MP + LP
Recognizing the premiums described we can easily arrive at an approximation for the “risk-
free” rate, the interest rate paid by the U.S. Treasury. The risk-free rate, designated RF,
includes the basic rental cost of money, plus the premiums for inflation and maturity, the
nondiversifiable risk elements.
As an example, U.S. Treasury bonds, the long-term bonds the U.S. government issues, are
currently offering an interest rate of approximately 5.0 percent. If we consider the basic rent
plus the inflation premium plus the maturity premium, the risk premiums discussed above
that apply to the U.S. government’s obligations, we find that:
Where:
I = the Interest Rate
BR = Basic Rental cost of money, approximately 2 percent
DP = Default Premium
IP = Inflation Premium, currently running about 4 percent, increased
because the Federal Reserve is concerned that the strength of
the economy would cause prices to rise
MP = Maturity Premium
LP = Liquidity Premium
160
2007, POME, Gautam_Koppala, All Rights Reserved
Interest rates move in response to the general level of business activity in the economy. If
the economy is strong, interest rates, which are the price of money, rise as demand for
money rises. The financial markets see this interest rate movement in the market for U.S.
Treasury securities. By monitoring this market, business Project Managers are in a position to
make decisions regarding the financing of their business, as the interest rates they will be
charged are generally determined in relation to the Treasury security interest rates.
Capital Asset Pricing Model
This interest discussion establishes a basis for looking at other securities. After all, equity
investors want a return that recognizes these same risk premiums and rewards the investor
for giving up the right to a defined maturity, for taking a subordinated, lower priority role to
other financing, and for giving up the right to a regular payment of income. Scholars have
analyzed this relationship and identified a relationship that describes these needs. Finance
theoreticians have described the Capital Asset Pricing Model (CAPM) as an equation that
determines the return required of an investment having a particular risk relationship to the
general market. This equation is:
kj = RF + bj(km – RF)
The measure of beta has been the subject of much academic debate, but generally it relates
the volatility or riskiness of a particular security to the general market for similar securities.
That is, it relates a particular stock, j, to the performance of the Standard & Poor’s 500
Average, the Dow Jones Industrial Average, or some similar well-known market measure.
Relating Risk and Return
Though the CAPM equation, in current markets, does not really present a definitive market
value relationship for an investment, by relating risk and required return for a prospective
investment to the risk-free rate (RF—the government bond rate) and the market (km)
161
2007, POME, Gautam_Koppala, All Rights Reserved
through an assessment of riskiness (bj), an investor is able to apply a rational assessment of
validity to a projected, estimated, or definitively required rate of return. The investor is then
in a position to decide whether the investment is attractive or not.
This defined relationship between risk and return leads to the old adage, “If it sounds too
good to be true, it probably is.” This saying applies to investments as well as, if not better
than, to other situations. If someone offers an extraordinarily high rate of return, it must
mean that there is an extraordinarily high risk associated with the opportunity. Despite any
objections that might be raised, the relationship of risk and return is clearly valid and as such
should be heeded.
Extending the Theory
Over the years many sources of investment guidance have estimated the beta coefficients for
different stock issues. Drawing on the difficulty of establishing just how much riskier one
situation or investment is than another, we find that in these estimates of beta, very few
Projects stocks are evaluated at a beta higher than 2.The consequence of this leads to an
important result in the financial marketplace. Taking the CAPM equation and using 2 as beta,
recognizing that historically RF has been 6.0 percent and km is estimated long-term to be
approximately 10 percent, the consequence is a required rate of return of:
Where:
kj = the Required Rate of Return on an investment j
RF =the risk-free rate, usually the rate on a 10-year or 20-year U.S.Treasury bond
bj = “beta sub j” is the risk coefficient that relates investment j to the market
km = the rate of return available on a known portfolio in the relevantmarket, the basis
for the comparison to j
kj = RF + bj(km – RF)
kj = 6 + 2(10 – 6)
kj = 14
If beta is 2, frequently the highest beta coefficient because it is so hard to say that one
opportunity is more than twice as risky, twice as volatile, as the market, then to be
attractive, a risky investment must offer the investor a rate of return greater than 14
162
2007, POME, Gautam_Koppala, All Rights Reserved
percent. It is this recognition that has established a market for high-risk, non-investment-
grade securities. If a Projects that does not qualify as an investment-grade borrower offers a
bond at a rate of, say, 15 or 16 percent interest, there will be some investors—risk takers—
who, seeing a rate of return higher than their required rate of return, will invest, establishing
the junk bond market and making it possible for riskier companies to attract the funding they
need to move their businesses forward. To further explain how this works, remember that
interest expense is deductible before computing taxes..
Time Value of Money
The importance of determining the risk-based required rate of return, k, cannot be
overstated. All financial decisions should incorporate an assessment of this risk and the
return required as a basis for action.
In essence, we use “k” to assess the real value of whatever we are considering. An essential
element of understanding our business system is the recognition that we can always earn a
return—an income—however modest, by investing our money in a low- or no-risk investment
offering a basic interest rate—a basic rental cost for the use of our money.
We further recognize that if we leave our money invested for periods longer than the stated
interest period, the investment will continue to earn interest and will also earn interest on the
interest. This lesson goes back to childhood when a parent took you to the savings bank and
explained that if you deposit your money in the bank, the bank will pay you interest and that
interest will compound, enabling your deposit to grow and grow. This understanding is our
starting point. It can be described as, “A dollar today is worth more than a dollar tomorrow.”
Taking risk into account results in changing expectations of that return. The greater the risk,
the greater the return must be to make taking that risk attractive to us. This premise makes
it possible for us to evaluate alternative opportunities by judging the risk and then applying
our requirements for return based on that risk. If after taking risk into account, the return is
satisfactory, we will make the investment; if it is not, we will not.
The way we assess the investment is to relate the value of the money we pay out to the
amount of money that we will receive would be worth if it were computed in today’s terms.
Or, we relate the value that something will be worth in the future to what an acceptable
investment would be worth, using the required rate of return, k, as the basis for the
assessment.
163
2007, POME, Gautam_Koppala, All Rights Reserved
To make this concept simple, assume you required a rate of return of 10 percent and you
had $100 to invest for one year. To be attractive to you under these circumstances, you
would need to receive at least your $100 back plus a 10 percent additional amount, or $10
($100 × .10). Therefore, we can say that the future value, in one year, of the investment
for which we will pay $100, must be $110.
Similarly, we can say that an investment that will pay us $110 in one year has a present
value of $100 today if our required rate of return is 10 percent. It is important to recognize
that such analysis goes both ways. We need to be able to compute the future value from the
present and to compute the present value from the future. In fact, we can go either way. If
we know any three of the four variables—Present Value, Future Value, Term, and Rate of
Return—we can compute the missing variable and then assess the investment.
Present Value—the cost of an investment or the value today of monies to be received in the
future
Future Value—the dollar yield of an investment or the value of monies to be received at
some time in the future from an investment made today
Term—the life of the investment
Rate of Return—the rate of return offered by an investment or required by the investor
In some situations payments made are in equal instalments. In such cases we refer to the
payments as annuities. An annuity is a series of equal periodic payments whose value may
be determined by use of specialized computations or by summing the values derived by
calculating the present value or the future value, whichever is appropriate, of each of the
payments individually. One computation quirk to keep in mind is that in calculating the future
value of an annuity, payments are assumed to begin at the end of the first period and to
occur at the end of each subsequent period. If the payments begin at the beginning of the
period and continue at the beginning of subsequent periods, the sequence of payments is
known as an annuity due and the value of the annuity is increased by one interest
computation.
In the Appendix at the end of the course are some tables that help relate present value to
future value, both for individual sums of money and for annuities, which, as noted, are
regular periodic payments of the same amount of money over a period of time extending
beyond one period. As we will see in the next POME Chapter, we can compute the present
value of capital investments by applying the principles of time value of money to the facts
that we determine.
164
2007, POME, Gautam_Koppala, All Rights Reserved
Valuation
We can use our understanding of time value of money, along with the application of risk
assessment, to evaluate investment opportunities. So, we can determine that the value of an
investment is a function of what we will receive in the future, discounted to the date of the
investment. Thus, if we want an investment of $100 to yield 10 percent over 5 years, we can
compute $100 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10, which equals $161.05. Therefore, the
future value of an investment of $100 at 10 percent for five years is $161.05. A look at the
future value table shown in the Appendix confirms that the future value of $1, at 10 percent
interest, compounded annually for five years is $1.6105. Therefore, the future value of $100
computed the same way will be $100 × 1.6105, or $161.05.
All investments can be assessed the same way. Therefore, the determination of the value of
an investment depends on the present value (PV), future value (FV), interest rate (I) and
term (N, for number of periods). Present value and future value tables referred to in the
following pages are in the Appendix to this manual. These same calculations can be done
very easily using one of many financial calculators available from any office supply store.
These calculators perform the same calculations demonstrated in the following pages. We
can also determine how much we will need at some time in the future, to buy something or
to reach a desired milestone. Let’s look at an example.
POME Case Study:
An Illustrative Example
Suppose you want to purchase a retirement home when you retire in 20 years. You have a
specific home in mind that is currently available for $85,000. You expect market prices to
increase an average of 6 percent per year for the next 20 years. What will the house be
worth when you are ready to buy it? Looking at the table for future values in the Appendix,
under the 6 percent column across the 20 period line, we find the factor of 3.207, which tells
us that the value of the house will be $85,000 × 3.207 or $272,595.
As a second part to this problem, let us determine how much we need to save each year if
we can invest our savings at 10 percent for the entire time. Since we want to save the same
amount each year for the twenty years, we are talking about an annuity. We need the
annuity to be worth $272,595 in 20 years using a 10 percent interest factor. Looking at the
future value of an annuity table (see Appendix), we see the factor for an annuity for 20
165
2007, POME, Gautam_Koppala, All Rights Reserved
periods at 10 percent is equal to 57.275. Therefore, if we divide the $272,595 by the factor
57.275, we find that if we save $4,759.41 each year for the twenty years, we will have
accumulated enough money to pay for the house. This example is illustrated in Exhibit below.
Exhibit: Valuation Computations
Assessing Investments
We can use these tools to assess any investment, recognizing that the value of the
investment is whatever we receive, related to what we paid in, and related to our expectation
of return, which, in turn, depends on our assessment of risk.
To determine the attractiveness of an investment in a bond, therefore, we evaluate the
interest payments we will receive and the return of the face amount of the bond at maturity
and compare that result to our investment amount. So, a bond that will pay us a coupon
rate, the stated interest rate of the bond, of 10 percent, equal to $100 per year for five
years, and will then pay us $1,000, the face amount of the bond, is worth $1,000.00 to us
now if our required rate of return is 10 percent, but is worth $1,080.30 to us if our required
rate of return is 8 percent, or $927.50 if our required rate of return is 12 percent. We can
use the factors in Exhibit , taken from the Present Value Table, to see how we reach this
conclusion.
166
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: Assessing Investments
These computations tell us many things. Not only do they tell us what such a bond is worth
at different discount rates, but they also demonstrate the relationship between nominal
interest rates, the 10 percent that the bond pays based on its face amount, and market
rates. If the bond’s interest rate exceeds the current market, the bond will sell at a premium,
and, conversely, if the bond’s interest rate is lower than the current market rate, the bond
will sell at a discount. This enables an investor to receive a return competitive with the
market rate. If that were not possible, there would be no market for securities that offered
returns different from the current market.
Equity investments can be evaluated in a similar manner. The investor, in considering an
equity investment, has a desired rate of return in mind. This return is invariably higher than
would be required for a risk-free or a low-risk investment as equity investments are clearly
riskier. Additionally, an equity investment does not promise regular cash income. Therefore,
the expectation is that when the return is actually received, it will be significantly more
rewarding.
The reward for an equity investment is a function, not of dividends, but of earnings. The
earnings of a Projects belong to the shareholders so that a dividend, which is a distribution of
the Project’s earnings to the shareholders, is actually a distribution by the Projects of money
that already belongs to the shareholders. However, it is deemed to have a separate value.
More important, however, than the dividends, is the market value of the stock. When
investors purchase shares in a Projects, they do so in a market and with the expectation
that, someday, they will resell those shares into the market. Therefore, the market price that
investors pay for shares must be a reflection of the perceived present value of the money
that the shareholder expects to receive in the future, when he or she sells the shares back
into the market.
167
2007, POME, Gautam_Koppala, All Rights Reserved
Unlike a bond, there is no certainty of timing for redemption or sale of the stock. The
shareholder will hold the stock until the current market value of the shares is higher than the
perceived present value of the future market performance, as determined using the
investor’s required rate of return. This all makes sense, but is probably not a picture of
reality. Most investors make investment decisions largely on the basis of past performance
and intuitive perception. However, underlying this perception is an assessment that the
future market price will be higher, and will be enough higher to make it worthwhile to buy
and hold this stock.
Valuing an Investment
Valuing an investment involves applying the tools of time value of money to the expectation
of return, recognizing the riskiness of the investment in determining the required rate that
will be applied. That is, the value today of an investment is the present value of the future
cash flows (whether periodic payments, maturity payment, or price received when sold) of
the investment in question, discounted at a rate of return required by the investor and
determined by applying a risk assessment to the investment.
The required rate of return that the investor establishes for a particular investment is used as
the “k,” the discount rate used to convert future cash flows into present value for comparison
to the price of the investment.
POME Case Study:
The following problem highlights the flexibility of this tool. Using the table below and the time
value of money tables in the Appendix, answer the questions that follo
1. At what price will each of these investments yield 10 percent?
2. What is the approximate yield (return on investment) percentage of each if the
investment required today is $8,000?
Investment Value at Maturity Maturity
A $30,000 15 years
B 13,000 7 years
C 20,000 10 years
D 15,000 20 years
168
2007, POME, Gautam_Koppala, All Rights Reserved
Finally, let’s consider a more comprehensive example related to personal financial planning.
For this analysis, assume that you are a 25-year-old who wishes to retire in 40 years with
$1,000,000 in the bank. Although a million dollars won’t be as attractive then as it is now,
having it will be far better than not having it.
 We know the future value: $1,000,000.
 We know the term: 40 years.
 We know the interest rate: 10 percent.
Using the future value tables, we find the factor related to 40 years at 10 percent: 45.259.
Dividing $1,000,000 by 45.259 equals $22,095.54, which tells us that if we were to invest
$22,095.05 today in an investment that promised a 10 percent interest rate compounded
annually, at the end of 40 years we would have $1,000,000.
We can use the present value tables equally effectively. The present value interest factor for
40 years at 10 percent is .022. Multiplying $1,000,000, the future value, by .022, the
present value interest factor, equals $22,000. This is essentially equivalent to the
$22,095.05 determined using the future value interest factor. The difference is a result of
rounding. In fact, if we had a table of four decimal places, the factor would be .0221 and the
answer would be $22,100.00, very close to the $22,095.05.
Perhaps, however, as a 25-year-old, you do not have $22,000 available to invest for 40
years. You are able to save some money from your weekly salary. How much would you need
to save each year from your compensation to accumulate a $1,000,000 fund when you retire
(all tax considerations are ignored for this exercise).
Using the future value of an annuity table, we find the factor for the future value of an
annuity for 40 years at 10 percent is 442.58. Dividing $1,000,000 by the factor 442.58
equals $2,259.48. Saving $2,259.41 over the course of each year for 40 years and investing
that money at 10 percent will yield a retirement fund of $1,000,000.
Using the present value of an annuity table is slightly more complicated because we must
cover two steps.
The present value of a $1,000,000 fund to be available in 40 years is, as we saw before,
$22,100. The present value of an annuity factor for 40 years at 10 percent is 9.779. We need
to work with the present value of the retirement fund to equate to the present value of the
annuity that will equal that fund. Dividing the $22,100 by 9.779 equals $2,259.94, equal to
the annuity computed using future value amounts.
169
2007, POME, Gautam_Koppala, All Rights Reserved
As is obvious from all this, the use of time value of money techniques, coupled with an
understanding of risk and return, enables an investor to decide whether an investment
opportunity is appropriate for him or her or not. These tools are extremely powerful and are
used for both personal and business investment decision making. As we will see in the next
POME Chapter, businesses use these same tools to judge capital investment opportunities.
At the present time interest rates are relatively low and the prospect of earning 10% per
year may seem unlikely. Although it is true that any bonds offering a 10% interest rate
would be quite risky, a significant number of mutual funds, funds that invest investor
deposits in a portfolio of corporate stocks, bonds, and other investments, have earned 10
percent or more for several years. Analysis of mutual fund investments through brokers or
through Morningstar.com or Lipper.com will identify a number of alternatives at different risk
levels.
Managing the time value of money has been part of our responsibility since we were very
young. In business it takes on even more importance as we manage money on behalf of
others: lenders, shareholders, and others in our Projects. The essence of time value of
money is that, “A dollar today is worth more than a dollar tomorrow.” However, the things
that affect this value are volatile and must be taken into account:
 Risk: the higher the risk, the higher the return must be.
 Specific Risks: default, inflation, maturity, liquidity.
 Required Return: the rate we must earn to satisfy the funding sources, a function not
only of financial risk, but also of alternative opportunities, Project Managerial philosophy,
and general economic conditions.
The Project Manager/ Finance Manager must take into account all of these factors when
looking at investment alternatives.
To solve this problem, you could also use the future value interest factor by dividing the
future value by the future value interest factor.
Part 1 Present Value
Future Value Term Interest Rate Factor Present Value
A $30,000 15 yrs. 10% .239 $7,170
B $13,000 7 yrs. 10% .513 $6,669
170
2007, POME, Gautam_Koppala, All Rights Reserved
C $20,000 10 yrs. 10% .386 $7,720
D $15,000 20 yrs. 10% .149 $2,235
To arrive at the correct answers, you need to divide the future value by the present value to
determine the future value interest factor.
Part 2
Present Future Interest Interest
Investment Value Value Term Rate Rate
Factor
A $8,000 $30,000 15 yrs. 3.750 Between 9% and 10%
B $8,000 $13,000 7 yrs. 1.625 Between 7% and 8%
C $8,000 $20,000 10 yrs. 2.500 Between 9% and 10%
D $8,000 $15,000 20 yrs. 1.875 Between 3% and 4%
To solve this problem you could also use the present value interest factor by dividing the
present value by the future value.
171
2007, POME, Gautam_Koppala, All Rights Reserved
MANAGING
LIABILITIES
172
2007, POME, Gautam_Koppala, All Rights Reserved
Managing Liabilities
The borrowing of money creates business liabilities.
POME Case Study:
Rethinking Liabilities
“Hi, Koppala. You said that we should analyze the Projects’ financial statements and bring
any of our concerns to this meeting. I’m concerned about the increase in liabilities. I know
that sales are growing and that we’ve had to invest a lot of money in a new building and new
equipment to keep up with the demand, but shouldn’t we be reducing our liabilities when
business is this good? If you can’t pay off your debts in the good times, what’s going to
happen when things get tight?”
“Chris, that’s an excellent question. I know a lot of people feel that way. They just don’t like
debt. Is there anyone else who shares Chris’s concern?”
Koppala notes several raised hands and then calls on one of the others.
“Chris, Projects can’t sustain the kind of growth we’re experiencing out of current income.
And think about your own finances. You’re incredibly disciplined—you’re one of the few
people I know who’s never carried a balance on your credit cards. Yet you financed your first
home with a mortgage. When you sold it last year, you really made a bundle. That was an
excellent investment, and you couldn’t have made it if you hadn’t financed the house.
“Increasing our liabilities in the Projects is like that in a lot of ways. As long as we’re
financing things that will bring in more revenue and profit over the long term, we’re better
off.”
173
2007, POME, Gautam_Koppala, All Rights Reserved
Sources of Finance
Long Term Finance Short Term Finance
(Project Finance) (Working Capital)
Sources of Long-term Finance
Share Capital
Long-term Debt
Equity Preference Bond /
Lease
Debenture
Domestic International Term Loans
GDR/ADR etc.
International Domestic
Rupee Foreign
Currency Euro Foreign
Retained New Issue (ECB) NCD
Bond Currency
Earnings Bond PCD
(Dividend
INTERNATIONAL
Policy) Public Issue Rights Issue FCD
FINANCE
174
2007, POME, Gautam_Koppala, All Rights Reserved
Sources of Short-term Finance
Working Capital Loan Commercial Paper
(Money Market)
Rupee Foreign
Currency
Working Capital Management
The Liabilities of the Business
Liabilities are the obligations of a business. They may be long-term or short-term. They
evolve from management actions, creating commitments to pay money to vendors,
employees, and others in return for goods or services or in compliance with laws and
obligations. The decision to purchase has a payment consequence that must be recognized
and managed by the operating responsibility. POME explores what short-term liabilities are,
how they are managed, and the impact on the Projects as a whole of the decisions the
Project Manager makes. We also cover long-term liabilities, primarily long-term debt,
recognizing the differences in risk and return related to these short- and long-term financing
choices.
We have already discussed the importance of debt as part of the funding for a business,
recognizing that the use of borrowed funds limits the amount of investment required of the
shareholders. We have examined the effect of debt on cost of capital and on the investment
decision-making process. To make this point one more time, consider an example of the
effects of financial leverage, the use of debt to increase revenues, profits, and return on
investment, shown in Exhibit below.
175
2007, POME, Gautam_Koppala, All Rights Reserved
Exhibit: The Effects of Leverage
Notice in Exhibit above how, as the relative levels of debt and equity making up the total
capital change, increasing the debt and decreasing the equity for a given level of
capitalization and operating profit, this results in an increase in the return to the
shareholders who remain. This consequence recognizes the increased risk undertaken by the
equity holders, whose investment is subordinated to the debt.
Short-Term Or Current Liabilities
The current liabilities section of the Balance Sheet shows all the obligations of the Projects
that are due within the next year. These obligations include accounts payable, notes payable,
taxes payable, accruals, and the current portion of long-term debt.
Accounts Payable
Accounts Payable, also known as trade payables, reflects obligations undertaken by the
Projects in the normal course of business. Vendors generally offer credit terms to qualifying
customers in order to entice them to do business. Because these credit terms are so
prevalent in industry today, it is rare for a Projects not to offer credit in business-to-business
relationships, and those that do not are often very limited in their opportunities to do
business. Vendors expect that their customers will pay their obligations according to the
terms established. However, some customers must be reminded to pay their bills. We
discussed the management of accounts receivable, the other side of accounts payable.
Bearing in mind that we have suggested in our discussion of cash management that we want
to hold our cash as long as we can, if we make sure our accounts receivable are paid on
time, we, in effect, manage our customers’ accounts payable, at least with respect to us.
176
2007, POME, Gautam_Koppala, All Rights Reserved
Only if our vendors are relaxed in their enforcement of credit can we manage our obligations
and use vendor funds to support our business. Nevertheless, because most vendors do not
charge interest for delinquent accounts, it may be advantageous to delay payment of our
payables if our cash is tight. In fact, today more and more companies are recognizing that
delaying the payment of accounts payable, “stretching” their payables, is an inexpensive way
to finance their business. The risk is that, if we are routinely delinquent in our payments, we
will become known as a slow pay customer and the availability of credit will be restricted.
The general rule for managing accounts payable is to “hold our cash as long as we can,
subject to never jeopardizing our credit rating.” Our credit rating is our ticket to borrowing
from our vendors. If our access is limited, whether in business or personally, it restricts our
flexibility and our opportunities. It also may necessitate additional bank borrowing, incurring
interest costs, which decrease profits, and make it harder to grow our Projects.
Our credit rating is also one of the criteria that our bank considers in assessing our
creditworthiness. If our credit rating is low, any loans we do get will carry higher interest
rates, further reducing our profits.
The use of accounts payable to grow our business, therefore, is a critical Project Managerial
decision. The choice of vendors, the items and quantities purchased, the terms we seek and
agree to, and the payment practices we follow all combine to describe our business
management. Too many companies operate without understanding the interrelationships
among these elements and end up buying more than they need, buying items that are not
needed, managing the credit they have poorly, and sacrificing profits, growth, and overall
business success simply because they did not understand how important and how
interrelated these decisions really are.
Notes Payable
The Notes Payable account generally reflects interest-bearing short-term funds, usually
borrowed from banks either as a one-time loan or as a revolving line of credit. The choice is
often made without understanding the difference, resulting in a use of credit that does not
fully meet the Project’s needs.
A one-time loan, the borrowing of a specific amount of money for a specific, limited period of
time, makes sense when the need is just that, a specific amount of money required for a
specific purpose with a specific termination when the money can be paid back. Unfortunately,
many companies agree to a limited loan when what they need is the flexibility of a revolving
177
2007, POME, Gautam_Koppala, All Rights Reserved
line of credit that fluctuates with cash flows but is available to extend the capabilities of the
Projects as the business grows.
Taxes Payable
As part of our economic system, many of our activities generate obligations to pay taxes to
the various levels of government. When we recognize these obligations, we record them as
tax expenses and as taxes payable. We pay property taxes on the land and buildings we
occupy as well as on the value of other fixed assets and inventory that we own. Sometimes,
these taxes are paid to municipal governments to provide funding for the local services we
utilize; sometimes, they are paid, as excise taxes or income taxes, to state governments for
statewide services; and sometimes, they are paid, as income taxes, to the federal
government.
The obligation to pay taxes is mandated by law and we cannot choose whether or not to pay.
However, we are only obligated to pay the minimum amount of tax the law stipulates.
Therefore, many companies expend a great deal of effort seeking to lower the taxes they
must pay, in some cases by improperly accounting for expenses. The consequence of that
type of action is to mislead anyone who reviews the Projects’ financial statements and seeks
to establish value or understanding of the operations of the Projects. Not only do companies
that “cook their books” to evade taxes face many consequences in the courts and in the
investment market, they no longer have good information to serve as a basis for decision
making. They become less able to manage their business. We look at such actions more
closely.
Many people hold the philosophy that paying taxes diminishes our income. However, since
we are obligated to pay these taxes, another way to look at them is to recognize that, under
our current system, for every dollar we pay in taxes, we keep between one and one-half and
two or more dollars after taxes. Therefore, to maximize the wealth of the shareholders, we
should manage the business to be strongly profitable and we should pay in taxes the
minimum necessary in accordance with managing the business in that profitable manner. To
summarize, evasion of taxes is against the law, but avoidance of taxes, that is minimizing
that which we owe, is sound business practice and should be followed to the extent that
minimizing our taxes really increases the reward to the shareholders. Some taxpayers incur
excessive expenses avoiding taxes, resulting in a reduced return to the investors.
We should never undertake any action solely to reduce our taxes. Under our current system,
to avoid one dollar in taxes means we must spend at least two-and-a half dollars. Given the
178
2007, POME, Gautam_Koppala, All Rights Reserved
importance of cash in a business, any decision to spend merely to reduce taxes needs to be
examined very carefully.
Accruals
There are two methods of accounting, cash and accrual. In cash accounting, transactions are
only recorded when cash actually moves. There are no accounts receivable or payable and
revenue is recognized only when the sale is paid for. In accrual accounting every effort is
made to record activity in the period in which it occurs. Sometimes, in order to do that, it is
necessary to record transactions that relate to the period, even though they are determined
after the period is over and were not really obligations until the period was over. Accruals,
which is what accounting for these transactions is called, are predominantly accrued payroll,
accrued taxes, and accrued expenses.
Accrued payroll occurs when the payroll due date falls into the next period, or more likely,
year. For example, a Projects pays its employees on Friday for the period that ended on the
previous Sunday. In 2004, July 1 was a Thursday. For a Projects with a June 30 year-end,
the last payroll paid during the fiscal year was paid on June 25, probably for the period that
ended on June 20. The payroll for the last 10 days of June, not payable until July 2 and July
9, needs to be accrued in order for the Projects to match the expenses and the revenues
through June 30. Similarly with taxes—both payroll taxes, and more particularly income
taxes—the tax obligation cannot be calculated until all the other accounting has been
completed. The taxes that would have been owed as of June 30, but which are not due until
September 15, will be accrued as of June 30. A final calculation and adjustment of the tax
expense occurs later.
Accrued expenses are similar, but because accounting for business activity cannot wait until
all the bills relating to the prior period have been received and entered, after a few days the
accounting department records those bills relating to the prior period as a journal entry to
bring the expenses back into the proper period. Because in most companies the amounts
accrued are not significantly different from one month to the next, accruals are really only
important at the end of the year. At that time, accruals are computed carefully and journal
entries are made that are only reversed at the end of the next fiscal year, when the new
year-end accruals are prepared. The reversing process makes it possible to record only the
expenses appropriate for the period in the last accounting period of the year.
Long-Term Debt
179
2007, POME, Gautam_Koppala, All Rights Reserved
Long-term debt, usually bank debt, reflects money borrowed for longer than one year. In
some cases when a Projects borrows long-term money, a portion is due to be repaid each
year. The amount due within twelve months is recorded and reported as a current liability,
Long-Term Debt Due within One Year or Current Portion of Long-Term Debt, while the
remainder of the obligation is reported as Long-Term Debt below the current liabilities on the
Balance Sheet.
All debt, whether funded by a bank or not, is loaned based on the credit worthiness of the
borrower, as assessed by the lender. Though all lenders and vendors go through different
credit assessment procedures, all attempt to determine how likely it is that the borrower will
be able to pay for the loan. The extension of credit as part of the sales process is as much a
loan as is a formal note presented to a bank. In the following pages we examine the criteria
for credit, considering the kinds of concerns that a lender evaluates. Although we use a bank
as an example, trade credit and borrowing from a bank are very similar. As an assessment,
we also look at how a bank determines its interest rate so that when you negotiate for a
loan, you will understand the issues as well as the lender does.
When you establish a borrowing relationship with a bank, it is wise to initiate the process
long before you need the money, so that you can choose your bank as well as your banker,
the form of funds as well as the source. Many businesspeople do not realize that they do not
have to accept the “banker of the day.” If you begin the borrowing process when the need is
imminent, your negotiating power and your options are severely limited. There is real truth
to the old saying, “The best time to borrow money is when you don’t need it.” Being well
prepared gives the borrower the most power.
Similarly, when seeking leasing funds or equity capital, do not settle for the first choice to
present itself. Rather, shop around for compatibility as well as price. To settle for less than
the most appropriate available resource is to open the Projects up to relationship problems
that only aggravate the other challenges facing businesses today. The Internet today
significantly increases the options available.
Larger companies, needing larger amounts of long-term financing, often turn to the bond
market to fulfill their needs. The market for corporate bonds is enormous, with funding
available from individual investors, bond mutual funds, retirement funds, and large corporate
investors such as insurance companies and institutions with investable endowments.
Corporate bonds, often issued through investment bankers in a manner similar to common
180
2007, POME, Gautam_Koppala, All Rights Reserved
stocks, require careful planning and management, in part because there is often not a single
lender with whom to negotiate should the need arise.
As with everything else, the more control businesspeople maintain, the more likely they are
to be successful. If they delay application until the last moment, all of the negotiating power
and all of the options rest with the banker. The borrower becomes a supplicant rather than
an applicant.
Access to Credit
In today’s marketplace it is far easier to gain access to credit than it was a generation ago
and earlier. Today the use of credit is widespread and bankers and other lenders understand
that to make money they have to make money available. As a result, it is easy to get credit,
and it is easy to get the wrong kind of credit from the wrong source. In the following sections
we discuss several important aspects of managing a Projects’ access to credit. The intent is
to ensure that the borrower understands the same things that the lender understands.
Borrowing money should be undertaken positively and proactively, with a clear
understanding of how the lending decision, as well as the borrowing decision, is made.
Choosing a Bank Lending Officer
As part of making the borrowing process a carefully considered business decision, the
borrower should try to maintain control of the process. If your needs are, or are likely to be,
reasonably significant, it is desirable to seek out a high-ranking officer to be your primary
contact. This individual will be your representative throughout the approval process. In
today’s banking environment, it is unlikely that the loan officer who works directly with the
borrower will have the authority to approve a large loan. Similarly, investment decisions
generally require several reviews and approvals. Other officers will approve the funding, or a
loan or investment committee will judge the application. The higher your lending officer’s
rank, the less complicated and time consuming the approval process will be, providing the
officer endorses and advocates the application.
THE “C’S” OF CREDIT
Because there are so many words beginning with “C” that apply to the credit process, every
discussion of credit includes a presentation of the “C’s” of credit. Identification of these terms
provides an easy way to remember the issues and criteria involved in a credit decision. The
181
2007, POME, Gautam_Koppala, All Rights Reserved
following list includes the traditional “C” words, as well as some that are less frequently used.
The key terms are:
 character
 capacity
 capital
 cash flow
 collateral
 conditions
 competition
 credibility
 competence
 communications
 covenants
 coverage
Not all of these terms are relevant to all credit situations, and not all of those utilized have
the same level of importance in all circumstances. However, borrowers and lenders should
address each of these issues when considering any arrangement. The resulting evaluation
will be thorough and surprises will generally be avoided.
Authors of programs, articles, and credit management textbooks focus on some of these
differentiable criteria. However, all these elements come into play either directly or indirectly.
It is important to recognize that lenders consider a broad range of assessment and
evaluation bases when reviewing a loan application. In the following discussion of these
criteria, the focus is on borrowing and lending; they are, however, equally applicable to
soliciting and investing. The standards are no less stringent in an investment situation.
Character
The assessment of character is the evaluation of the borrower’s predisposition to repay an
obligation. It is an attempt to measure integrity, the commitment to repay that motivates the
borrower even if a problem arises. Character involves the borrower’s reputation in business
and personal dealings. It recognizes the borrower’s personal attributes, including historic
behavior.
Included in the character assessment are considerations of:
 Business reputation: The reliability of one’s word, measured through references,
credit history, and reputation.
182
2007, POME, Gautam_Koppala, All Rights Reserved
 Management experience: What the borrower has done in the past and how well it
has been done. The age of the borrower or the organization and the extent of the time
reflected in the experience are included in this part of the evaluation, recognizing that
past achievements may be a predictor of future accomplishments. Although a previous
failure is not necessarily a knockout, it will raise major concerns in the mind of a lender.
 Risk orientation: An assessment of the attitude that the borrower has toward
financial resources. Conservatism is valued in this consideration.
Today a high character rating is essential if you want to get a loan approved. In times past
character was often considered necessary and sufficient to permit the approval of a loan. If
the lender knew the borrower personally and had high regard for the borrower’s character,
the loan was approved, based on the borrower’s word. Now, the character assessment is
necessary, but it is not sufficient. Without a satisfactory character assessment, a loan will
generally not be approved, but other criteria must also be met.
Early in 1993, US President Clinton suggested that lenders should increase the level of
“character lending” as part of the effort to improve the national economy. Although this
suggestion received extensive media coverage, there has been no indication that lenders
plan to change their evaluation process. In light of the recent credit problems and regulatory
scrutiny, lenders will continue to require that borrowers satisfy many other evaluative
criteria. One change, however, was the establishment of the “low doc” and MicroLoan
programs under the auspices of the Small Business Administration (SBA). These programs,
which involve modest-sized business loans acquired through banks but partially guaranteed
by the SBA, require far less paperwork and impose fewer restrictions than do conventional
bank loans.
Even though many other criteria are involved, the character assessment is the most
important evaluation of all. In every case, the character of the borrower will be considered
and only those applicants who satisfy the character criterion will be given further
consideration.
Capacity
Capacity measures the ability of the borrower to utilize the amount of credit sought. This
measure is important because funds committed by a bank to one borrower cannot be
committed to another, even if the first has not utilized them. The lender, therefore, wants to
make sure that funds committed have some likelihood of being used, providing interest
income to the lender.
183
2007, POME, Gautam_Koppala, All Rights Reserved
Another aspect of the assessment of capacity is the evaluation of the borrower’s ability to
use the credit effectively. If the funds cannot be used effectively, there is a much greater risk
that the loan will not be repaid. Funds that are used—or are “available”—for nonproductive
purposes, will not generate a return. Numerous instances of this type of bad loan were
publicized at the height of the banking crisis in the early 1990s. Time after time lenders did
not assess the capacity of a borrower to utilize the credit sought or offered for a business
application.
Often the Projects’ financial statements, particularly if confirmed either through audit or
review, provide the evidence of capacity that a lender requires. Most bankers identify
financial statements as the most important information a borrower provides.
In a similar vein, capacity assesses the business’s ability to utilize an equity investment
effectively and to generate an appropriate return on the investment. Very often, a business
will seek too much or too little funding, resulting in an unsuccessful financing arrangement.
Capital
Capital is a consideration that refers to the level of owners’ equity in the business. The
lender is attempting to assess the level of owner commitment to the borrower organization.
If the bank is going to be the primary source of funds for a business, the loan should be
conservative, or the bank may deny the loan request.
If there is a substantial amount of equity (net worth) in the business, it indicates that there
will be value in the assets to protect the bank even if the assets are not specifically identified
as collateral for the loan. Remember that in liquidation debt is paid off before the
shareholders receive any payments. Therefore, the level of equity provides security for the
lender.
In the case where the loan is sought to provide funds for an acquisition or for some purpose
other than the direct support of operations, the bank may insist on additional equity to
preserve the existing debt/equity ratio. Bankers have expressed this requirement as, “If this
investment is such a good idea, why are you asking me to take all the risk?”
The assessment of a borrower’s capital is not so much a measure of creditworthiness as it is
a measure of lender protection. It has become more important in last few years as the banks
have experienced a widespread banking crisis.
184
2007, POME, Gautam_Koppala, All Rights Reserved
Capital is often evaluated through ratio analysis. Bankers benchmark leverage and liquidity
ratios such as debt/equity, current ratio, and inventory and receivables turnover.
Cash Flow
Cash flow is generally defined as the net income of the business plus any noncash expenses
such as depreciation, depletion, amortization, and extraordinary additions to reserves.
The estimate of future cash flows helps the bank assess the borrower’s ability to service the
debt being evaluated. The issues relate first to meeting the interest requirements and then to
the repayment schedule. If the Projects’s cash flow projections do not indicate comfort in
covering these requirements, banks will not make the loan.
Banks evaluate financial statements even when both the lender and the borrower know that
the projected growth of the business will consume all of the cash generated. Cash flow
analysis assesses the Projects’s ability to return the funds to the lender. Because of this
requirement, companies often make unrealistic projections of working capital or
underestimate the need for supporting assets. Otherwise, it requires assumptions such as
funding all incremental fixed assets with externally generated funds.
In some cases this last assumption suggests that the Projects will have to return to the bank
for more funds for asset acquisition. This criterion may be satisfactorily addressed within a
strategic plan that identifies an exit strategy— a plan to bring substantial new equity into the
business some years later. This topic is discussed in greater depth later.
Again, bankers benchmark using cash flow ratios such as cash flow adequacy, operating cash
index, mandatory cash flow index, and debt coverage.
Collateral
Collateral is an asset or a group of assets pledged to secure debt. The security assures the
lender that, in the event of failure to make contractual payments on the debt (default), the
lender may take possession or control of the asset(s) and dispose of them to recover the
value of the loan.
To be good collateral, the assets must have recognized value in the market. During the early
1990s, the markets for many assets used for collateral, notably real estate and machinery,
declined in value, resulting in an under-protected position for many banks. The subsequent
foreclosures (claiming the assets for the lenders) put a number of companies out of business
185
2007, POME, Gautam_Koppala, All Rights Reserved
and further depressed the markets. This, in turn, created wider losses for the lenders and
exaggerated the economic recession.
Good collateral is never a substitute for a bad loan. In the 1990s many bankers learned this
lesson the hard way. Collateral that they thought would provide more than adequate value
should the borrower not meet the loan obligation was not marketable at a sufficient price or
at all. This was particularly true of real estate in the Northeast and California, and to a lesser
extent, in other parts of the country. Similarly, equipment collateral lost much of its value as
the used machinery markets softened. Even though collateral is often required, a well-trained
banker will never make a loan based principally on the perceived value of collateral.
Conditions
The strength of the economy and of the specific industry of the borrower also influences the
availability of credit. In a weak economic period credit is harder to obtain because lenders
are concerned that the business will be adversely affected and the loan will be jeopardized.
Similarly, if the borrower’s industry is suffering, the borrower will have a harder time, even if
the Projects is actually doing well. And the reverse is true, too. A strong economy and a
strong industry ease the availability of credit. It is said that “a rising tide lifts all boats.”
A banker recently noted that “conditions” has, for his bank, become an overriding criterion
If the economic conditions of the industry and the general marketplace are not positive,
credit will not be offered. This particular bank, which is an aggressive small business lender,
has become very sensitive to the tenor of the marketplace and the overall economy as
indicators of loan success.
Competition
As included in credit criteria, competition can be viewed in two different ways. The
competition may be related to the lender or to the borrower.
The lender’s competitors have an influence on the availability of loan funds from the chosen
lender. If one competitor is lending aggressively to increase market share, the other lenders
in the same market will become more aggressive, and funds will be more readily available,
even for marginal loans. Conversely, if previously aggressive competitors tighten up or
encounter difficulties, the entire lending community will limit the availability of credit.
When considered in relation to the borrower, the evaluation of competition takes into account
the borrower’s position in the market and its ability to compete with others in the same
186
2007, POME, Gautam_Koppala, All Rights Reserved
market. For example, a Projects seeking funds may have a good application from every
consideration, but if it is seeking to compete with very strong and aggressive market players,
the amount of credit extended may be restricted or controlled more tightly than if the
competition is weaker, less well organized, or fragmented.
Credibility
Credibility is not one of the “C” words normally presented, but the credibility of the
borrower is becoming more and more a critical part of the assessment. Credibility is in many
ways an extension of the character criterion that is always listed first in the “C’s” of credit.
Because borrowers often have only limited financial and operational history, the borrower’s
credibility is measured in the context of the professionals and others associated with the
credit applicant. With the fluidity of banking relationships more the norm than the exception,
lenders are finding it necessary to rely on the information provided or confirmed by others.
Credit references are very important, but references are not particularly indicative of
creditworthiness. Even in those instances where a Project is virtually insolvent, it is likely
that there are three or four vendors with whom the Projects has maintained a good payment
record.
These are the credit references the Projects provides. The information garnered from these
references will be positive and, in the absence of any conflicting reports, would indicate that
the potential borrower is a good risk. If all of the references are small and local, their value
as corroborators of Projects-provided information may be limited. On the other hand, if the
references are larger firms or are national in scope, these references may be more useful.
Similarly, financial information provided by the applicant that includes financial statements
audited by a CPA carries more weight than statements without such confirmation. The
reputation of the CPA reflects positively on the applicant, particularly if the CPA firm is well
known and well respected by the lender. In some instances an unqualified (that is without
qualifications) audit opinion by a highly regarded local firm will be much more valuable in
establishing the credibility and the creditworthiness of the applicant than will a similar audit
opinion by a much larger regional, national, or even “Big Four” firm. On more than one
occasion, bankers have gone on record as preferring a local firm’s evaluation. Similarly most
lenders have stated that they would like to meet with the Project’s accountants or attorneys
as well as the borrower when making a loan to a Projects as a means of gauging the quality
of the applicant.
187
2007, POME, Gautam_Koppala, All Rights Reserved
Another way that the credibility and therefore the creditworthiness of an applicant are
evaluated is through one of several credit rating organizations such as Dun and Bradstreet,
Fitch, Moody’s, and Equifax. These agencies gather credit experience information relative to
many companies from many of the vendors in the marketplace. They also gather financial
statements, legal filings, and other information, all of which they report to subscribers and
use to establish credit ratings on companies. Many vendors rely on these ratings when
making their own credit decisions.
Competence
Lenders have defined competence as a credit criterion as the Project Managerial ability of
the people who own and run the business. Very often, the founders of entrepreneurial
enterprises start their businesses because they have a good idea, a solution for a real
business problem, or a better way to achieve some technological objective. However, they do
not have substantial Project Managerial experience and are not equipped to direct their
business successfully as it moves beyond the very basic levels. The provider of funds wants
to be sure that the additional resources that he or she is being asked to provide will be
managed properly and the additional business size and strength that the money will enable
will be handled effectively. Assessing Project Managerial competence is an effort to assess
this likelihood. Many companies grow much faster than their management can handle, but
the entrepreneurs often do not recognize this or are unwilling to relinquish management
control to an outsider, fearing they will simply not “understand” the business to the extent
necessary. Frequently, even if they do recognize and acknowledge the need, they do not
have the hiring and selection skills to choose the proper Project Manager to handle the task.
This is the competence measure.
A mezzanine lender, usually a nonbank lender that provides medium-term (5–7 years)
loans to help a borrowing Projects that is transitioning from small to large and from
traditional bank loans to bonds or major financing arrangements, included the following
paragraph in its announcement brochure:[*] The single most important factor in our
investment decision is the quality of the people who makbe up a Projects’s management
team. We expect them to have both the requisite technical expertise for their industry as well
as the broad Project Managerial skills required to grow the Projects.
Communications
The same lender also added communications to the list of criteria. He noted that a
customer who has established a relationship with the bank before seeking funds and who has
188
2007, POME, Gautam_Koppala, All Rights Reserved
a reputation for keeping the bank informed is a much more attractive borrower than
someone who only comes to the bank when funds are needed. The extension of this is that
an application will be more successful if it includes the structure and frequency of
communications, whether it involves reviews, submission of financial reports, periodic
updates on the business situation, or other opportunities for the lender or investor to see and
understand what is happening. There is a general fear of the unknown, and if what is being
done with the money is unknown, the fear on the part of the provider is substantial.
Covenants
Covenants are less a credit criterion than an effort by the lender to be sure that credit, once
received, will be managed properly, protecting the interests of the lender. Covenants are
requirements that borrowers must meet in order to keep the loan. They include positive
covenants that define measures the Projects will achieve, such as maintaining a current ratio
of 2:1 or achieving profits in at least two or three quarters every year. They are positive
performance statements: “The Projects will . . .”
Another class of covenants is the negative covenants, limiting payment or other actions by
the Projects that might impair its ability to pay the bank on time or at all. These covenants
may limit the owner or Project Manager’s compensation or the investment in fixed assets
without the bank’s explicit approval. They are often phrased: “The Projects will not . . .”
The last class of covenants is neither positive nor negative, but it requires the Projects to
issue timely borrowing certificates that define collateral assets and financial position, to
produce periodic financial statements, to earn an unqualified audit opinion or review by their
independent accountants, and to pay all taxes on time.
Coverage
The credit criterion coverage requires the Projects to maintain certain financial statistics
such as Times Interest Earned or Fixed Charge Coverage ratios that assure that operating
earnings or assets are sufficient to meet credit-related obligations. Coverage ratios help the
bank measure the level of protection the Projects maintains.
POME Prescribe
189
2007, POME, Gautam_Koppala, All Rights Reserved
V
Visualize it!
POME Prescribe
190
2007, POME, Gautam_Koppala, All Rights Reserved
BANKING
INDUSTRY
191
2007, POME, Gautam_Koppala, All Rights Reserved
Banking Industry for Bank Guarantees:
Definition of a Bank:
The definition of a bank varies from country to country.
Under English law, a bank is defined as a person who carries on the business of
banking, which is specified as:
• conducting current accounts for customers
• paying cheques drawn on a given person, and
• collecting cheques for their customers.
Examples of statutory definitions:
• "banking business" means the business of receiving money on current or deposit
account, paying and collecting cheques drawn by or paid in by customers, the making
of advances to customers, and includes such other business as the Authority may
prescribe for the purposes of this Act; (Banking Act (Singapore), Section 2,
Interpretation).
• "banking business" means the business of either or both of the following:
1. receiving from the general public money on current, deposit, savings or other similar
account repayable on demand or within less than [3 months] ... or with a period of
call or notice of less than that period;
2. paying or collecting cheques drawn by or paid in by customers[2]
Since the advent of EFTPOS (Electronic Funds Transfer at Point Of Sale), direct
credit, direct debit and internet banking, the cheque has lost its primacy in
most banking systems as a payment instrument. This has lead legal theorists to
suggest that the cheque based definition should be broadened to include
financial institutions that conduct current accounts for customers and enable
customers to pay and be paid by third parties, even if they do not pay and
collect cheques.
Wider commercial role
However the commercial role of banks in Projects is wider than banking, and
includes:
192
2007, POME, Gautam_Koppala, All Rights Reserved
• issue of banknotes (promissory notes issued by a banker and payable to bearer on
demand)
• processing of payments by way of telegraphic transfer, EFTPOS, internet banking or
other means
• issuing bank drafts and bank cheques
• accepting money on term deposit
• lending money by way of overdraft, installment loan or otherwise
• providing documentary and standby letters of credit, guarantees, performance bonds,
securities underwriting commitments and other forms of off balance sheet exposures
• safekeeping of documents and other items in safe deposit boxes
• currency exchange
• sale, distribution or brokerage, with or without advice, of insurance, unit trusts and
similar financial products as a 'financial supermarket'
Law of banking
Banking law is based on a contractual analysis of the relationship between the
bank and the customer. The definition of bank is given above, and the
definition of customer is any person for whom the bank agrees to conduct an
account.
The law implies rights and obligations into this relationship as follows:
1. The bank account balance is the financial position between the bank and the
customer, when the account is in credit, the bank owes the balance to the customer,
when the account is overdrawn, the customer owes the balance to the bank.
2. The bank engages to pay the customer's cheques up to the amount standing to the
credit of the customer's account, plus any agreed overdraft limit.
3. The bank may not pay from the customer's account without a mandate from the
customer, e.g. a cheque drawn by the customer.
4. The bank engages to promptly collect the cheques deposited to the customer's
account as the customer's agent, and to credit the proceeds to the customer's
account.
5. The bank has a right to combine the customer's accounts, since each account is just
an aspect of the same credit relationship.
6. The bank has a lien on cheques deposited to the customer's account, to the extent
that the customer is indebted to the bank.
193
2007, POME, Gautam_Koppala, All Rights Reserved
7. The bank must not disclose the details of the transactions going through the
customer's account unless the customer consents, there is a public duty to disclose,
the bank's interests require it, or under compulsion of law.
8. The bank must not close a customer's account without reasonable notice to the
customer, because cheques are outstanding in the ordinary course of business for
several days.
These implied contractual terms may be modified by express agreement
between the customer and the bank. The statutes and regulations in force in
the jurisdiction may also modify the above terms and/or create new rights,
obligations or limitations relevant to the bank-customer relationship.
Types of investment banks
• Investment banks "underwrite" (guarantee the sale of) stock and bond issues for
the Projects, trade for their own accounts, make markets, and advise corporations on
capital markets activities such as mergers and acquisitions.
• Merchant banks were traditionally banks which engaged in trade financing. The
modern definition, however, refers to banks which provide capital to firms in the form
of shares rather than loans..
Both Combined:
• Universal banks, more commonly known as a financial services company, engage in
several of these activities. For example, First Bank (a very large bank) is involved in
commercial and retail lending, and its subsidiaries in tax-havens offer offshore
banking services to customers in other countries. Other large financial institutions are
similarly diversified and engage in multiple activities. In Europe and Asia, big banks
are very diversified groups that, among other services, also distribute insurance,
hence the term bancassurance is the term used to describe the sale of insurance
products in a bank. The word is a combination of "banque or bank" and "assurance"
signifying that both banking and insurance are provided by the same corporate entity.
Bank Guarantees:
To ensure the correct process is followed for Bank Guarantees and to define the Inputs,
responsibilities and information flow for Bank Guarantees
194
2007, POME, Gautam_Koppala, All Rights Reserved
Step Who Details
#
Expected
turnaround time
for a standard
Bank Guarantee
is 5-10 business
days, based
upon the
business.
Expected
Note 1 turnaround for
a non-standard
Bank Guarantee
is more than 5-
10 days as long
as pre-approval
(as in Step 2
below) is
provided with
the request.
1 Bank
Guarantees can
be utilised, but
not limited to
the following:
• Means of securing
payment upfront
• In Lieu of retention of
monies
195
2007, POME, Gautam_Koppala, All Rights Reserved
• Customers security
for system
functionality as setout
in the
Contract/Order/Functi
onal Specification
2 Requestor Complete the request using
the Company Bank
Guarantee form.
Once the guarantee is
completed, the requestor
prints a copy of the request,
attaches the appropriate
paperwork, being:
• a copy of the
contract; or
• a copy of the relevant
pages of the contract
in relation to the
guarantee
requirements, and
forwards to the Bank
Guarantee
administrator.
For non
standard
guarantees (eg.
evergreen or
non standard
wording), you
196
2007, POME, Gautam_Koppala, All Rights Reserved
will need to
provide
evidence of the
pre approval by
legal and
treasury that
was obtained in
the contract
negotiation
process.
3 Regional The Bank Guarantee system
Finance Lead will seek approval from the
Approval appropriate Finance
Management, They:
• Check and verify that
Bank Guarantee is
complete and
consistent with
company policy;
• Seek further
classification where
necessary, then it is
forwarded to Treasury
for final approval.
4 Treasury Treasury gives final
Approval approvals for all bank
guarantees. Instruction is
then provided to the Bank
Guarantee administrator to
obtain the bank guarantee
from the bank.
197
2007, POME, Gautam_Koppala, All Rights Reserved
5 Bank Matches request with hard
Guarantee copy supporting material
Administrator sent in step 2. Liaises with
the bank to have the
guarantee drawn. Also
ensures correct records are
kept to adhere to internal
Company record keeping
requirements.
6 Bank Receives bank guarantee
Guarantee from bank. Enters unique
Administrator identification code into the
system for billing purposes
and releases out of the
system. Provides the
requestor with the bank
guarantee and keeps copy
with supporting paperwork.
7 Requestor Provides bank guarantee to
customer and ensures that a
copy is kept on the job file.
Ensures that each bank
guarantee is closed out
correctly as follows:
• Standard Guarantees
8 Requestor that expires as per
nominated expiry date
– nothing to be done
by the requestor.
• Standard Guarantees
that expire before the
198
2007, POME, Gautam_Koppala, All Rights Reserved
nominated expiry date
– obtains the original
from the customer
and provides to the
Bank Guarantee
administrator to close
out in our system and
with the bank. If the
original has been
misplaced, a letter
from the customer on
letterhead is required
to close this out. This
will ensure that fees
do not continue to be
charged to the job.
Evergreen – obtains the
original from the customer
and provides to the Bank
Guarantee administrator to
close out in our system and
with the bank. If the original
has been misplaced, a letter
from the customer on
letterhead is required to
close this out. If the
guarantee is not closed out in
this way, fees will continue to
be charged to the job.
9 Bank Manages the return of the
Guarantee Bank Guarantee in line with
Administrator Company Policy and also
manages internal record
199
2007, POME, Gautam_Koppala, All Rights Reserved
keeping processes including
closing out in the system.
TERMS THAT YOU MUST KNOW FOR THE BANKING LIASON TO PROJECTS SECTOR
Account party:
The party which addresses the bank for the issue of a letter of credit , e.g. the account party
can be an importer, a buyer, a construction contractor or a supplier bidding on a contract.
Interbank Offered Rate (IBOR):
200
2007, POME, Gautam_Koppala, All Rights Reserved
Also known as the interbank rate, this is the interest rate applied on short term loans
between banks and which serves as a reference rate for other types of loans, including buyer
credit or supplier credit. The interest rate terms are calculated daily and determined
according to the length of and currency of the loan. A number of financial centres offer an
IBOR, including London (LIBOR), Paris (PIBOR), Singapore (SIBOR), Zurich (ZIBOR), etc. The
US Federal Funds Rate is also an example of an interbank rate.
Guarantee credit:
A bank credit not involving the actual provision of funds by the bank, but rather the bank’s
assumption of liabilities or obligations on behalf of its customers, e.g. bill guarantee,
acceptance or surety credit.
Interbank market:
A market where banks borrow and lend to each other, usually for very short-term periods.
Interbank transactions:
Foreign exchange or lending transactions between banks as opposed to transactions between
banks and non-bank clients.
Interest arbitrage:
A type of arbitrage consisting of investment in interest-bearing instruments in different
currencies, with the aim of earning a profit by taking advantage of existing or expected
interest rate and exchange rate differentials.
Interest charge:
Interested charged i.e. negative interest.
Interest during construction (IDC), Pre-commissioning interest:
Interest on loans accruing during the performance of the supply contract, which are in
general capitalized and added to the principal amount outstanding
Interest make-up agreement (IMU):
An arrangement involving an export credit agency or an EXIMBANK whereby these make
possible the granting of a concessional fixed rate loan to support exporters.
Interest rate:
201
2007, POME, Gautam_Koppala, All Rights Reserved
(1) The rate at which interest is due on any obligation, or is paid on interest bearing assets.
Export & Import Finance
• Export Credit:
- EPC & Bill Negotiation
- PCFC & FBD
• Import Credit:
- Buyer’s Credit
- Supplier’s Credit
• Quasi Credit Facilities:
- LC, Bank Guarantee
Types of LCs, ICC & UCPDC,
Types of Bank Guarantees; Deferred Payment Guarantee
Interest Rate Coverage:
Coverage against adverse fluctuations in interest rates
Interest rate differential:
The spread between two different facilities or between spot and forward rates. (An indicator
of future changes in the spot exchange rate).
Interest Rate Equalization: Subsidization :Make-up.
A service offered by Export Credit Agencies or EXIMBANKS providing commercial banks with
the difference between the subsidized rate payable on the bank’s ECA supported loan and the
bank’s market cost of funds, plus an agreed interest spread.
Intermediation:
An activity performed by banks and other financial institutions, aimed at matching the
financial needs of certain companies with the financial surpluses of other companies. Banks
can purchase direct claims from deficit units, while issuing secondary claims to depositors.
Opposite: disintermediation.
202
2007, POME, Gautam_Koppala, All Rights Reserved
Intermediate consignee:
The bank, forwarding agent or other intermediary, acting as agent in the foreign country on
behalf of the exporter, purchaser or ultimate consignee, charged with the delivery of the
exported merchandise to the ultimate consignee.
Investment bank: Merchant banks.
A financial intermediary specialised in offering a variety of services, such as acting as a
broker in share and bond deals, underwriting new security issues, facilitating mergers and
other corporate reorganizations, providing long-term loans and/or equity capital, etc., rather
than in lending out its own funds. More specifically, the term refers to US banks like Merrill
Lynch, Goldman Sachs and Salomon Brothers which underwrite and deal in securities and do
not take deposits directly from the public.
Investment Fund:
A holding company usually managed by an investment banker which collects savings from
investors to be used to acquire participation in agreed sectors and countries.
Investment paper:
Securities which are particularly suitable for long term investments.
Investment risk guarantee:
A guarantee scheme, usually government-operated, covering part of the risks connected with
investments abroad.
Invisibles/Invisible trade:
Non-merchandise trade, including transport services (freight, shipping, etc.), most types of
services (banking, insurance, tourism etc.) and investment.
Issuing bank:
A bank which opens a letter of credit, thereby assuming the obligation to pay the beneficiary
or the correspondent bank if the documents presented are in accordance with the terms of
the letters of credit.
Advising bank:
203
2007, POME, Gautam_Koppala, All Rights Reserved
Also known as the notifying bank. This is the bank operating in the exporter's country which
handles letter of credit on behalf of the foreign bank, by notifying the exporter that the credit
has been opened in his favour and informing him of the terms and conditions of the letter of
credit. It does not necessarily have responsibility for payment.
Term loan:
A business loan with a final maturity of more than one year, payable according to a specified
schedule.
Tied aid credit:
This refers to the practice of providing a grant and/or a concessional loan, either alone or
combined with an export credit, which is linked to an export sale from the donor country.
Tied loan:
A loan made by a government agency whereby the foreign borrower is required to spend the
related financial resources in the lender's country.
Authorized bank:
A bank allowed by a country’s public authorities to process the decentralized payment
transfers.
Aval:
A form of guarantee, generally given by a commercial bank, on a negotiable instrument. An
aval is usually an unconditional guarantee of payment and is not affected by the terms of the
underlying transaction. Avals are recognized only in certain countries (mainly European),
though usually not in countries with an Anglo-Saxon legal base.
Bank(er's) Acceptance; Bank bill:
A draft or bill of exchange whose acceptor is a bank.
Bank commission:
A bank charge for special services (credit commission) or for risk coverage, added to the
interest on loans extended to its clients.
Bank discount rate:
204
2007, POME, Gautam_Koppala, All Rights Reserved
The rate at which a bank discounts notes. A rate quoted on a discount basis understates
bond equivalent yield. This difference must be calculated when comparing the return on
yields on a discount basis and equivalent coupon securities.
Bank draft:
An international transfer of funds through an instrument very similar to a cheque.
Bank for International Settlements (BIS):
An international bank based in Basel, Switzerland, serving as a forum for monetary co-
operation between several European central banks, the Bank of Japan and the U.S. Federal
Reserve System.
Bank guarantee:
A guarantee, issued by the bank of the foreign purchaser, to pay the seller/exporter up to an
agreed percentage of the value of the goods shipped in case of default by the purchaser.
Bank-issued medium-term note:
A medium-term certificate of indebtedness, issued by a bank on demand, with maturities
ranging between 2 to 8 years.
Bank release:
A negotiable time draft drawn on and accepted by a bank, which adds its credit and standing
to that of the importer.
Banker's Bank:
A bank established by consent by independent and unaffiliated banks as a clearing house for
financial transactions.
Banker's draft:
This is an order from a buyer/importer to his bank to make a payment to the bank of the
seller/exporter.
Balance
the difference between credits and debits in an account.
205
2007, POME, Gautam_Koppala, All Rights Reserved
bank charges
money paid to a bank for the bank's services etc
branch
local office or bureau of a bank
checkbookUS
book containing detachable checks; chequebookUK
checkUS
written order to a bank to pay the stated sum from one's account; chequeUK
credit
money in a bank a/c; sum added to a bank a/c; money lent by a bank
credit card
(plastic) card from a bank authorising the purchasing of goods on credit
current account
bank a/c from which money may be drawn at any time; checking accountUS
debit
a sum deducted from a bank account, as for a cheque
deposit account
bank a/c on which interest is paid; savings accountUS
fill inUK
to add written information to a document to make it complete; to fill outUS
interest
money paid for the use of money lent - interest rate n.
loan
money lent by a bank etc and that must be repaid with interest.
206
2007, POME, Gautam_Koppala, All Rights Reserved
overdraft
deficit in a bank account caused by withdrawing more money than is paid in
pay in
to deposit or put money in to a bank account
payee
person to whom money is paid
paying-in slip
small document recording money that you pay in to a bank account
standing order
an instruction to a bank to make regular payments
statement
a record of transactions in a bank account
withdraw
to take money out of a bank account - withdrawal n.
POME Prescribe
U
Understand yourself
to better understand
others.
POME Prescribe
207
2007, POME, Gautam_Koppala, All Rights Reserved
INSURANCE
MANAGEMENT
208
2007, POME, Gautam_Koppala, All Rights Reserved
Insurance Management:
A contract whereby the insurer undertakes to reimburse the policyholder in the event of a
specified contingency or peril, against the payment of a premium. Insurance, in law and
economics, is a form of risk management primarily used to hedge against the risk of a
contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one
entity to another, in exchange for a premium. Insurer is the company that sells the
insurance. Insurance rate is a factor used to determine the amount, called the premium, to
be charged for a certain amount of insurance coverage. Risk management, the practice of
appraising and controlling risk, has evolved as a discrete field of study and practice.
The below mentioned are not only the insurances available. They are also lot many
available, POME depicted only which is pertinent to daily Operations.
Types of insurance in Operations:
Before choosing an insurance policy you will need to evaluate your Projects’s Operations and
its Projects insurance needs. Your insurance requirements vary considerably depending on
the type of Projects you operate.
Some insurers offer insurance package policies specially tailored to cover your Projects
needs. There are also individual products that may be relevant to the particular nature of
your business.
Your industry association may also provide important insurance advice, some associations
organize insurance packages for their members.
There are broad types of Projects insurance:
 Assets & revenue insurance
To protect your assets and revenue-generating capacity, here are some of the types of
insurance available:
Building and contents
Covers the building, contents and stock of your Projects against fire and other perils
such as earthquake, lightning, storms, impact, malicious damage and explosion.
209
2007, POME, Gautam_Koppala, All Rights Reserved
Burglary
Insures your Projects assets against burglary, and is most important for retailers or a
Project which maintains an unattended premises.
Project interruption or loss of profits
Covers you if your Project is interrupted through damage to property by fire or other
insured perils. Ensures your ongoing expenses are met and anticipated net profit is
maintained through a provision of cash flow.
Fidelity guarantee
Covers losses resulting from misappropriation by employees who embezzle or steal.
“Errors and Omissions” Insurance
Professional malpractice insurance is generally called errors and omissions (or E&O)
insurance. These policies are the basic first line of defense against claims of negligence or
malpractice. E&O policies are generally “claims made” insurance policies. What this means
is that the policy that is in place when a claim is made is the policy that defends the claim.
Naturally, the question of when a claim is actually made can become a legal battle, especially
if the extent of your coverage has changed or you changed carriers at some point. Notably,
if you switch insurance carriers, you need to be careful to make sure that you have insurance
for “prior acts” or else you run the risk of your new carrier saying that old project is not their
problem.
Commercial Risk Coverage:
An insurance policy or guarantee cover which gives protection to the supplier or a
financing bank against losses linked to the verification of a Commercial risk. The
specific events covered vary with the policy and the insurance agency.
Machinery breakdown
Protects your Project when mechanical and electrical plant and machinery at the work
site break down.
Motor vehicle
It is compulsory to insure all company or Project vehicles for third party injury liability.
Many different types of policies are available, so make sure you understand the
options before making a decision. There are four basic options:
210
2007, POME, Gautam_Koppala, All Rights Reserved
• Compulsory third party (injury) - covers you for claims made against you for
personal injuries and legal costs arising from the use of your car. You must obtain this
insurance to register your car.
• Third party property damage - covers your liability for damage to another person
or to the property of others and your legal costs. It doesn’t include repairs to your own car if
you caused an accident.
• Third party, fire and theft - covers you against the events covered above, as well
as fire and theft. It also insures against damage caused if your car was stolen.
• Comprehensive - covers you for all of the above plus damage caused to your own
car by you in an accident. If you're buying a car on an instalment basis, financiers will usually
insist on this cover.
 People insurance
Insurance cover for you and your employees:
Workers Compensation
You must provide accident and sickness insurance for your employees - workers
compensation - through an approved insurer. Workers compensation is covered by
separate state and territory legislation.
Personal accident and illness
If you are self employed you won’t be covered by workers compensation, so you need
to cover yourself for accident and sickness insurance through a private insurer.
There are several types of life insurance. Some are investment-type funds where you
contribute over a certain time and get back your investment plus interest earnings at
the maturity date. Others are designed to cover risk - things that could happen to you.
• Income protection or disability insurance - covers part of your normal income if
you are prevented from working through sickness or accident.
• Trauma insurance - provides a lump sum when you are diagnosed with one of
several specified life threatening illnesses.
• Term life insurance or whole of life cover - provides your dependents with a lump
sum if you die.
• Total and permanent disability insurance - provides a lump sum only if you are
totally and permanently disabled before retirement.
211
2007, POME, Gautam_Koppala, All Rights Reserved
Superannuation
If you are running a Project or employing people, you are likely to have
superannuation obligations to your employees. If you are self-employed you also need
to provide for your retirement - superannuation is generally used to provide for a
retirement plan.
Comprehensive General Liability Insurance
Comprehensive general liability insurance (or CGL) typically covers claims of personal injury
or property damage. CGL policies are typically “occurrence” policies. In that situation, the
policy in place at the time of the occurrence is the policy that defends a claim.
CGL policies generally have complex exclusions from coverage. They generally do not cover
damages that are covered in an E&O policy. Another important point is that they generally
exclude coverage the actual work of contractors. Contractors often struggle to find insurance
dollars to settle problems. This is an important factor for architects to understand when
dealing with claims or litigation.
 Liability insurance
Types of liability insurance you need to consider:
Public Liability
Public liability insurance protects you and your Project against the financial risk of
being found liable to a third party for death or injury, loss or damage of property or
‘pure economic’ loss resulting from your negligence.
Professional Indemnity
Professional indemnity insurance protects you from legal action taken for losses
incurred as a result of your advice. It provides indemnity cover if your client suffers a
loss - either material, financial or physical - directly attributed to negligent acts.
Product Liability
If you sell, supply or deliver goods, even in the form of repair or service, you may
need cover against claims of goods causing injury or damage. Product liability
insurance covers damage or injury caused to another Project or person by the failure
of your product or the product you are selling.
 Others
Political Risk Insurance for Projects
212
2007, POME, Gautam_Koppala, All Rights Reserved
The value of political risk insurance in support of projects has increased, as sovereign
guarantees decline and project financing becomes more complex. political risk specialists can
help arrange insurance covers, including:
• Confiscation, expropriation and nationalization, including cancellation and/or forced
renegotiation of project agreements
• War, civil war, terrorism and political violence
• Forced abandonment and forced divestiture
• Failure to honor sovereign guarantees
• Selective discrimination
Unfair calling of guarantees issued in support of the project
Inflation Rate Coverage:
An insurance or guarantee cover which protects the supplier against a significant
increase in the manufacturing costs of capital goods, when a long lead time between
the signing of the contract and the delivery of the final products is entailed. It is also
known as cost escalation coverage.
Export credit insurance:
A policy to cover some of the riskier areas faced by exporters i.e. non- payment due
either to insolvency of the importer (commercial risk) or political events (political risk).
Export credit insurance is frequently mentioned in connection with export credit
guarantees. While guarantees cover bank export loans, insurance policies are issued
directly in favour of the exporters. In many developing countries this type of insurance
is either not available or is too expensive. Several types of export credit insurance are
available. These differ from country to country according to the needs of the local
business community. The most widely used types of export credit insurance include
the following:
(1) Short-term export credit insurance: generally covers credit periods not exceeding
180 days. Pre-shipment and post-shipment export stages are covered and protection
may be provided against political and commercial risks.
213
2007, POME, Gautam_Koppala, All Rights Reserved
(2) Medium- and long-term export credit insurance: issued for credits extending for
periods over 12 months. It provides cover for exports of capital goods, construction or
special services.
(3) Investment insurance: issued to companies investing in foreign countries. The
Multilateral Investment Guarantee Agency (MIGA), affiliated to the World Bank, offers
this type of insurance.
(4) External trade insurance: applies to goods not shipped from the originating
country. It is not available in a number of developing countries.
(5) Exchange risk insurance: covers losses arising from the fluctuation of the
respective exchange rates of the importer's and exporter's national currencies over a
determined period of time.
Formation of capital coverage:
A financing technique used by insurance companies and pension funds, whereby the
contributions of the insured parties are accumulated to form the capital required for
the payment of insurance benefits.
Credit Coverage’s
Credit insurance repays some or all of a loan back when certain things happen to the
borrower such as unemployment, disability, or death. Mortgage insurance is a form of credit
insurance, although the name credit insurance more often is used to refer to policies that
cover other kinds of debt, where as the Mortgage insurance insures the lender against
default by the borrower.
Credit risk insurance:
Insurance designed to cover the risks of non-payment of a credit.
Global policy:
A credit insurance policy which covers all export activities of the exporter during an
agreed period, usually one year.
214
2007, POME, Gautam_Koppala, All Rights Reserved
POME LIGHTER VEIN:
POME LIGHTER VEI&:
Definitions to help you understand what those check point reports are really
telling us, in other words, Decoding the Jargon---------------------------
215
2007, POME, Gautam_Koppala, All Rights Reserved
Essentially complete
It's half done.
We predict...
We hope to God!
Risk is high, but within acceptable ranges of risk
100:1 odds, or with 10 times over budget using 10 times the people we said we'd
employ.
Potential show stopper.
The team has updated their resumes.
Serious but not insurmountable problems.
It'll take a miracle...
Basic agreement has been reached.
The @##$%%'s won't even talk to us.
Results are being quantified.
We're massaging the numbers so they will agree with our conclusions.
Task force to review.
Seven people who are incompetent at their regular jobs have been loaned to the
project
216
2007, POME, Gautam_Koppala, All Rights Reserved
Nobody's even thought about it.
Still analysing the requirements.
Not well understood.
Now that we've thought about it, we don't want to think about it anymore.
Requires further analysis and management attention.
Totally out of control!
Results are promising
Turned power on and no smoke detected -- this time...
Unacceptable stretching-out of the time scale
It's late!
Still in the early phase of the learning curve
New
The requirement was changed and the programme concluded
Cancelled
Experiencing transient malfunctions
217
2007, POME, Gautam_Koppala, All Rights Reserved
Going wrong
Conceptually configured in several variations
Modified
POME Prescribe
N
Never lie, cheat or
steal; always strike
a fair deal.
POME Prescribe
218
2007, POME, Gautam_Koppala, All Rights Reserved
STRUCTURE OF
BUSINESS AND
IMPACT OF FINANCIAL
STATEMENTS
219
2007, POME, Gautam_Koppala, All Rights Reserved
The Structure of Business and the Impact of Financial
Statements
The legal structure of a business may take many forms. All businesses, regardless of their
legal structure, prepare and utilize financial statements the same way. Though in some cases
certain line labels differ, the meaning and interpretation of the financial statements and the
essential elements of financial management are the same. In fact, the essence of financial
management is the same for a business and for individuals and their families. Individuals
practice many, if not most, of the same techniques with regard to their own financial
condition as financial Project Managers do for the businesses that employ them. A brief look
at the most common business structures will help make this clear.
Proprietorship Based Projects
A Proprietorship Based Projects are the simplest form of business structure. It is a
business that is owned by one person who runs the business actively and treats it as an
extension of himself or herself. A Proprietorship Based Projectsis the easiest form of a
business to establish, requiring only that the proprietor meet local and state registration and
licensing requirements. Because the business is treated as an extension of the owner, the
owner retains liability for the business’s obligations and recognizes all of the assets,
liabilities, profits, or losses as belonging to the owner. Income taxes, for example, are paid
as part of the personal tax return of the owner, with no other reports or filing requirements.
In summary, a Proprietorship Based Projects is easy to establish and easy to terminate; its
assets and liabilities belong to the owner directly; its taxes and obligations are taxes and
obligations of the owner.
A Proprietorship Based Projects faces some limitations as well. Because it is an extension of
the owner, the business faces limits on the debt it can incur because lenders are lending to
the entrepreneur and make their credit decisions based on the creditworthiness of the
individual. The Proprietorship Based Projects encounters difficulties in attracting professional
Project Managers because the owner is often reluctant to grant authority to someone else to
establish personal liabilities and obligations for the owner, and Project Managers are
reluctant to have their authority and responsibility so limited. Also of importance is the fact
that a Proprietorship Based Projects does not survive the proprietor. That is, the business
terminates with the death or withdrawal of the owner.
Partnership Based Projects
220
2007, POME, Gautam_Koppala, All Rights Reserved
A Partnership Based Projects is an agreement between two or more people to work
together and share in the ownership and operation of a business. Such an operation shares
some of the benefits of a proprietorship, such as a single incidence of annual taxation, on the
individual tax returns of the partners and based on the share of the profits or losses each has
agreed to take. However, the establishment of a Partnership Based Projects often involves
definition of rights and responsibilities for each partner as well as the documentation of share
and other agreements. Such documentation costs much more than does the establishment of
a proprietorship. There are some significant disadvantages to a Partnership Based Projects as
well. Perhaps the most important one is that each partner is liable for all the debts of the
Partnership Based Projects, so, if one partner cannot pay his or her share, all the other
partners, or even just one, are responsible for the obligation. Under certain circumstances, a
partner may agree to provide funds for the business, but otherwise to remain uninvolved in
the operations. In such cases the partner may be a limited partner, with rights to share in
the financial success, but not in the liabilities (beyond the investment). Such a Partnership
Based Projects is known as a limited Partnership Based Projects. The normal structure, with
all partners actively participating in the organization is known as a general Partnership Based
Projects .
Partnership Based Projects s has more access to debt financing because the credit of the
Partnership Based Projects is based on the creditworthiness of the partners, rather than on
only one individual. Similarly, a Partnership Based Projects may have access to more and
better management talent because the Project Manager might have the opportunity to be a
partner at some time. Until recently, most professional organizations (accountants, lawyers,
architects, etc.) were Partnership Based Projects s. Today, many are structured as Limited
Liability Partnership Based Projects s (LLP) or Limited Liability Companies (LLC), new forms
of structure that provide more liability protection to the partners and owners.
Just as Proprietorship Based Projects terminates with the death or departure of the owner,
so, too, a Partnership Based Projects dissolves with the death or withdrawal of a partner.
However, it is possible to establish a Partnership Based Projects arrangement that
immediately reconstitutes the Partnership Based Projects after such a dissolution.
Corporation Based Projects
Establishing a Corporation Based Projects requires more formality and more legal
involvement than a Proprietorship Based Projects or even a Partnership Based Projects . This
is in part because a Corporation Based Projects is deemed to be independent of its individual
221
2007, POME, Gautam_Koppala, All Rights Reserved
shareholders and can, therefore, continue to exist even if a shareholder dies or transfers
shares to someone else.
This ability to transfer ownership, or to change the number of shares to attract additional
owners, facilitates the attraction of professional management, who can hope to receive
ownership shares if they are successful. It also makes it easier to attract financing because
the lender/investor knows that the Corporation Based Projects will continue to exist, even if
part of management leaves. This makes their debt potentially more secure.
Among the advantages of financing a Corporation Based Projects is the limitation of liability
that is associated with Corporation Based Projects s. Because the Corporation Based Projects
survives the owners, it is deemed to undertake its own responsibility. Therefore, the
shareholders and Project Managers of the Corporation Based Projects are protected from
liability for the debts and obligations of the Corporation Based Projects .
A major disadvantage of a Corporation Based Projects is the tax treatment applied to
corporate earnings. Again because of the independent identity of the Corporation Based
Projects, it is taxed directly on its earnings. If the Corporation Based Projects distributes its
earnings to the shareholders as dividends, these dividends are taxed at the recipient level
even though the Corporation Based Projects was taxed when the profits were made. In
2003, the tax rate on dividends paid to shareholders was reduced, making dividends
somewhat more attractive and reducing the double taxation penalties. Many people continue
to feel that dividend payments should go to the shareholders free of any taxation at the
individual taxpayer level.
Although most businesses are proprietorships, these proprietorships only represent a small
percentage of the business value in the United States. And although the number of
businesses that are Corporation Based Projects s is the lowest among the three structures,
Corporation Based Projects s account for more than 90 percent of all business value in the
country. It is for this reason that presentation of financial statements normally follows the
corporate format.
Financial statements for proprietorships and Partnership Based Projects s differ from those of
Corporation Based Projects s only in the presentation of the equity portion of the Balance
Sheet. For these other entities the owners’ equity is often identified as “owner’s capital” or
“partners’ capital” or some similar term, whereas a Corporation Based Projects ’s equity
222
2007, POME, Gautam_Koppala, All Rights Reserved
section, where different terminology may be used, refers to common stock (or capital stock),
additional paid-in capital, and retained earnings.
Other Business based Project Structures
In recent years a number of variations of these legal structures have been developed to
accommodate the needs of owners and changes in legal interpretations. Among these are “S”
Corporation Based Projects s, which are Corporation Based Projects s legally, but which are
taxed as Partnership Based Projects s; Limited Liability Companies and Limited Liability
Partnership Based Projects s, which provide protection for the owners from responsibility for
some debts incurred through the actions of others; Trusts, such as Real Estate Investment
Trusts, established to protect investors from risk in real estate transactions in which they are
only investors; and other types of entities created to satisfy particular needs. The financial
reporting for these entities is essentially the same as for Corporation Based Projects s,
except in the equity section, and the statements they prepare are similar to those presented
earlier.
Financial information is presented in the same manner regardless of the legal structure of the
business, and because this is so, financial statements are consistently understood across all
industries and business structures. Businesses can take any one of several legal forms,
depending on the desires and concerns of the owners.
 Proprietorships—owned and actively operated by one person who retains all the
benefits and undertakes all the liabilities, easily formed and dissolved, incurring a single
level of taxation, limited access to debt, terminating with the withdrawal of the owner
 Partnership Based Projects —owned and operated by more than one person, sharing
the benefits and the liabilities, more complex to establish and run, incurring a single level
of taxation, dissolving with the withdrawal of a partner
 Corporation Based Projects —owned by one or more stockholders, considered a legal
entity separate from its owners, taxed at the operating level, existing beyond the
transfer of stock ownership.
Businesses make capital investments for many reasons, nearly all related to improving the
competitive position of the Projects. Therefore, the assessment of these investments should
be predicated on the need to deliver an appropriate reward to the shareholders of a
Corporation Based Projects or owners of other business types as well as to pay the other
providers of the needed funds their expected rate of return. We can identify six classes of
capital investments:
223
2007, POME, Gautam_Koppala, All Rights Reserved
Replacement—enabling the Projects to continue to do what it has done in the past. These
investments do not involve new technologies or capabilities, but merely replace worn out or
destroyed capacity.
Expansion—increasing the capacity of the Projects, permitting the Projects to take advantage
of additional volume opportunities. These investments often take longer than replacement
projects to become fully utilized and involve, in many cases, taking market share from
competition, which is more difficult than merely retaining existing volume.
Rationalization—undertaking efforts to improve technology, lower cost, or increase
productivity, often requiring changes that have not been fully proved. These projects
frequently also include expanded capacity.
Development—advancing the Projects through new products, new markets, or new
technologies. These projects often incorporate elements of all of the above options plus
significant changes in Projects operations.
[This line denotes the separation between those projects that generate a return and those
that do not.]
Mandatory—satisfying legal or contractual requirements by making required investments.
These projects may result from changes in legislation (such as the environmental protection
laws or the Americans with Disabilities Act) or from safety requirements (required by
insurance companies or the Occupational Safety and Health Administration) or from
negotiations (such as actions required as a result of collective bargaining). These
investments do not offer any return but must be made.
Other—upgrading or changing assets deemed necessary or desirable by management but
offering no measurable financial return to the Projects. These investments might include
upgrades to the computer systems to satisfy the Sarbanes-Oxley requirements (discussed
further in Chapter 12) or other concerns, refurbished office décor to improve employee
morale or provide the appropriate image to visiting customers and others, or executive
perquisites needed to attract and retain key corporate executives.
In this listing, the top four investment purposes are presented in order of increasing risk. As
a consequence of this progressively higher risk, expansion projects require a higher rate of
return than do replacement projects; rationalization projects require a higher rate of return
than expansion; and development projects require a still higher return.
224
2007, POME, Gautam_Koppala, All Rights Reserved
Mandatory and Other projects, both of which often have no return at all, must be paid for
through the return earned by the profitable projects, because shareholders, who are
rewarded through the profitability of the Projects’s performance, including the capital
investments, require an adequate return regardless of how their money is utilized.
The consequence of this is to require the profitable projects to also pay for those projects
that are deemed necessary but do not offer a return on their own. This is important, because
the investors who provide the funds for these capital investments are not willing to forgo any
return just because the Projects must make investments that do not offer a return.
Let’s look at the effect on the required rate of return for a project. Assume that the cost of
capital is 10 percent. Therefore, the required rate of return on a replacement project, being
least risky, must offer a rate of return equal to the cost of capital. All other profitable
projects must offer higher rates of return, and the greater the risk, the greater the return
must be. Assume that the incremental risk raises the required rate of return 2 percent for
each step.
Cost of Capital
1. Risk Return Trade-Off
2. Debts (Long-term & Short-term), Preference
Shares & Equity Shares and their Risk
Profiles
3. Cost of Debt Capital; Cost of Preference
Capital; Cost of Equity Capital
4. Weighted Average Cost of Capital
5. Interest Tax Shield
225
2007, POME, Gautam_Koppala, All Rights Reserved
Cost of Capital
Preference
Share Equity
Short-term Share
Cost of
Capital Debt
Long-term
Debt
Risk
WACC K0 = WdKd (1-T) + WpKp + WeKe
Impact of Capital Structure
on Cost of Capital
Project Financing – Project Cost & Means
of Financing
Project Cost = All Non-Current Assets
+ 25% of Current Asset
Means of Financing: To be decided by
Project Capital Structure
Requirement of Working Capital Finance
We can build a table
to demonstrate this, as shown in Exhibit below. Because the profitable projects must pay for
the others, we need to adjust the required rates. If we assume that 80 percent of our capital
budget is for profitable projects and 20 percent of our capital budget is for the nonprofitable
projects, we must increase the required rates of return by 25 percent (20/80) to
226
2007, POME, Gautam_Koppala, All Rights Reserved
accommodate the shareholders’ requirements. So we recalculate the table, as shown in
exhibit below.
Exhibit: Required Rate of Return for Various Project Types
Exhibit: Recalculating the Required Rate of Return
These higher required rates of return shown in Exhibit 7–5 adjust for risk and for the funding
of the non-profitable projects.
Applying Cost of Capital
There are almost always more alternative investment opportunities available than there are
funds available to pay for them. The cost of capital provides a basis for evaluating these
investments and determining which are most beneficial, at least from a financial perspective.
The assessment of the various projects raises several other issues to consider.
In order to judge among the investment opportunities, the Project Manager must recognize
several decision criteria. Financial return is one, and we examine the financial assessment in
the next few pages. But before considering the financial evaluation, it is important to
understand some other aspects of the capital budgeting landscape.
The decisions relating to project choice are complicated by a number of factors beyond the
financial ones. For example, some projects may be mutually exclusive. That is, the decision
to fund one immediately eliminates the other. Sometimes, these are alternative ways to
solve the same problem. Other times, they represent corporate decisions to move the
business toward one market and away from another. The decision to choose one over
another often involves favoring the project of one Project Manager over the project of
227
2007, POME, Gautam_Koppala, All Rights Reserved
another, setting up internal conflicts and competitions that have nothing to do with financial
management.
Another area of concern relates to the interdependence of potentially separate projects. In
some cases parts of a project are distinct, but the funding of one requires the funding of
another. However, because Project Managerial authority often has financial limits, such
projects may be separated in an effort to gain approval in pieces of a project that might not
get approved as a single investment. Consider for example, the building of a research
laboratory on a particularly attractive piece of property, access to which would require
building a road. Perhaps the road cost, as a single project, would fit within the discretionary
authority of a Project Manager. Similarly, the cost of the laboratory would also fit within that
individual’s authority. However, combined the cost would exceed the Project Manager’s
authority. In some instances, the Project Manager might seek to fund the road as one project
and the laboratory as another, exercising his or her authority separately for the two parts of
what is really one project. The financial Project Manager will often recognize the
interdependence of two or more projects and intervene in the best interests of the
shareholders. This does not necessarily mean that the project will not be funded, only that a
larger group of decision makers will evaluate the project.
In most companies, the fact that the capital budget is limited restricts the number and size of
investments. This limitation is described as capital rationing, the restriction of overall
investment and the requirement that investments be evaluated to assure that the best ones
are chosen. This in turn leads to the careful financial and operational evaluation of the
investment options.
In order to accomplish this careful financial evaluation, the financial Project Manager needs
to determine the true cost of the project as well as the appropriate revenues and operating
expenses that will yield the profits from the investments that will be the basis of the
computed return on investment. The next section addresses these issues and sets a
framework for calculating the investment cost.
Determining Investment Cost
Determining the cost of a fixed asset is often much more complex than looking at the
invoice. For this discussion we focus on the acquisition of a piece of productive equipment,
but you can extrapolate these issues to include real property or even the acquisition of
another Projects. Though it may seem that the examples are focused on manufacturing
companies, these concepts are equally applicable to service companies, to not-for-profit
228
2007, POME, Gautam_Koppala, All Rights Reserved
organizations, and to government agencies, without regard to size. In addition to the
acquisition cost, the investment includes site preparation, installation and training, and
incremental working capital. This last item creates confusion and misunderstanding, but it
represents a very important aspect of capital investment funding.
The acquisition cost is fairly straightforward. It includes the invoice cost of the asset as well
as the transportation to bring it to the site. In the minds of many people, investment is only
acquisition. It is not!
Site preparation costs obviously include the costs of making the location ready, but they also
include the financial consequences of removal and sale or disposal of anything being
replaced. Sometimes this requires expenditures to remove the old asset, receipts from its
sale, adjustment of depreciation to assure that the value of the old asset has been accounted
for, and computed tax consequences of the actions. The tax computations involve recognition
of depreciation expense recaptured if the asset is sold, accounting for depreciation not yet
recorded if the asset was not fully depreciated, and computation and separate taxation of
any capital gains resulting from the sale of the asset.
Installation costs include the physical installation of the asset, connection and testing of all
related services, and training personnel and management in the proper use or operation of
the asset. Among the challenges associated with these and the other costs of acquiring an
asset is the recognition that all costs included in the determination of the cost of the asset
are included in the accounting basis for the asset and will be depreciated or amortized over
the life of the asset. Although this increases the value of the investment, which will impact
the rate of return percentage, it also delays the recognition of the cost of the asset in the
financial results of the Projects. This means that all costs considered part of the cost will be
capitalized, recorded as part of the asset on the Balance Sheet. This cost, subject to
depreciation, will be recovered by the Projects through depreciation expense recorded in the
Income Statement over several years. If these investment costs were treated as expenses of
the accounting period in which they were spent, they would pass through the Income
Statement immediately, reducing profit and therefore reducing the taxes of the current
period. The choice to capitalize these expenditures has implications for the Projects and for
the shareholders because of the time value of money as discussed in Chapter 6.
Working capital as part of asset cost is also hard for many Project Managers to understand.
The working capital involved includes the incremental accounts receivable resulting from the
new sales that represent the revenues associated with the project. It also involves the
229
2007, POME, Gautam_Koppala, All Rights Reserved
incremental inventory required to support the operation of the asset and to support the
incremental sales. When an asset involves increases in accounts receivable and inventories,
these additional assets add to the capital required to finance the acquisition. This amount
needs to be included in the project cost to be evaluated. In some cases, a new piece of
equipment results in improved efficiencies and actually reduces the inventory required, but
generally such a reduction is not deducted from the asset cost. This is one example of
conservatism in investment evaluation. The understanding of the working capital requirement
is complicated by the assumption that when the investment is terminated, the working
capital investment will be recovered. As we will see, the difference between the working
capital investment at the beginning and the working capital recovery at the end is a function
of the time value of money.
The cost of the investment is the sum of the acquisition cost, the site preparation cost, the
installation cost, and the incremental working capital required. The return on investment
related to the asset will be computed based on this total project investment cost.
POME Prescribe
O
Open your eyes and
see things as they
really are.
POME Prescribe
230
2007, POME, Gautam_Koppala, All Rights Reserved
TAXATION
231
2007, POME, Gautam_Koppala, All Rights Reserved
Taxation:
POME Lighter Vein:
Taxation, generally in Projects is inevitable, as it involves cash flows. Normally, Tax is a
financial charge or other levy imposed on an individual or a legal entity by a state or a
functional equivalent of a state (for example, secessionist movements or revolutionary
movements). Taxes are also imposed by many sub national entities. Taxes consist of direct
tax or indirect tax, and may be paid in money. A tax may be defined as a "pecuniary burden
laid upon individuals or Project or property to support the government. A tax "is not a
voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative
authority" and is "any contribution imposed by government whether under the name of toll,
tribute, impost, duty, custom, excise, subsidy, aid, supply, or other name."
In modern taxation systems, taxes are levied in money, but in-kind are characteristic of
traditional or pre-capitalist states and their functional equivalents. The method of taxation
and the government expenditure of taxes raised is often highly debated in politics and
economics. When taxes are not fully paid, civil penalties (such as fines) or criminal penalties
may be imposed on the non-paying entity or individual.
POME Lighter Vein:
232
2007, POME, Gautam_Koppala, All Rights Reserved
The emphasis given on Taxation is due to the involvement of different taxes in the projects
based upon the region and its norms, we execute the projects. Hence, for an Operations
Person, it is always important to acquaint about the types of Taxes and its involvement and
to complete the project commercially and legally, by paying the taxes.
Also, this POME Chapter helps in the calculation of the taxes of the individuals payrolls. The
Taxes vary from country to country, here; we categorized only the Taxation Concepts which
are required for the Operations angle.
Direct and Indirect
Taxes are sometimes referred to as direct tax or indirect tax. The meaning of these terms
can vary in different contexts, which can sometimes lead to confusion. In economics, direct
taxes refer to those taxes that are collected from the people or organizations on whom they
are ostensibly imposed. For example, income taxes are collected from the person who earns
the income. By contrast, indirect taxes are collected from someone other than the person
ostensibly responsible for paying the taxes. In law, the terms may have different meanings.
In constitutional law, for instance, direct taxes refer to poll taxes and property taxes, which
are based on simple existence or ownership. Indirect taxes are imposed on rights, privileges,
and activities. Thus, a tax on the sale of property would be considered an indirect tax,
whereas the tax on simply owning the property itself would be a direct tax. The distinction
can be subtle between direct and indirect taxation, but can be important under the law.
233
2007, POME, Gautam_Koppala, All Rights Reserved
(Hong Kong Trade Development Council 2007)
Tax burden:
Law establishes from whom a tax is collected. In many countries, taxes are imposed on
business (such as corporate taxes or portions of payroll taxes). However, who ultimately
234
2007, POME, Gautam_Koppala, All Rights Reserved
pays the tax (the tax "burden") is determined by the marketplace as taxes become
embedded into production costs. Depending on how quantities supplied and demanded vary
with price (the "elasticities" of supply and demand), a tax can be absorbed by the seller (in
the form of lower pre-tax prices), or by the buyer (in the form of higher post-tax prices). If
the elasticity of supply is low, more of the tax will be paid by the supplier. If the elasticity of
demand is low, more will be paid by the customer. And contrariwise for the cases where
those elasticities are high. If the seller is a competitive firm, the tax burden flows back to the
factors of production depending on the elasticities thereof; this includes workers (in the form
of lower wages), capital investors (in the form of loss to shareholders), landowners (in the
form of lower rents) and entrepreneurs (in the form of lower wages of superintendence).
POME Lighter Vein:
To illustrate this relationship, suppose the market price of a product is US$1.00, and that a
$0.50 tax is imposed on the product that, by law, is to be collected from the seller. If the
product is a luxury (in the economic sense of the term), a greater portion of the tax will be
absorbed by the seller. For example, the seller might drop the price of the product to $0.70
so that, after adding in the tax, the buyer pays a total of $1.20, or $0.20 more than he did
before the $0.50 tax was imposed. In this example, the buyer has paid $0.20 of the $0.50
tax (in the form of a post-tax price) and the seller has paid the remaining $0.30 (in the form
of a lower pre-tax price).
235
2007, POME, Gautam_Koppala, All Rights Reserved
Types of taxes:
The Organization for Economic Co-operation and Development (OECD) analysed the most
comprehensive analysis of worldwide tax systems. In order to do this it has created a
comprehensive categorization of all taxes in all regimes which it covers:
 Ad valorem
An ad valorem tax is one where the tax base is the value of a good, service, or property.
Sales taxes, tariffs, property taxes, inheritance taxes, and value added taxes are different
types of ad valorem tax. An ad valorem tax is typically imposed at the time of a transaction
(sales tax or value added tax (VAT)) but it may be imposed on an annual basis (property
tax) or in connection with another significant event (inheritance tax or tariffs). An alternative
to ad valorem taxation is an excise tax, where the tax base is the quantity of something,
regardless of its price. For example, in the United Kingdom, a tax is collected on the sale of
alcoholic drinks that is calculated by volume and beverage type, rather than the price of the
drink.
 Environment Affecting Tax
This includes natural resources consumption tax, Greenhouse gas tax (Carbon tax, "sulfuric
tax", etc), and others.
 Capital gains tax
A capital gains tax is the tax levied on the profit released upon the sale of a capital asset. In
many cases, the amount of a capital gain is treated as income and subject to the marginal
rate of income tax.
 Consumption tax
A consumption tax is a tax on non-investment spending, and can be implemented by means
of a sales tax or by modifying an income tax to allow for unlimited deductions for investment
or savings.
236
2007, POME, Gautam_Koppala, All Rights Reserved
 Corporation tax
Corporate tax refers to a direct tax levied by various jurisdictions on the profits made by
companies or associations and often includes capital gains of a Project. Earnings are
generally considered gross revenue less expenses.
 Excises
Unlike an ad valorem, an excise is not a function of the value of the product being
taxed. Excise taxes are based on the quantity, not the value, of product purchased.
For example, in the United States, the Federal government imposes an excise tax of
18.4 cents per US gallon (4.86¢/L) of gasoline, while state governments levy an
additional 8 to 28 cents per US gallon.
Excises (or exemptions from them) are also used to modify consumption patterns
(social engineering). For example, a high excise is used to discourage alcohol
consumption, relative to other goods. This may be combined with hypothecation if the
proceeds are then used to pay for the costs of treating illness caused by alcohol
abuse. Similar taxes may exist on tobacco, pornography, etc., and they may be
collectively referred to as "sin taxes". A carbon tax is a tax on the consumption of
carbon-based non-renewable fuels, such as petrol, diesel-fuel, jet fuels, and natural
gas. The object is to reduce the release of carbon into the atmosphere. In the United
Kingdom, vehicle excise duty is an annual tax on vehicle ownership.
 Income tax
An income tax is a tax levied on the financial income of persons, corporations, or other legal
entities. Various income tax systems exist, with varying degrees of tax incidence. When the
tax is levied on the income of companies, it is often called a corporate tax, corporate income
tax, or corporation tax. Individual income taxes often tax the total income of the individual
(with some deductions permitted), while corporate income taxes often tax net income (the
difference between gross receipts, expenses, and additional write-offs).
The "tax net" refers to the types of payment that are taxed, which included personal earnings
(wages), capital gains, and business income. The rates for different types of income may
vary and some may not be taxed at all. Capital gains may be taxed when realized (e.g. when
shares are sold) or when incurred (e.g. when shares appreciate in value). Business income
237
2007, POME, Gautam_Koppala, All Rights Reserved
may only be taxed if it is significant or based on the manner in which it is paid. Some types
of income, such as interest on bank savings, may be considered as personal earnings (similar
to wages) or as a realized property gain (similar to selling shares). In some tax systems,
personal earnings may be strictly defined where labor, skill, or investment is required (e.g.
wages); in others, they may be defined broadly to include windfalls (e.g. gambling wins).
Personal income tax is often collected on a pay-as-you-earn basis, with small corrections
made soon after the end of the tax year. These corrections take one of two forms: payments
to the government, for taxpayers who have not paid enough during the tax year; and tax
refunds from the government for those who have overpaid. Income tax systems will often
have deductions available that lessen the total tax liability by reducing total taxable income.
They may allow losses from one type of income to be counted against another. For example,
a loss on the stock market may be deducted against taxes paid on wages. Other tax systems
may isolate the loss, such that business losses can only be deducted against business tax by
carrying forward the loss to later tax years.
 Inheritance tax
Inheritance tax, estate tax, and death tax or duty are the names given to various taxes
which arise on the death of an individual.
 Poll tax
A poll tax, also called a per capita tax, or capitation tax, is a tax that levies a set amount per
individual. One of the earliest taxes mentioned in the Bible of a half-shekel per annum from
each adult Jew (Ex. 30:11-16) was a form of poll tax. Poll taxes are administratively cheap
because they are easy to compute and collect and difficult to cheat. Economists have
considered poll taxes economically efficient because people are presumed to be in fixed
supply. However, poll taxes are very unpopular because poorer people pay a higher
proportion of their income than richer people. In addition, the supply of people is in fact not
fixed over time: on average, couples will choose to have fewer children if a poll tax is
imposed.
 Property tax
238
2007, POME, Gautam_Koppala, All Rights Reserved
A property tax is a tax imposed on property by reason of its ownership. A property tax is
usually levied on the value of property owned. There are three species of property: land,
improvements to land (immovable man-made things, e.g. buildings) and personal property
(movable things). Real estate or realty is the combination of land and improvements to land.
Property taxes may be charged on a recurrent basis (e.g., yearly). A common type of
property tax is an annual charge on the ownership of real estate, where the tax base is the
estimated value of the property.
In contrast with a tax on real estate (land and buildings), a land value tax is levied only on
the unimproved value of the land ("land" in this instance may mean either the economic
term, i.e., all natural resources, or the natural resources associated with specific areas of the
earth's surface: "lots" or "land parcels").
When real estate is held by a higher government unit or some other entity not subject to
taxation by the local government, the taxing authority may receive a payment in lieu of taxes
to compensate it for some or all of the foregone tax revenue.
 Retirement tax
Some countries with social security systems, which provide income to retired workers, fund
those systems with specific dedicated taxes. These often differ from comprehensive income
taxes in that they are levied only on specific sources of income, generally wages and salary
(in which case they are called payroll taxes). A further difference is that the total amount of
the taxes paid by or on behalf of a worker is typically considered in the calculation of the
retirement benefits to which that worker is entitled.
 Sales tax
Sales taxes are a form of excise levied when a commodity is sold to its final consumer. Retail
organizations contend that such taxes discourage retail sales. The question of whether they
are generally progressive or regressive is a subject of much current debate. People with
higher incomes spend a lower proportion of them, so a flat-rate sales tax will tend to be
regressive. It is therefore common to exempt food, utilities and other necessities from sales
taxes, since poor people spend a higher proportion of their incomes on these commodities,
so such exemptions would make the tax more progressive. This is the classic "You pay for
239
2007, POME, Gautam_Koppala, All Rights Reserved
what you spend" tax, as only those who spend money on non-exempt (i.e. luxury) items pay
the tax.
 Tariffs
An import or export tariff (also called customs duty or impost) is a charge for the movement
of goods through a political border. Tariffs discourage trade, and they may be used by
governments to protect domestic industries. A proportion of tariff revenues is often
hypothecated to pay government to maintain a navy or border police. The classic ways of
cheating a tariff are smuggling or declaring a false value of goods. Tax, tariff and trade rules
in modern times are usually set together because of their common impact on industrial
policy, investment policy, and agricultural policy. A trade bloc is a group of allied countries
agreeing to minimize or eliminate tariffs against trade with each other, and possibly to
impose protective tariffs on imports from outside the bloc. A customs union has a common
external tariff, and, according to an agreed formula, the participating countries share the
revenues from tariffs on goods entering the customs union. In general,A tax imposed by a
government on goods as they enter (or leave) the country. It may be imposed for
Protectionist reasons and/or to generate revenues for the government. Tariff types include ad
valorem, specific, variable or some combination of these.
 Toll
A toll is a tax or fee charged to travel via a road, bridge, tunnel or other route.
Historically tolls have been used to pay for state bridge, road and tunnel projects.
They have also been used in privately constructed transport links. The toll is likely to
be a fixed charge, possibly graduated for vehicle type, or for distance on long routes.
Shunpiking is the practice of finding another route to avoid payment of tolls. In some
situations where tolls were increased or felt to be unreasonably high, informal
Shunpiking by individuals escalated into a form of boycott by regular users, with the
goal of applying the financial stress of lost toll revenue to the authority determining
the levy.
 Transfer tax
240
2007, POME, Gautam_Koppala, All Rights Reserved
Historically, in many countries, a contract needed to have a stamp affixed to make it valid.
The charge for the stamp was either a fixed amount or a percentage of the value of the
transaction. In most countries the stamp has been abolished but stamp duty remains.
Stamp duty is levied in the UK on the purchase of shares and securities, the issue of bearer
instruments, and certain partnership transactions. Its modern derivatives, stamp duty
reserve tax and stamp duty land tax, are respectively charged on transactions involving
securities and land. Stamp duty has the effect of discouraging speculative purchases of
assets by decreasing liquidity. In the transfer tax is often charged by the state or local
government and (in the case of real property transfers) can be tied to the recording of the
deed or other transfer documents. Taxes on currency transactions are known as Tobin
taxes.
 Value Added Tax / Goods and Services Tax
A value added tax (VAT), also known as 'Goods and Services Tax' (G.S.T), or 'Impuesto
Indirecto sobre la Prestacion de Servicios' (I.S.I.), Single Business Tax, or Turnover Tax in
some countries, applies the equivalent of a sales tax to every operation that creates value.
To give an example, sheet steel is imported by a machine manufacturer. That manufacturer
will pay the VAT on the purchase price, remitting that amount to the government. The
manufacturer will then transform the steel into a machine, selling the machine for a higher
price to a wholesale distributor. The manufacturer will collect the VAT on the higher price,
but will remit to the government only the excess related to the "value added" (the price over
the cost of the sheet steel). The wholesale distributor will then continue the process,
charging the retail distributor the VAT on the entire price to the retailer, but remitting only
the amount related to the distribution mark-up to the government. The last VAT amount is
paid by the eventual retail customer who cannot recover any of the previously paid VAT. For
a VAT and sales tax of identical rates, the total tax paid is the same, but it is paid at differing
points in the process.
Economic theorists have argued that the collection process of VAT minimizes the market
distortion resulting from the tax, compared to a sales tax. However, VAT is held by some to
discourage production.
 Wealth (net worth) tax
Some countries' governments will require declaration of the tax payers' balance sheet (assets
and liabilities), and from that exact a tax on net worth (assets minus liabilities), as a
241
2007, POME, Gautam_Koppala, All Rights Reserved
percentage of the net worth, or a percentage of the net worth exceeding a certain level. The
tax is in place for both "natural" and in some cases legal "persons".
 Local Sales Tax:
Goods move with in a sate.
 Central sales Tax:
Goods move from one stae to another in the same country.
 Turnover tax:
A form of indirect taxation imposed on a firm's sales revenues.
POME LIGHTER VEI&:
242
2007, POME, Gautam_Koppala, All Rights Reserved
POME Prescribe
K
Keep trying no
matter how hard it
seems—it will get
easier.
POME Prescribe
243
2007, POME, Gautam_Koppala, All Rights Reserved
Linking Departmental functions
Performance
244
2007, POME, Gautam_Koppala, All Rights Reserved
Linking Departmental functions through Financial
Performance in Projects
Throughout this course we have looked at financial and accounting information from the
perspective of the Projects as a whole, without considering the relationship between the
responsibilities of a Project Manager and the financial effects on that Projects. In POME, we
want to summarize this relationship and consider the various levels within the Projects and
how they are interrelated. To do so, we begin at the highest level, the Projects, and progress
to more specific and detailed levels, through subsidiary, division, department, group, and
individual.
POME Case Study:
Financial Management Is Everyone’s Responsibility and It Is Continuous
“You’ve all learned so much over the past year, I think you could come to work in corporate
accounting and finance—except that we need you right where you are. The fine work you did
as part of the planning process really demonstrates how much you’ve accomplished.”
“Does that mean we won’t be having these meetings anymore?” “No, Les. I think it’s
important to talk about Projects performance with people throughout the Projects. You all
know how your department fits in and where it has an impact on financial results.
“This year we’ll continue to see how we can improve results and we’ll talk about some other
performance measures that can help us monitor the internal and external environments.
When the marketplace is changing so fast, we don’t want to get caught with our radar
down.”
“Koppala, I want to thank you for all the time you’ve given us this year. It’s great to know
how we measure up financially, and it’s given all of our employees better tools for making
this a stronger and more efficient place to work. I’d really miss these meetings if we gave
them up.”
The Inverted Triangle: Finance From Broad to Specific
245
2007, POME, Gautam_Koppala, All Rights Reserved
In the consideration of financial management topics, the discussion has looked at all aspects
of assets, liabilities, revenues, and expenses and at all aspects of Project Managerial
responsibility.It was clear that the rules of finance apply equally well at the broadest level of
business management and at the individual level, whether in your business role or in your
personal role. The essence of financial management is the same throughout. The conclusion
to this course reiterates this general applicability.
The Projects
In all of our discussion thus far we have looked at issues from a Projects standpoint. The
Projects produces financial information derived from all of the activities of its different parts.
The financial information, in the form of standardized financial statements, summarizes
financial performance and conditions in a manner and following a format that can be
understood by most readers.
Obviously, the performance of the various subsidiaries, divisions, departments, groups, and
individuals that make up the Projects, in aggregate, yield the results that are reported. As we
consider these subparts of the Projects, we see where each impacts the Projects as a whole.
By understanding what each part does and how it contributes to the whole, you should see
where your efforts and actions appear in the financial performance of the Projects and
should, therefore, be able to understand how you influence the results.
Obviously, a part of this consideration involves the responsibility of Project Managers to focus
their efforts on benefiting the Corporation Based Projects and the owners (shareholders) and
creditors of the Corporation Based Projects . Recognizing that every individual also has a
responsibility to work for his or her own benefit and that of his or her family, the Project
Managerial responsibility must be reconciled with the personal responsibility. This results in
the types of problems often described as the “agency” issue. When the Project Manager is
honest, reconciliation is not difficult; if you do a good job for the owners, in terms of
increasing the stockholder value, you will be rewarded with compensation and continued job
opportunity. Unfortunately, however, when the personal goals become too strong, this
priority is reversed, sometimes resulting in actions that benefit the Project Manager at the
expense of the Projects or in causing the Project Manager to falsify the results to make them,
and by association the Project Manager as well, appear better than they are. In the best of
circumstances, the compensation and rewards for Project Managers are aligned with the
benefits to the shareholders, including limitations as to the amount of reward tied to an
individual year’s results. Because Project Managers can manipulate the short-term results,
246
2007, POME, Gautam_Koppala, All Rights Reserved
tying the personal rewards to longer time periods, perhaps in a cumulative way, should result
in better long-term performance.
This naturally leads back to the planning discussions. The better job of planning the Project
Managers do, the more likely it is that the results will turn out as planned. The Project
Managers of the strongest performing companies clearly understand the factors that affect
their businesses and plan for them in the context of their environment. If they carefully
choose Project Managers who understand their responsibilities and develop compensation
and reward systems that motivate appropriate Project Managerial behavior, the businesses
will generally be successful. Companies such as General Electric, Coca-Cola, and Johnson &
Johnson are examples where these relationships have been successfully developed.
This discussion also enables us to consider another concept that affects the consolidation of
the Projects as a whole. In some cases, the work of one segment serves as an input to
another. The results may not always be a situation of simple addition. Consider a subsidiary
that sells to another subsidiary of the same Projects. The selling entity is expected to make a
profit on its efforts so it charges a profit on top of its costs. However, since the two
subsidiaries are within the same Projects, there is no real profit to the Projects as a whole.
Therefore, when two parts of the same Projects sell to each other, the accountants must
eliminate the intraProjects profit. This elimination assures that the consolidated Projects
results are correct. In some of the financial scandals, some of these elimination adjustments
were not made or were not made correctly, resulting in inflated revenues and profits.
The consolidation process takes place outside either subsidiary so that the managements of
each are in a position to assess the performance of their own part of the Projects. This, too,
is important because companies reward their Project Managers on the basis of performance
and should not penalize one management group because it assisted another management
group to meet its goals. The whole area of eliminations and consolidations is an area of
contention and misunderstanding and needs to be managed very carefully.
Related to the concept of consolidation is that of centralization, which is combining specific
functions of a Projects into one centralized center in order to improve Projects efficiency,
enabling the Projects to take advantage of combined resources. A prime example of
appropriate centralization is the cash management function. By bringing all of the cash from
all parts of the Projects into a central control, the cash Project Manager has more cash to
work with, can negotiate better returns by investing larger amounts or for longer periods,
applying the cash most effectively for the entire Projects. To centralize cash effectively, the
247
2007, POME, Gautam_Koppala, All Rights Reserved
Project Manager must understand where and when it will be generated, where and when it
will have to be disbursed, and have proper investment policies in place for when there are
temporary excess amounts to be invested. Nevertheless, it is obvious that focusing cash
management attention brings significant benefits to the Projects. By extension, and this is
key to overall Project Managerial success, other activities, such as distribution, may benefit
from similar centralization efforts. Done properly, centralization improves the efficiency of
the Projects and its operating parts, subsidiaries, and individual locations, permitting them to
concentrate on those activities in which they specialize.
Subsidiary
Each subsidiary of a Projects is generally treated as if it were independent. Each such
Projects has its own goals and objectives, budgets and plans, and all are expected to perform
according to their budgets. They are measured against their plans, against last year, and
sometimes against their competition, in all cases using the financial information they
produce.
All of the detail we have covered in these chapters applies to a subsidiary in exactly the same
manner as it applies to the parent Projects. In most cases a subsidiary has all the assets of
an independent Projects. Sometimes, the parent Projects takes on responsibility for credit
and accounts receivable management. More frequently, it controls the cash of the entity,
metering it out on an as-needed basis. If the parent does control the cash, the cash Project
Manager maintains clear records as to the source of the cash under management, making it
possible to create records that show, on the books of the subsidiary, a “Due from Parent”
account in lieu of cash. A comparable “Due to Subsidiary” account reflects the same balance,
but on the liability side of the parent. It is accounts such as these that are eliminated in
consolidation and that permit the subsidiary to measure its performance just as the parent
Projects measures the performance of the Projects as a whole.
Because subsidiaries compete with each other for capital investment funds, all recommended
projects for capital investment require return on investment computations. Those projects
from among all the divisions that offer the highest return generally get the most favorable
attention.
Sometimes, projects are deemed critical that may offer less return than other projects in
other subsidiaries. The decision to fund one of these is part of the prerogative reserved for
top management. Such decisions, however, do not detract from the validity of the capital
investment decisions criteria.
248
2007, POME, Gautam_Koppala, All Rights Reserved
Clearly, all the points made about planning and budgeting at the corporate level apply
equally at the subsidiary level. The Project Managers of a subsidiary have operating
responsibilities for the subsidiary similar to those of the senior Project Managers of the entire
Projects, only on a smaller and more concentrated scale. Often, a subsidiary has the same
Project Managerial titles as those of the parent Projects. Project Managers at the subsidiary
level prepare the budgets and plans for the subsidiary, which in turn provide the input to the
budgets and plans consolidated for the whole Projects. Similarly, the performance results of
the subsidiary are consolidated with other subsidiaries and operating segments of the
Projects to create the financial and performance reports for the entire entity.
Division
A division is a part of a Projects. As such, it may not have a Balance Sheet. The division often
uses assets that are shared, so attempting to construct a full Balance Sheet is not
meaningful. However, we are still able to report on the performance of the division and focus
attention on several critical aspects of the division’s financial situation.
It is certainly possible to construct a divisional Income Statement, measuring sales, costs,
and expenses, and comparing these results to budget, to prior years, and to other companies
in the same field. Annual budgets for divisions of companies are usually focused on the
income statement and the management of accounts receivable and inventories of the specific
division. If the division is generating increasing sales at higher margins and is controlling its
inventories and accounts receivable, its management will receive high marks from the parent
Projects’ executives.
Divisional planning and budgeting follow the same patterns as those described for the
subsidiaries and are consolidated to form corporate budgets and plans. The performance
results are consolidated as well. Because the division is an integrated part of the Projects, it
generally does not have its own balance sheet, but it does have its own profit and loss
statement, generally drawing at least some of its services and expenses from other parts of
the Projects. Therefore, with divisions, the consolidation process becomes critical in assuring
the accuracy and validity of the corporate financial results. Several of the financial scandals
of the past few years, including Global Crossing and Parmalat, resulted in part from internal
control and consolidation failures.
The performance of the division, reflected in the divisional Income Statement, is measurable
in all of the operating lines of the parent Projects’ Income Statement: sales, cost of sales,
and the individual lines of the operating expense section. It will be harder to attribute
249
2007, POME, Gautam_Koppala, All Rights Reserved
interest expenses to a division because of the shared expenses that remain at the parent
level and because of the shared assets used to generate the sales. For example, if a Projects
uses one manufacturing plant to produce the products for three divisions, it may be very
difficult to separate out responsibility for the cost of the production equipment. Projects cost
accountants compute standard, or expected, product costs and charge the division for those
costs, absorbing variances at the plant and corporate level. If one division sells more than
was anticipated and another sells less than planned, there may or may not be an adjustment
to costs, but such adjustment will be arbitrary.
However, it is possible to measure the use of and cost of working capital. Divisional
management is generally held accountable for the investment in accounts receivable and
inventory related to the division’s customers and products. There may be a “capital
consumption” charge, an attempt to have divisional management recognize the cost of
carrying its working capital assets. The management is also expected to track average
collection period and inventory turnover because these assets are specifically related to the
divisional activities. We also recognized consequences when the unsatisfactory part of the
Projects was sold off and separated from the rest of the Projects.
Divisional capital investment evaluations are typically prepared in conjunction with other
functional areas, such as operations. The division is generally responsible for sales, whereas
the operations function is responsible for production and distribution. Therefore, in a Projects
with a divisional structure, production is often designated as a separate division, the
“manufacturing” division, and capital investment analysis involves input from both entities.
Department
Departments are often responsible for only a small segment of one or a few lines on an
Income Statement. Nevertheless, the specific responsibilities of the department are visible in
the Income Statement of the division, the subsidiary, or even the whole Projects. If it is the
sales department, it is responsible for the top line of the Income Statement—or part of it at
least. There are sales budgets and forecasts, as well as expense budgets to guide the costs
of generating those sales. Individual Project Managers take on responsibility for specific
aspects of the departmental activity whether individual products or sales functions or support
tasks to help achieve the goals. These functions are visible in the composition of the
operations and expectations of the area.
Departmental budgets and measurements are more likely to be expense focused, with
particular attention directed to key expense lines. For example, the advertising department
250
2007, POME, Gautam_Koppala, All Rights Reserved
concentrates on the costs of advertising production and placement, on personnel costs, and
on directly related support costs. There is little or no attention paid to administrative
expense, product cost, or development expense. On the other hand, the research and
development department focuses on laboratory and testing costs, development expense, and
technical research and is only tangentially interested in selling costs or logistics.
Some departments or groups of departments may be considered cost centers, if they only
involve expenses, or profit centers, if they have responsibilities for revenues as well. Cost
centers and profit centers provide another breakdown of the detail within a Projects,
permitting management to understand how the Projects results have been achieved.
Group
As we focus on smaller and smaller economic segments, we look at finer and finer
designations of cost and contribution. The media buying group of the advertising department
is really only interested in the cost of media and the number of placements or contacts
established, and measures its performance on the basis of these, often nonfinancial,
measurements. Success depends on achieving benchmarks tied to the activities of the
narrowly defined group. But here, too, the financial effects of the group are visible in the
financial reports of all the entities above it. The consequences of overspending at the group
level are evident at the department level and so forth. It really does not matter where you
see yourself. It is possible for you to identify how you affect the results of the larger and
larger entities within the Projects.
Individuals
Obviously, this tracing can be taken all the way to the individual working within a group. It is
very important that each member of the group recognize that he or she has a real impact on
the results of the segments to which he or she belongs. If everyone were aware of the effect
brought to the entity, the overall performance would be better, wherever it is measured. This
is the essence of a Project Managerial program called “Open Book Management.”[*] Open
book management is built on the premise that each person has an impact on the financial
success and condition of whatever entity is involved and the more that each person knows
about this the better off the entire organization is. Open book management operates on the
assertion that if an individual, on any level and of any rank, understands how financial
systems work and where they fit in the organization, they will respond by doing their job
better and paying more attention to necessary compared to discretionary or even careless
expenditures.
251
2007, POME, Gautam_Koppala, All Rights Reserved
It is certainly possible to assign each person within a group or department responsibility over
some spending or some task. It is asserted that, given such responsibility, the individual will
do a better job of controlling costs and delivering results and it will be more likely than not
that the people and the entity will deliver the results predicted in the budget. The more you
know, the more likely you are to use the information effectively.
252
2007, POME, Gautam_Koppala, All Rights Reserved
CORPORATE
FINANCING
ACCOUNTS
253
2007, POME, Gautam_Koppala, All Rights Reserved
Corporate Financial Reporting
Corporate Finance
Resource
Mobilisation
Risk Management
Investment
Decisions
Short Term
Financial Financial
Finance
Strategy Derivatives
Long Term
Finance
Physical Financial
Assets Assets
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
254
2007, POME, Gautam_Koppala, All Rights Reserved
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 Lighter Vein:
255
2007, POME, Gautam_Koppala, All Rights Reserved
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.”
POME Lighter Vein:
256
2007, POME, Gautam_Koppala, All Rights Reserved
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.
257
2007, POME, Gautam_Koppala, All Rights Reserved
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.
258
2007, POME, Gautam_Koppala, All Rights Reserved
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
259
2007, POME, Gautam_Koppala, All Rights Reserved
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.
260
2007, POME, Gautam_Koppala, All Rights Reserved
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
261
2007, POME, Gautam_Koppala, All Rights Reserved
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.
262
2007, POME, Gautam_Koppala, All Rights Reserved
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.
263
2007, POME, Gautam_Koppala, All Rights Reserved
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
264
2007, POME, Gautam_Koppala, All Rights Reserved
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
265
2007, POME, Gautam_Koppala, All Rights Reserved
 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
266
2007, POME, Gautam_Koppala, All Rights Reserved
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.
267
2007, POME, Gautam_Koppala, All Rights Reserved
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
268
2007, POME, Gautam_Koppala, All Rights Reserved
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:
269
2007, POME, Gautam_Koppala, All Rights Reserved
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,
270
2007, POME, Gautam_Koppala, All Rights Reserved
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:
271
2007, POME, Gautam_Koppala, All Rights Reserved
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
272
2007, POME, Gautam_Koppala, All Rights Reserved
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.
273
2007, POME, Gautam_Koppala, All Rights Reserved
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.
274
2007, POME, Gautam_Koppala, All Rights Reserved
POME Lighter Vein:
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
275
2007, POME, Gautam_Koppala, All Rights Reserved
 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
2. Income Statement CEO/CFO
3. Free Cash Flow CEO/CFO
Statement
4. Orders CEO/CFO/SBG
Presidents
5. Working Capital CEO/CFO
6. Income Variance CFO/BAP/IR
7. Functional Census & Cost CEO/CFO/Corporate
Sr. VPs/SBG
Functional VPs and FT
Leaders
8. General & Administrative CEO/CFO/Corporate
Expense Sr. VPs
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
276
2007, POME, Gautam_Koppala, All Rights Reserved
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).
277
2007, POME, Gautam_Koppala, All Rights Reserved
278
2007, POME, Gautam_Koppala, All Rights Reserved
Key Financial Metric(s):
Revenue Growth %
Current Period
Net Sales & Operating Revenue – External (FM 410000)
÷ -1
Comparison Period
Net Sales & Operating Revenue – External (FM 410000)
Income Statement Report
279
2007, POME, Gautam_Koppala, All Rights Reserved
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)
Selling & Marketing Expense (S&M) as a % of Sales
Selling and Marketing Expense (FM 571000)
÷
Net Sales & Operating Revenue – External (FM 410000)
General and Administrative (G&A) Expense as a % of Sales
282
2007, POME, Gautam_Koppala, All Rights Reserved
General and Administrative Expense (FM 572000)
÷
Net Sales & Operating Revenue – External (FM 410000)
Total Fixed Cost as a % of Sales
Total Fixed Cost
÷
Net Sales & Operating Revenue – External (FM 410000)
283
2007, POME, Gautam_Koppala, All Rights Reserved
The Total Fixed Cost grouping on the Income Statement Report is made up of all other
operational costs that are not considered variable costs including Corporate approved
adjustments. This cost grouping is used exclusively for internal management reporting
purposes and is only referenced on the Income Statement Report. Total Fixed Cost should
not be confused with the term Fixed Cost of Goods Sold defined in the Corporate
Management Income Statement POME Chapter. Total Fixed Costs is the sum of the following
cost components:
+ Total Fixed Cost of Goods Sold (FM 520000)
+ Other Manufacturing Costs (FM 521600)
+ Distribution & Logistics Expense (FM 530000)
+ Other Operating Expense (FM 540000)
+ Research, Development & Engineering Expense (FM 560000)
+ Selling, General & Administrative Expense (FM 570000)
1
+ Corporate Assessment (COGS) Pre Tax (FM 906240)
1
+ Corporate Assessment (SG&A) Pre Tax (FM 906245)
1
+ Margin Adjustment Pre Tax (FM 906220)
1
+ Defined Pension Adjust Pre Tax (FM 906280)
= Total Fixed Costs
Operating Margin %
Operating Income Measurement Basis (FM 906100)
÷
Net Sales & Operating Revenue – External (FM 410000)
The numerator in this metric calculation is Operating Income Measurement Basis. Within FM,
two calculations are performed to obtain Operating Income Measurement Basis:
1st) + Gross Profit (FM 550000)
– Research, Development & Engineering Expense (FM 560000)
– Selling, General & Administrative Expense (FM 570000)
= Operating Income Pre-Assessment (FM 551000)
2nd) + Operating Income Pre-Assessment (FM 551000)
284
2007, POME, Gautam_Koppala, All Rights Reserved
1
– Corporate Assessment (COGS) Pre Tax (FM 906240)
– Corporate Assessment (SG&A) Pre Tax (FM 906245) 1
1
– Margin Adjustment Pre Tax (FM 906220)
1
– Defined Pension Adjust Pre Tax (FM 906280)
= Operating Income Measurement Basis (FM 906100)
Profit Before Tax (PBT) Margin %
PBT Measurement Basis (Ongoing) (FM 906200)
÷
Net Sales & Operating Revenue – External (FM 410000)
The numerator in this metric calculation is PBT Measurement Basis (Ongoing). Within FM,
two calculations are performed to obtain PBT Measurement Basis (Ongoing):
1st) + Operating Income Pre-Assessment (FM 551000)
2
+ Other Non-Operating Income & (Expense) (FM 600000)
= Profit Before Tax (FM 552000)
2nd) + Profit Before Tax (FM 552000)
1
– Corporate Assessment (COGS) Pre Tax (FM 906240)
1
– Corporate Assessment (SG&A) Pre Tax (FM 906245)
1
– Margin Adjustment Pre Tax (FM 906220)
– Non US Defined Pension Adjust Pre Tax (FM 906280) 1
1
– Income Adjust Pretax (FM 906260)
– Allocated Financing Charge Pre Tax (FM 906270) 1
– Non US Defined Pen Adj Bef Tax-ContraCorp (FM 906290) 1
+ Special Items – Initial (Exp) Pre Tax (FM 906400) 1
+ Special Items - Transfers (Exp) Pre Tax (FM 906410) 1
= PBT Measurement Basis (Ongoing) (FM 906200)
Return on Sales %
285
2007, POME, Gautam_Koppala, All Rights Reserved
Net Income Measurement Basis (Ongoing) (FM 906300)
÷
Net Sales & Operating Revenue – External (FM 410000)
The numerator in this metric calculation is Net Income Measurement Basis (Ongoing). Within
FM, two calculations are performed to obtain Net Income Measurement Basis (Ongoing):
1st) + Profit Before Tax (FM 552000)
– Total Income Taxes (FM 649999)
+ Net Income from Disposed Businesses (FM 680000)
= Net Income (FM 690000)
2nd) + Net Income (FM 690000)
– Corp Assessment After Tax (FM 906340) 1
– Margin Adjustment After Tax (FM 906320) 1
– Non US Defined Pension Adjust After Tax (FM 906380) 1
– Income Adjustment After Tax (FM 906360) 1
– Allocated Financing Charge After Tax (FM 906370) 1
1
+ Special Items After Tax (Exp) – Initial (FM 906450)
+ Special Items After Tax (Exp) - Transfers (FM 906460) 1
= Net Income Measurement Basis (Ongoing) (FM 906300)
Free Cash Flow Statement Report
286
2007, POME, Gautam_Koppala, All Rights Reserved
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
287
2007, POME, Gautam_Koppala, All Rights Reserved
made to recognize the cash outflows as investing activities instead of cash flow from
operations, therefore not impacting FCF.
288
2007, POME, Gautam_Koppala, All Rights Reserved
Key Financial Metric(s):
SBG Free Cash Flow (FCF) Conversion %
Free Cash Flow (FM 992000)
÷
Net Income Measurement Basis (On going) (FM 906300)
The denominator in this metric calculation is Net Income Measurement Basis (Ongoing). The
calculation of this Income Statement component is described in the Income Statement
Report section of this POME Chapter. The numerator in this metric calculation is Free Cash
Flow. The following calculation is performed to report Free Cash Flow by SBG:
+ Net Income Measurement Basis (Ongoing) (FM 906300)
+ Depreciation & Amortization (FM RF912200)
– Capital Expenditures (FM 912100)
+/– Change in Working Capital
+/– Change Other Current Assets
+/– Change Other Accrued Liabilities
+/– Change Other Long Term Assets
+/– Change Other Long Term Liabilities (FM 204993)
+ Cumulative Translation Adjustments on Net Investment & Income Tax
= Free Cash Flow (FM 992000)
Company and Corporate FCF Conversion %:
Free Cash Flow (FM 992000)
÷
Net Income (FM 690000)
The denominator in this metric calculation is Net Income. The calculation of this Income
Statement component is described in the Income Statement Report section of this POME
289
2007, POME, Gautam_Koppala, All Rights Reserved
Chapter. The numerator in this metric calculation is Free Cash Flow. The following
calculation is performed to report Free Cash Flow at the consolidated Company level and
Corporate level:
290
2007, POME, Gautam_Koppala, All Rights Reserved
+ Net Income (FM 690000)
+ Depreciation & Amortization (FM RF912200)
– Capital Expenditures (FM 912100)
+/– Change in Working Capital
+/– Change Other Current Assets
+/– Change Other Accrued Liabilities
+/– Change Other Long Term Assets
+/– Change Other Long Term Liabilities (FM 204993)
+ Cumulative Translation Adjustments on Net Investment & Income Tax
= Free Cash Flow (FM 992000)
The following paragraphs briefly describes the components of Free Cash Flow except for
Working Capital which is described in the Working Capital Report section of this POME
Chapter. For more detailed descriptions of the FM Balance Sheet accounts mentioned, the
COA can be referenced on the Corporate Controller’s web-site via the intranet.
Depreciation & Amortization (FM RF 912200)
Depreciation and Amortization are expenses reported within the Income Statement but are
non-cash items and therefore added back to FCF.
Capital Expenditures (FM 912100)
Capital Expenditures are a use of cash in the period the capital spending is reported.
Other Current Assets
Other Current Assets is made up of the following FM Balance Sheet accounts; the period-
over-period changes in these accounts are used to calculate FCF:
+ Other Current Assets (FM 105000)
+ Legacy Receivables – Current (FM 102983)
+ Financing Receivables (FM 102993)
= Other Current Assets
Other Accrued Liabilities
Other Accrued Liabilities is made up of the following FM Balance Sheet accounts; the period-
over-period changes in these accounts are used to calculate FCF:
291
2007, POME, Gautam_Koppala, All Rights Reserved
+ Non-Income Taxes payable – Current (FM 201987)
+ Current Portion Future Tax Liabilities (FM 201991)
+ Accrued Liabilities (FM 203000)
1
– Dividends Payable (FM 206200)
+ Other Comprehensive Income (FM 304000)
2
– Cumulative Translation Adjustments (FM 304991)
= Other Accrued Liabilities
(1)
Dividends payable is a component of Accrued Liabilities. It is deducted in the above
calculation since dividends are considered part of financing activities.
(2)
Cumulative Translation Adjustments is a component of Other Comprehensive Income. It
is deducted in the above calculation since it is reported as a separate component of FCF.
292
2007, POME, Gautam_Koppala, All Rights Reserved
Two adjustments are made to calculate the change in Other Accrued Liabilities:
+ Special Items– Initial (Expense) Pre Tax (FM 906400)
+ Special Items –Transfers (Expense) Pre Tax (FM 906410)
+ Tax Adjustments
= Other Accrued Liabilities Adjustments
Special Items– Initial (Expense) Pre Tax (FM 906400) and Special Items –Transfers
(Expense) Pre Tax (FM 906410) capture Corporate approved non-recurring adjustments. As
an example, business units initially record repositioning charges in their General Ledger
Income Statement and Balance Sheet with the following journal entry for the repositioning
expense:
Special Items Before Tax (Expense) - Initial XX
Other Accrued Liabilities XX
Corporate sponsored repositioning charges are reported on the Corporate level Income
Statement and not at the SBG level. This adjustment is made to back out the increase in
liabilities on the SBG’s Balance Sheet consistent with Measurement Net Income, which
excludes the income impact of the Special Items.
Tax Adjustments include two adjustments for taxes to properly reflect SBG FCF. For the SBG
FCF calculation, the result is that the tax provision is treated as “paid”.
#1) The period-over-period changes in these Tax FM Balance Sheet accounts are
included in Other Accrued Liabilities and therefore adjusted in the FCF
statement:
+ Income Taxes Receivable – Current (FM 102987)
+ Current Deferred Income Tax Assets (FM 104000)
+ Def. Income Taxes Asset – Long Term (FM 109000)
+ Current Income Taxes Payable (FM 201985)
+ Current Deferred Income Taxes Payable (FM 201986)
+ Long Term Tax Liabilities (FM 204992)
= Tax Liability Adjustment to Other Accrued Liabilities
293
2007, POME, Gautam_Koppala, All Rights Reserved
#2) The following adjustments are made to Other Accrued Liabilities to recognize the
tax provision (expense) at the SBG level as the tax cash payment:
– Total Income Taxes (FM 649999)
– Total Income Tax Payments (FM 914825)
+ Adj. To Alloc. Tax Pymnts (FM 914890)
= Tax Payment Adjustment to Other Accrued Liabilities
294
2007, POME, Gautam_Koppala, All Rights Reserved
Other Long Term Assets
Other Long Term Assets is made up of the following FM Balance Sheet accounts; the period-
over-period changes in these accounts are used to calculate the FCF:
+ Investments (FM 111000)
+ Long Term Financing Receivables (FM 107992)
+ Long Term Legacy Receivable (FM 107993)
+ Property, Plant and Equipment (FM 108000)
+ Intangible Assets (FM 110000)
+ Other Long Term Assets (FM 113000)
+ Prepaid Pension Cost – Long Term (FM 114000)
= Other Long Term Assets
Because Capital Expenditures, Depreciation and Amortization are reported on the FCF
statement separately, these items are adjusted out of Other Long Term Assets. The current
period expenses are used in the following accounts:
+ Capital Expenditures (FM 912100)
+ Depreciation of PP&E (FM 912200)
+ Total Amortization (FM 913000)
= Adjustment to Other Long Term Assets
Other Long Term Liabilities (FM 204993)
The period-over-period change in this FM Balance Sheet account is used to calculate FCF.
Cumulative Translation Adjustments (CTA) on Net Investment and Income Tax
Cumulative Translation Adjustments (FM 304991) is a component of Other Comprehensive
Income. This account captures the adjustments resulting from the translation of financial
statements from an operating unit's functional currency (i.e., Euro, GBP, JPY) into the US$
reporting currency. CTA on net investment and tax balances are included in FCF to offset the
non-cash changes in the related Balance Sheet accounts. The adjustment is made by
including the current period expense in these accounts:
+ CTA Net Investment (FM 926100)
+ CTA Income Tax Accounts (FM 926130)
= FCF Cumulative Translation Adjustments
295
2007, POME, Gautam_Koppala, All Rights Reserved
Orders Report
Short Cycle Orders Report
Long Cycle Orders Report
296
2007, POME, Gautam_Koppala, All Rights Reserved
The Orders Report provides high-level new orders and backlog orders information by SBG
and SBU. As defined in this report, “orders” are sales revenues from customer orders
received. Based on the nature of the sales cycle of Company’s lines of business, two
separate reports are issued: Short Cycle Orders Report and Long Cycle Orders Report. The
data that is captured in these reports are compiled from each SBG’s corresponding ERP
system.
The Short Cycle Orders Report captures new orders by SBG and for specific SBUs whose
sales cycle is short. The report includes actual orders received Quarter-to-date (QTD), an
orders forecast for the full quarter; and shows comparisons vs. latest forecast, and Prior Year
(PY). The Short Cycle Order Report is a weekly report.
The Long Cycle Orders Report captures backlog orders information by SBG and for specific
SBUs whose sales cycle is long, as in the case where sales are tied to long-term contracts.
The report includes backlog orders by month from the beginning of the current year; and
shows comparisons vs. PY. The Long Cycle Orders Report is a monthly report.
297
2007, POME, Gautam_Koppala, All Rights Reserved
Key Financial Metric(s):
The following metrics are captured in the Short Cycle Orders Report:
QTD Current Year (CY ) vs. PY %
 Current Quarter Orders Received QTD 
 
 ÷  −1
 
 PY Quarter Orders Received QTD 
QTD % Complete vs. PY % Complete
 (Current Quarter Orders Received QTD/latest forecast Full Quarter Orders)
 
 ÷  −1
 (PY Quarter Orders Received QTD/PY Full Quarter Orders) 
 
Current Quarter Run Rate
PY Full Quarter Order x (1 + Average Daily Orders Rate %)
298
2007, POME, Gautam_Koppala, All Rights Reserved
Within this metric calculation, the Average Daily Order Rate (ADOR) % is calculated as
follows:
 (Current Quarter Orders Received QTD/QTD Working Days) 
 
 ÷  −1
 
 (PY Quarter Orders Received QTD/ LY QTD Working Days) 
Required Daily Orders To Make QTR
 (Latest forecast Full Quarter Orders - Current Quarter Orders Received QTD )
 
 ÷ 
 Remaining Working Days of the Quarter 
 
The following metric is captured in the Long Cycle Orders Report:
Current Month Ending Backlog
+ Ending backlog last month
+ New orders
– Shipments
+ Other Orders
= Current Month Ending Backlog
Working Capital Report
299
2007, POME, Gautam_Koppala, All Rights Reserved
300
2007, POME, Gautam_Koppala, All Rights Reserved
The monthly Working Capital (WC) Report shows overall working capital performance for
each SBG as well as total Company (excluding working capital balances from Corporate).
The report includes:
• Graphical summaries of Working Capital balances, WC metrics (13 Point working
capital turns, DSO, DOS and DPP) and WC components (Inventory, Receivables and
Payables & Advances). Comparisons are shown versus latest forecast, AOP and PY.
• Working Capital balances and WC components (Inventory, Receivables and Payables &
Advances) in absolute values for the current month. Comparisons are shown versus
latest forecast, AOP and PY.
The components of Working Capital are direct extracts from Balance Sheet accounts but do
require some POME Chapter adjustments. Since Working Capital performance focuses on the
cash producing activities of the operations, adjustments identified as Cash Flow Blocks are
made to capture the impact of certain events such as acquisitions, divestitures and inter-
company Balance Sheet transfers. These events may have a favorable or unfavorable impact
to cash that inaccurately reflects the real cash generation capacity of the business unit
operations. For example, in the case of an acquisition where the purchase price includes
working capital balances, an adjustment is made to recognize the cash outflows as investing
activities instead of a use of cash flow from operations.
For the purposes of evaluating WC, 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.
Key Financial Metric(s):
Working Capital (FM 924100)
+ Working Capital Receivables (FM 921500)
+ Inventories (FM 103000)
– Accounts Payables & Customer Advances (FM 923000)
= Working Capital (FM 924100)
301
2007, POME, Gautam_Koppala, All Rights Reserved
Within this metric calculation, Working Capital Receivables is a calculation of the following FM
Balance Sheet accounts:
+ Current Receivables (FM 102000)
– Discounted Trade Accounts Receivables (FM 102104)
– Discounted Trade Notes Receivables (FM 102108)
– Legacy Receivables - Current (FM 102983)
– Income Taxes Receivable – Current (FM 102987)
– Long Term Financing Receivables (FM 107992)
– Financing Receivables (FM 102993)
+ Long Term Receivables (FM 107000)
– Long Term Legacy Receivables (FM 107993)
= Working Capital Receivables (FM 921500)
Accounts Payables & Customer Advances is the summation of the following FM Balance Sheet
accounts:
+ Trade Payables (FM 201100)
+ Customer Advances and Deferred Income (FM 202000)
= Accounts Payables & Customer Advances (FM 923000)
Working Capital Turns 13 Point Average (FM 924110)
Recent 12 months External Sales (FM 920110)
÷
Working Capital 13 Months Average (FM 924105)
The Recent 12 Months External Sales is the summation of the last 12 months of external
sales captured in the Income Statement within Net Sales & Operating Revenue – External
(FM 410000) account. The Working Capital 13 Months Average is calculated by taking the
last 13 months ending Working Capital (FM 924100) balances and dividing by 13.
Days Sales Outstanding (DSO)
302
2007, POME, Gautam_Koppala, All Rights Reserved
Days Sales Outstanding (DSO) is an operational metric that designates the number of days
invoices remain in the receivables balance. DSO is calculated using the “back out” method.
There is a current month calculation as well as a three-month average which is the last
three months divided by three. Both metrics are calculated but only the 3-month average
metric is used for management reporting purposes.
The following is an example of the DSO calculation for December month end:
There are three DSO metrics that are used to measure Working Capital Receivables month
end performance:
• Days Sales Outstanding with Unbilled (FM 921900)
• Days Sales Outstanding without Unbilled (FM 921980)
• DSO Cash In (FM 921925)
The corresponding 3-month average DSO metrics are:
• DSO With Unbilled 3mo Avg. (FM 921950)
• DSO Without Unbilled 3mo Avg. (FM 921985)
• DSO Cash In 3mo Avg. (FM 921975)
303
2007, POME, Gautam_Koppala, All Rights Reserved
Days Sales Outstanding with Unbilled (FM 921900)
This metric measures the healthiness of receivables driven by sales of both short cycle and
long cycle businesses.
The components are Adjusted Trade Receivables with Unbilled (FM 921700) and Adjusted
External Sales for DSO (FM 920120).
Adjusted Trade Receivables with Unbilled is calculated as follows within FM:
+ Trade & Note Receivables - Current (FM 102991)
– Discounted Trade Accounts Receivables (FM 102104)
– Discounted Trade Notes Receivables (FM 102108)
= Adjusted Trade Receivables with Unbilled (FM 921700)
Adjusted External Sales for DSO captures the true up to sales for VAT (Value Added Tax)
taxes, since the receivable balances captures this tax for businesses that sell in regions and
countries where VAT is imposed. Sales reported in the Income Statement excludes VAT
taxes. The following calculation is performed within FM for Adjusted External Sales for DSO:
+ Net Sales & Operating Revenue – External (FM 410000)
+ Ext Sales Adjustments for DSO (FM 921450)
= Adjusted External Sales for DSO (FM 920120)
Days Sales Outstanding without Unbilled (FM 921980)
This metric measures the healthiness of trade receivables primarily driven by sales of short
cycle businesses excluding the impact of unbilled revenues driven by long cycle businesses.
The components are Receivables W/O Unbilled and Discounted (FM 921100_d) and Adjusted
External Sales for DSO (FM 920120) as described previously.
Receivables W/O Unbilled and Discounted is calculated as follows within FM:
304
2007, POME, Gautam_Koppala, All Rights Reserved
+ Trade & Note Receivables - Current (FM 102991)
– Discounted Trade Accounts Receivables (FM 102104)
– Discounted Trade Notes Receivables (FM 102108)
– Unbilled Receivables (FM 102972)
= Receivables W/O Unbilled and Discounted (FM 921100_d)
DSO Cash In (FM 921925)
This metric measures the overall cash generating capacity of the business by capturing the
cash collected through customer cash advances/deferred income and netting these amounts
against trade receivables and unbilled balances to determine the overall “cash in” position of
the company. This DSO metric is more aligned with Customer-to-Cash strategies by focusing
cash collection efforts on initiatives that have a greater net cash impact to the business.
The components are Adjusted Trade Receivables Cash In (w Unbilled and Advances) (FM
921725) and Adjusted External Sales for DSO (FM 920120) as described previously.
305
2007, POME, Gautam_Koppala, All Rights Reserved
Adjusted Trade Receivables Cash In (w Unbilled and Advances) is calculated as follows
+ Trade & Note Receivables – Current (FM 102991)
– Discounted Trade Accounts Receivables (FM 102104)
– Discounted Trade Notes Receivables (FM 102108)
– Customer Advances and Deferred Income (FM 202000)
= Adjusted Trade Receivables Cash In (w Unbilled and Advances)
(FM 921725)
Past Due Receivables (FM 921200)
+ Receivable Past Due 1-30 (FM 921120)
+ Receivable Past Due 31-60 (FM 921130)
+ Receivable Past Due 61-90 (FM 921140)
+ Receivable Past Due 91-180 (FM 921150)
+ Receivable Past Due 181-365 (FM 921160)
– Receivable Past Due 365+ (FM 921170)
= Past Due Receivables (FM 921200)
Past Due Receivables are those receivables that customers have not paid on time.
Past Due Receivables % (FM 921250)
Past Due Receivables (FM 921200)
÷
Trade Receivables without Unbilled and Discounted (FM 921100)
Trade Receivable without Unbilled and Discounted is a calculation of the following FM Balance
Sheet accounts:
+ Trade & Note Receivables – Current (FM 102991)
– Discounted Trade Accounts Receivables (FM 102104)
– Discounted Trade Notes Receivables (FM 102108)
– Unbilled Receivables (FM 102972)
306
2007, POME, Gautam_Koppala, All Rights Reserved
= Trade Receivables without Unbilled and Discounted (FM 921100)
Days of Supply (DOS) (FM 922600)
Days of Supply (DOS) is an operational metric that designates the number of days products
remain in the inventory balance. DOS is calculated using the “back out” method. There is a
current month calculation (FM 922600) as well as a three-month average (FM 922610) which
is the last three months divided by three. Both metrics are calculated but only the 3-month
average metric is used for management reporting purposes.
The following is an example of the DOS calculation for December month end:
The components of DOS are Product Gross Inventory (FM 922200) and Cost of Goods Sold
(FM 500000).
The Product Gross Inventory is different than the Working Capital Inventory mainly due to
the exclusion of Rotable Inventories, Contracts in Progress – Engineering, Stores Inventory
and LIFO Pools. The following calculation is performed within FM for Product Gross
Inventory:
+ Inventories Related to Cost of Sales (FM 103991)
– Progress Payments – Production Inventory (FM 103114)
+ Contract Inventory (FM 103500)
– Service Inventory: Progress Payments – Contracts (FM 103502)
307
2007, POME, Gautam_Koppala, All Rights Reserved
+ Inventory Other (FM 103600)
– InterCo out of Balance Trade Rec/Pay (FM 134390)
– Stores Inventory (History Only) (FM 134100)
– Non-Product Related Inventory (FM 103603)
+ Inventory Reserves (FM 103200)
– Inventory Reserves – LIFO (FM 103280)
= Product Gross Inventory (FM 922200)
Cost of Goods Sold is an FM Income Statement account and is a summation of the following
accounts:
+ Total Variable Cost of Goods Sales (FM 510000)
+ Total Fixed Cost of Goods Sold (FM 520000)
+ Other Manufacturing Costs (FM 521600)
+ Distribution & Logistics Expense (FM 530000)
+ Other Operating Expense (FM 540000)
= Cost of Goods Sold (FM 500000)
Days Purchases in Payables (DPP) (FM 923400)
Days Purchases in Payables (DPP) is an operational metric that designates the number of
days supplier invoices remain in the payables balance. DPP is calculated using the “back out”
method. There is a current month calculation (FM 923400) as well as a three-month average
(FM 923410) which is the last three months divided by three. Both metrics are calculated
but only the 3-month average metric is used for management reporting purposes.
The following is an example of the DPP calculation for December month end:
308
2007, POME, Gautam_Koppala, All Rights Reserved
The components of DPP are Trade Payables (FM 201100) and Cost of Goods Sold (FM
500000).
Income Variance Report
The Income Variance Report shows period over period changes to Operating Income
Measurement Basis. The report is mainly an analytical tool facilitating detailed visibility into
business performance. The components of income variance are: 1) Price, 2) Inflation, 3)
Acquisitions / Divestitures, 4) Volume, 5) Foreign Exchange, 6) Mix, and 7) Productivity.
309
2007, POME, Gautam_Koppala, All Rights Reserved
The report is segmented by major Income Statement line items down to Operating Income
and is maintained within FM. The report format is an income walk beginning with a “Prior”
(or Base) period data point and walks through each component of income variance to a
“Current” (or End) period data point.
Key Financial Metric(s):
Price Variance
This variance captures the period over period change in the selling amount of all goods
and/or services. To isolate the impact of price, all other variables (i.e., changes in volumes)
must be held constant. As a rule, Price variance must be the same amount reported on both
Revenue and Operating Income variance analyses.
310
2007, POME, Gautam_Koppala, All Rights Reserved
The following is an example of the Price Variance calculation:
The 2005 Price Variance of Product C is equal to (€39) based on a price change of
(€0.44/Unit) x 2005 volume of 88 units. Note: The total average price change (0.76)
cannot be multiplied x the Current Period Volume, due to potential impact of changes in Mix.
The formula for calculating Price Variance is:
(Prior Period Price / Unit – Current Period Price / Unit) x Current Period Volume
Inflation Variance
This variance captures the period over period change in the actual purchase price of input
goods and services. Inflation is typically segregated into two buckets: Material and Non-
material. To isolate the impact of inflation, all other variables (i.e., changes in volumes)
must be held constant.
Material inflation captures the actual period over period change in purchase price of parts
and raw materials. Gains or losses in commodity hedging contracts are captured in materials
inflation. An exception to simply capturing this actual price change is to exclude the impact
of a real price reduction resulting from a negotiated price decrease, which is reported under
Productivity. If pricing remains flat as a result of pricing negotiations regardless of whether
311
2007, POME, Gautam_Koppala, All Rights Reserved
market prices have increased overall, this effect will still be captured under Inflation and not
Productivity.
Non-material inflation captures all other period over period purchase price changes.
312
2007, POME, Gautam_Koppala, All Rights Reserved
The following is an example of the Inflation Variance calculation:
The 2005 Inflation Variance of Phenol is $12,000,000 based on a cost change of ($0.10/Unit)
x CY unit volume of 120,000,000 units.
The formula for calculating Inflation Variance is:
(Prior Period Cost/Unit − Current Period Cost/Unit ) × Current Period Volume
Acquisition / Divestitures Variance
This variance captures isolates the period over period change in sales, costs, etc., related to
the purchase or sale of a business.
Volume Variance
This variance captures the period over period change in the number of units of like products
sold over comparison periods, holding all other variable constant such as Price, Mix and
Foreign Exchange. When comparing multiple products, product lines, market segments, or
lines of business, values must be calculated using total volume change and total prior period
price in order to eliminate the Mix impact.
313
2007, POME, Gautam_Koppala, All Rights Reserved
The following is an example of Revenue Volume Variance calculation:
The 2005 Volume Variance of the total Product Line is €643 based on the total volume
change of 129 Units x 2004 average price per unit of €4.97.
The formula for calculating Revenue Volume Variance is:
 Current Period Volume 
 
 −  × Prior Period Avg. Price/Unit of total Product Line
 
 Prior Period Volume 
The impact of volume variance on Operating Income is calculated in the following formula,
explicitly excluding the impact of Volume Leverage which is captured under Productivity:
Revenue Volume Variance x Prior Period OM% = Volume Variance at Operating
Income
For example, if the prior period Operating Margin % is 15%, then the Volume Variance at
Operating Income would be €96 using the Revenue Volume Variance of €643.
Foreign Exchange (FX) Variance
314
2007, POME, Gautam_Koppala, All Rights Reserved
This variance captures the impact of currency translation on the operational performance of
an operating entity whose ‘functional’ currency is different from the USD dollar reporting
currency. A functional currency is the currency in which the entity bills its’ customers and
pays for its goods and services (i.e., Euro for a business unit operating in France). The goal
of this variance is to isolate the impact of foreign exchange holding all other variables
constant. Since an operating entity has little to no control over foreign exchange
fluctuations, it should not be favorably nor unfavorably measured when its’ ‘functional
currency’ has strengthened or weakened versus the USD dollar.
The following is an example of the FX Variance calculation:
The 2005 Foreign Exchange Variance of Revenues is US $1,103 based on the FX change of
($0.22 USD$/Euro) x 2005 Revenues in Euros of €5,014.
The formulas for calculating FX Variance for Revenues and Costs are:
Revenue FX Variance :
 Current Period FX Rate 
 
 −  × Current Period Functional Currency Sales
 
 Prior Period FX Rate 
Cost FX Variance :
 Current Period FX Rate 
 
 −  × Current Period Functional Currency Cost
 
 Prior Period FX Rate 
315
2007, POME, Gautam_Koppala, All Rights Reserved
Mix Variance
Mix is the number and types of products sold within a business. This variance captures the
period over period change in share of product volumes sold relative to the volume of other
products sold within the product portfolio. Stated more simply, mix is selling more volume of
Product A and less volume of Product B, where each product has different selling prices and
product margins. Volume refers to the quantity of units sold; units can refer to products or
services. Based on the business, mix can be calculated at the market segment level, product
line or line of business.
316
2007, POME, Gautam_Koppala, All Rights Reserved
The formula for calculating Mix is a two-step approach:
1st Step: Calculate the Mix impact on Average Selling Price
The 2004 Average Selling Price is negatively impacted by (€0.79/Unit) due to changes in
product mix. Conceptually, Product C which has the highest selling price shows a large
decrease in volume as a percentage of the total volume sold causing the average selling price
to decrease.
2nd Step: Calculate the Mix variance utilizing the Average Selling Price calculated from
Step 1.
317
2007, POME, Gautam_Koppala, All Rights Reserved
The 2005 Mix Variance of the total Product Line is (€937) based on an Average Selling Price
variance of (€0.79/Unit) x 2005 Volume of 1,191 units.
To calculate the Mix impact on Operating Income, the same two-step approach is used to
calculate the impact on Average Product Costs (using variable product costs) due to changes
in Mix. Combining the Mix impact on Average Selling Price and Average Product Cost results
in the change of variable contribution and operating income.
Productivity Variance
Productivity can be simply explained as generating more revenue or production volume using
the same or less cost. This variance captures the period over period change in output per
unit of input (e.g. labor, equipment and capital), generally a cost improvement.
The following is a simple example illustrating Productivity:
During 2004, the business generated $100M in revenue and $20M in operating income.
During 2005, the business generated $100M in revenue and $25M in operating income.
Assuming no change in price or volume and zero inflation, the incremental income was
generated through Productivity.
There are three categories of Productivity: 1) Volume Leverage, 2) Project Savings, and 3)
Other Productivity.
1. Volume Leverage
Volume Leverage is the amount of decreased (or increased) cost below Variable Contribution
versus changes in Revenue. Theoretically, as sales increase, fixed costs (i.e., Fixed
Manufacturing Overhead, RD&E, Selling & Marketing, G&A) should not increase and this
considered volume leverage.
318
2007, POME, Gautam_Koppala, All Rights Reserved
The following is an example of Volume Leverage calculation:
The Volume Leverage is $70,000 based on increased sales volume of 25%. Volume Leverage
results in Productivity by doing more with less or equivalent cost.
2. Project Savings
This productivity variance captures the impact of cost savings initiatives such as Company
Operating System (OS), Functional Transformation (FT), Six Sigma and any identifiable
material savings initiatives.
Examples of Project Savings:
319
2007, POME, Gautam_Koppala, All Rights Reserved
1) An OS pilot site expects to lower its overall manufacturing cost by implementing standard
work processes and lean principles. As a result, the project will save the business $500K.
This benefit would be captured as OS productivity savings.
2) A business’ HR organization is undergoing a major transformation. One of the strategies
is to outsource transactional type processes. As a result of the outsourcing, the business
will save $100,000. These benefits are captured under FT productivity savings.
3. Other Productivity
This productivity variance captures either cost increases or savings that are not captured
under Volume Leverage or Project Savings including Repositioning projects.
Examples of Other Productivity Savings:
1) A Plant Controller corrected an accounting error that reduced fixed manufacturing cost by
$250,000. This would be Other Productivity.
2) A facility operates at 75% capacity due to low sales demand, no change is expected in
the future. The Plant Manager and Plant Controller receive repositioning funds from
Corporate and labor cost is reduced by $500,000. This savings is recorded Other
Productivity.
Functional Census & Cost Report
320
2007, POME, Gautam_Koppala, All Rights Reserved
321
2007, POME, Gautam_Koppala, All Rights Reserved
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):
322
2007, POME, Gautam_Koppala, All Rights Reserved
Functional Cost as % of Revenue
Net Functional Cost
÷
Net Sales & Operating Revenue – External (FM 410000)
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.
323
2007, POME, Gautam_Koppala, All Rights Reserved
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
324
2007, POME, Gautam_Koppala, All Rights Reserved
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 revenue is 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.
325
2007, POME, Gautam_Koppala, All Rights Reserved
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
326
2007, POME, Gautam_Koppala, All Rights Reserved
• 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
327
2007, POME, Gautam_Koppala, All Rights Reserved
- 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
328
2007, POME, Gautam_Koppala, All Rights Reserved
• 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
329
2007, POME, Gautam_Koppala, All Rights Reserved
• 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
330
2007, POME, Gautam_Koppala, All Rights Reserved
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.
331
2007, POME, Gautam_Koppala, All Rights Reserved
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.
Investment Decisions
Physical Assets Financial Assets
Fixed Variable
Technical Financial Income Income
Feasibility Viability Security Security
Capital
Budgeting
Techniques
• 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.
332
2007, POME, Gautam_Koppala, All Rights Reserved
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
General and Administrative Expense (FM 572000)
÷
Net Sales & Operating Revenue – External (FM 410000)
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
Indirect Spend Report
HON FY QTD YTD
2007 2007 V 2007 V 2007
Major Categories ($M) 2006 Act V PY V AOP Act V PY V AOP
AOP Target Target Target
T&E 418 424 417 72 2 (3) (5) 168 5 4 1
Purchased Labor 423 428 424 67 (7) (2) (3) 162 (21) 3 1
Professional / Purchased Services 821 804 800 117 18 14 13 313 15 20 18
Employee Related 208 205 203 30 7 3 2 85 (7) 1 (1)
Telecommunications 153 159 157 28 (2) (2) (2) 67 (4) (2) (3)
MarCom 184 194 189 37 (6) (2) (3) 78 (8) (1) (4)
Computer Hardware / Software 184 178 177 24 7 4 3 69 7 2 2
Operating Supplies 497 487 482 77 8 8 7 197 6 11 9
Office Supplies 72 67 66 11 1 (1) (1) 29 1 (2) (2)
Utilities / Energy 400 426 423 68 (5) (1) (2) 172 (3) 0 (1)
Lease / Rentals 404 405 397 67 0 (2) (3) 167 0 (3) (6)
Repair & Maintenance 396 385 382 68 (8) (7) (7) 165 (8) (6) (8)
Insurance 68 67 66 12 2 (1) (1) 33 (4) (5) (5)
Freight (In / Out) 651 667 657 107 (8) (6) (8) 272 (11) (9) (12)
Other 127 118 94 16 5 5 2 51 (5) (5) (15)
Total Indirect Spend 5,005 5,015 4,932 799 13 7 (7) 2,029 (35) 8 (25)
Sales 31,367 32,806 32,806 5,021 419 84 84 13,062 1,075 382 382
% of Sales 16.0% 15.3% 15.0% 15.9% 1.7% 0.4% 0.1% 15.5% 1.1% 0.5% 0.3%
2007 Run-Rate* 5,023 (18) (8) (91)
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).
333
2007, POME, Gautam_Koppala, All Rights Reserved
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.
Key Financial Metric(s):
Run Rate
Year To Date Spend
÷ * 52 Weeks
Number of Weeks
The report is based on the following Corporate approved Indirect Spend Categories:
334
2007, POME, Gautam_Koppala, All Rights Reserved
Indirect Spending Categories
Major Categories Category Descriptions
T&E Travel & Entertainment, Meeting Expense
Purchased Labor Subcontract Labor, Temporary Workers (e.g. Manpower)
Professional/Purchased Services Legal, Consultants, Audit/Accounting, IT, Professional Services, Janitorial, Landscaping, Security, Facilities, etc.
Employee Related Relocation, Training, Reward & Recognition, Educational Assistance
Telecommunications Telecommunications, Excludes GTS Allocations
MarCom Marketing & Communications
Computer Hardware / Software Computer Hardware & Software, Computer Hardware and Software Repair and Maintenance, Excludes GTS Allocation
Operating Supplies Manufacturing Consumables, Industrial Supplies, Factory Supplies
Office Supplies Office Supplies & Equipment
Utilities / Energy All Energy, Electric, Gas, Water, Any Other Utility Expense
Lease / Rentals Cars/Fleet, Office Equipment, Office Space, Aircrafts
Repair & Maintenance Repair & Maintenance, MRO, Building Grounds Equipment Maintenance
Insurance Insurance Excluding Risk Management Bills and Charges from Corporate
Freight (In / Out) Inbound and Outbound
Other Memberships, Subscriptions, All Other
Exclude:
Any allocations from Corporate, Shared Services, GTS, GCTS, Spend Should Be Reported By the Source
Allocations
Organization
Contributions All Contributions
Tax All taxes
Risk Management bills - property, worker's compensation, Nuclear Liability, Marine Cargo & Hull Liability,
Insurance Aviation Product & Hull Liability, Excess Liability, General and Personal Liability, International Casualty Liability
and Business Interruption
Packaging Supplies (Corrugated) Product Packaging
Other Exclusions Direct/Raw Materials
ACS & UOP Project Spend
Direct-Charged Subcontract Labor
Aero Direct-Charged Spend (Outside of Department Expenses)
Capital
Legal Settlements
Charitable Contributions/Donations
Grants
Patent Fees and Awards
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:
335
2007, POME, Gautam_Koppala, All Rights Reserved
Conversion Costs Categories
Major Categories Category Descriptions / Sub-category Indirect Production Non-Prod. Control. Uncontroll.
1 Plant Labor
1) Manufacturing Labor X X
- Touch Labor
- Non-Touch Labor
2) Non-Manufacturing Labor X X
2 Direct-Charged Costs Manufacturing Sub-contract Labor/Services X X
3 Employee Expenses
1) T&E X X
2) Employee Related X X
4 Supplies & Services
1) Purchased Labor X X
2) Professional/Purchased Services X X
3) Telecommunications X X
4) Computer Hardware / Software X X
5) Operating Supplies X X
6) Office Supplies X X
5 Utilities / Energy All Energy, Electric, Gas, Water, Any Other Utility Expense X X
6 Lease / Rentals Cars/Fleet, Office Equipment/Space, Factory Space, Machining Equipment X X
7 Repair & Maintenance Repair & Maintenance, MRO, Building Grounds Equipment Maintenance X X
8 Taxes, Insurance, Deprec. & Softwar Amort.
1) Taxes X X
2) Insurance X X
3) Depreciation X X
4) Software Amortization X X
9 Materials Handling Product Packaging (Inventoriable Cost) & Raws/Production parts warehousing costs X X
10 Other Memberships, Subscriptions, All Other X X
Exclude:
Pro-rate and Transfers Any allocations from Corporate, Shared Services, GTS, GCTS, Spend Should Be
Reported By the Source Organization
Contributions Charitable Contributions/Donations
Marcom Marketing & Communications, Advertising X
Distribution and Logistics Warehousing costs; Lease or rental costs of Railcars, Tractors, Tankers,
Shipping Containers, etc.; and Logistics labor costs including employee related
costs, All Associated with Post Manufactured Goods
Freight (In / Out) Inbound and Outbound (Standard and Premium) X
Direct/Raw Materials Including Associated Duties and Taxes
Patent and Royalties Licensing Fees
Bad Debt
Warranty
Prototype
ACS Project and Services Spend, UOP Equipment Business and Services Spend
Capital
Legal Settlements
Grants
SM Production Catalyst
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:
336
2007, POME, Gautam_Koppala, All Rights Reserved
337
2007, POME, Gautam_Koppala, All Rights Reserved
Conversion Costs with Sub-category Descriptions
Categories Category Descriptions Indirect Production Non-Prod. Control. Uncontroll.

1 Manufacturing Labor Incurred Salary, Fringe & Overtime X X


2 Non-Manufacturing Labor Incurred Salary, Fringe & Overtime (Plant Finance, ISC, HR, IT & Equipment Main.) X X
3 Direct-Charged Costs Manufacturing Sub-contract Labor/Services X X
4 T&E Travel & Entertainment, Meeting Expense X X
Non-Manufacturing Sub-contract Labor, Temporary Workers (e.g. Manpower) (Excludes
5 Purchased Labor Equipment Maintenance) X X
6 Professional/Purchased Services Legal, Consultants, Audit/Accounting, IT Services, Janitorial, Landscaping, Security, Facilities, X
etc. X
7 Employee Related Relocation, Training, Reward & Recognition, Educational Assistance X X
8 Telecommunications Telecommunications (Excludes GTS Allocations) X X
Computer Hardware & Software, Computer Hardware and Software Repair and Maintenance
9 Computer Hardware / Software (Excludes GTS Allocations) X X
10 Operating Supplies Manufacturing Consumables, Industrial Supplies, Factory Supplies X X
11 Office Supplies Office Supplies & Equipment X X
12 Utilities / Energy All Energy, Electric, Gas, Water, Any Other Utility Expense X X
13 Lease / Rentals Cars/Fleet, Office Equipment/Space, Factory Space, Machining Equipment X X
14 Repair & Maintenance Repair & Maintenance, MRO, Building Grounds Equipment Maintenance X X
15 Taxes Property, Excise, Use, Sundry, etc. X X
16 Insurance Insurance Excluding Risk Management Bills and Charges from Corporate X X
17 Depreciation Property, Plant and Equipment X X
18 Software Amortization Capitalized Software X X

19 Materials Handling Product Packaging (Inventoriable Cost) & Raw materials/Production parts warehousing costs X X
20 Other Memberships, Subscriptions, All Other X X

Exclude:
Pro-rate and Transfers Any allocations from Corporate, Shared Services, GTS, GCTS, Spend Should Be
Reported By the Source Organization
Contributions Charitable Contributions/Donations
Marcom Marketing & Communications, Advertising X
Distribution and Logistics Warehousing costs; Lease or rental costs of Railcars, Tractors, Tankers, Shipping
Containers, etc.; and Logistics labor costs including employee related costs, All
Associated with Post Manufactured Goods
Freight (In / Out) Inbound and Outbound (Standard and Premium) X
Direct/Raw Materials Including Associated Duties and Taxes
Patent and Royalties Licensing Fees
Bad Debt
Warranty
Prototype

Other Exclusions
ACS Project and Services Spend, UOP Equipment Business and Services Spend
Capital
Legal Settlements
Grants
SM Production Catalyst
IV. Other Financial Metrics
Revenue / Operating Income Conversion %
  Current Period  
   
  Operating Income Measuremen t Basis (HFM 906100) -  
  Comparison Period  
   
  Operating Income Measuremen t Basis (HFM 906100)  
 
 ÷ 
 Current Period 
 
  Net Sales & Operating Revenue - External (HFM 410000) - 
 Comparison Period 
 
 
  Net Sales & Operating Revenue - External (HFM 410000) 
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)
^ [1/ -1
÷
# of Years - 1]
Comparison Period
Net Sales & Operating Revenue – External (FM 410000)
339
2007, POME, Gautam_Koppala, All Rights Reserved
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) %
Sum of Annual Growth Rate Percentages:
(Yr 1 Annual Growth Rate % + Yr 2 Annual Growth Rate % + X3 + X4)
÷
Total Number of Years
This metric is primarily used in analyzing growth rates in revenues and income over multiple periods.
Return On Investment (ROI) 13 pt %
NIBI – On Going (Recent 12 Months) (FM 906306)
÷
Business Net Investment - 13pt Average (FM 991315)
The NIBI – On Going (Recent 12 Months) is the summation of the last 12 months of Net Income
captured in the Income Statement within Net Income Measurement Basis (On-Going) (FM 906300)
account plus last 12 months of interest captured in the Income Statement within Interest & Expense
(FM 620991) account net of taxes; interest balance is multiplied by (1 – Effective Tax Rate) to exclude
taxes.
The Business Net Investment – 13pt Average is calculated by taking the last 13 months Business Net
Investment EOP (FM 991300) ending balances and dividing by 13.
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
340
2007, POME, Gautam_Koppala, All Rights Reserved
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. Consider the following examples.
Profit after Tax
Shareholders’ Equity
Profit after Tax
Shareholders’ Equity
341
2007, POME, Gautam_Koppala, All Rights Reserved
Total Assets
×
Shareholders’ Equity
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 their interrelationships provides a different insight.
As you remember, the Income Statement summarizes all of the financial activity that took place during
the period shown in the statement heading. Because it covers only one period, it relates expenses and
profits to revenues achieved. By comparing the Income Statement from one period to that of another,
342
2007, POME, Gautam_Koppala, All Rights Reserved
whether previous or future, we can validate our conclusions or impressions by looking at other
statistics or by analyzing detailed information that may be available to us.
When we are inside the Projects, whether as analysts or as Project Managers, we have access to
detailed data that help explain the results summarized in the Income Statement. The ratios that we
look in POME will help us focus our analysis on the aspects of our operations that cause particular
ratios and relationships to come out as they do. Initially, in Exhibit below we consider the information
presented in the Income Statement, as it is really the measure of business performance.
Exhibit: The Income Statement
POME Prescribe
J
Just do it!
POME Prescribe
343
2007, POME, Gautam_Koppala, All Rights Reserved
CORPORATE
GOVERNANCE
344
2007, POME, Gautam_Koppala, All Rights Reserved
Corporate Governance
Corporate governance is not a new topic. It has been around for many years, often described as the
“agency issue.” However, in recent years it has taken on increased significance, demanding increased
attention. Since 2001 in particular, the corporate marketplace has seen a significant number of
headline grabbing scandals involving major Corporation Based Projects s. These scandals have raised
new questions about corporate governance and, as a direct consequence of some of these situations,
the U.S. Congress passed a very broad piece of legislation called the Sarbanes-Oxley Act of 2002. This
law has had a wide range of consequences directly affecting large public Corporation Based Projects
and public accounting firms and, less specifically, smaller public firms, private Corporation Based
Projects s, not-for-profit organizations, and regulatory entities in many different ways.
POME Case Study:
The Importance of Financial Reliability
“I’m glad you called this meeting, Koppala.”
“Why is that, Jonas?”
“Well, as you know, we have a new division Project Manager in my division and last week he called me
to ask about the quarterly financial report I had submitted. He specifically asked me if I really believed
the numbers in the report. I told him that ‘To the best of my knowledge, they are correct.’ And he then
asked me to certify that they were and to sign the certification, which I did. What’s that all about?”
“In July of 2002 Congress passed a law called the Sarbanes-Oxley Act that requires CEOs and CFOs of
public companies to certify that their financial statements are correct. Your division Project Manager
has to certify that the division numbers are right before our senior executives will certify to the
corporate financial statements, and he was just trying to make sure that the people who produce the
numbers believe them before he signs.”
The issues raised by this vignette are very important. Sarbanes-Oxley was developed and passed in
the aftermath of two very large and dramatic corporate failures, Enron and WorldCom. These
multibillion-dollar Corporation Based Projects s appeared to be very successful, but it turns out that
much of their success was not real, but was fabricated through elaborate schemes to create the
appearance of success and wealth. The U.S. Congress passed Sarbanes-Oxley to make it more difficult
to perpetrate the types of fraud these companies’ stories represent.
Defining Corporate Governance
345
2007, POME, Gautam_Koppala, All Rights Reserved
Corporate Governance
 After the revelation of serious scandals in leading
multinational companies, attention was focused on
the need of strengthened “corporate governance”.
 However, it had to settle with liberalization,
privatization, and de-regulation.
 “Regulation is an unnecessary barrier to trade in
services.” (WTO)
1
Fundamentally, it relates to
how a Corporation Based Projects is overseen. It is not management. Rather, it is oversight, the
overriding guidance and direction of the entity and the standards and values it reflects. In recent years
corporate governance has come to encompass the ethics of management, the recognition and delivery
of the essence of corporate responsibility to stockholders, employees, and community.
According to Robert A. G. Monks and Nell Minow in Corporate Governance (third edition, Malden, MA:
Blackwell Publishing, 2004), “corporate governance is the structure that is intended to make sure
that the right questions get asked and that checks and balances are in place to make sure that the
answers reflect what is best for the creation of long-term, sustainable value.”
Corporate governance addresses, in essence, how the Projects is guided and directed. What is implied
is that we should know and practice good corporate governance in our roles as corporate Project
Managers, directors, and investors. Clearly, in the scandals summarized in the next section, and this
list is by no means exhaustive, the Project Managers of these companies were not responsive to the
needs, interests, or expectations of the shareholders or to the interests of the general public, either.
As a result of these scandals and a broader concern for ethics and financial integrity in American
industry, as noted earlier, the U. S. Congress, in July 2002, passed a strong law called the Sarbanes-
Oxley Act of 2002, which mandated a number of significant changes to the way that businesses
operate, Project Managers manage, and external service providers perform their duties. The provisions
of this act are summarized after a summary of some of the most significant examples of Project
Managerial and reporting problems.
346
2007, POME, Gautam_Koppala, All Rights Reserved
The Major Corporate Scandals
Over the past several years numerous financial scandals have tested the financial systems and raised
the awareness of everyone as to the importance of accurate and timely financial information. Following
are some of the most significant instances of corporate and Project Managerial fraud. These cases have
resulted in several new laws that are designed to hold Project Managers accountable for the results
their Corporation Based Projects s report.
Enron
The Enron Corporation Based Projects grew out of a regional oil and gas supplier to become the
largest and most profitable and successful energy trading Projects in the country, if not the world. A
Wall Street darling, Enron’s stock rose to record levels and the Projects garnered much favorable
publicity for its creative products and extraordinary success in the world energy markets.
Its leaders were recognized for their success in creating wealth for themselves and their shareholders.
In the summer of 2001, some questions were raised about some of the contracts that Enron was
creating. These questions led to other questions, but the answers that were provided didn’t really
make sense, raising still more questions. During this time the executives of Enron were publicly
reassuring stockholders and analysts that everything was terrific at Enron. As more questions were
raised, some related to accounting transactions and the creation of special purpose entities,
tangentially related companies that served to facilitate some of the trading transactions. (The
treatment and disclosure of special purpose entities is specifically addressed in the Sarbanes-Oxley Act
of 2002.) The more analysts and investigators looked into Enron, the more confusing the whole
situation became. Ultimately, it was estimated that Enron Project Managers had established as many
as 3,500 of these questionable entities to effect their scheme.
At the same time it came out in the press that most if not all of the Projects’ 401(k) plan funding, the
primary retirement savings plan for Enron employees, was invested in Enron stock, and while for quite
some time this was very profitable and the 401(k) funds grew very rapidly, in the midst of the
questioning, the stock price began to drop and the value of the retirement funds declined. A provision
of the Enron 401(k) plan prohibited the trustees for the employees from selling the Enron stock in the
fund, so the value of the retirement funds declined precipitously and there was nothing the employees
could do about it. While the shareholders in the 401(k) plans were precluded from stock transactions,
the senior Project Managers of Enron sold stock and reaped millions of dollars. (Trading by senior
executives in times when trustees of pension funds and other retirement funds may not is specifically
addressed by the Sarbanes-Oxley Act of 2002.) In the end all of the value in those retirement accounts
was lost.
347
2007, POME, Gautam_Koppala, All Rights Reserved
At the same time that senior Enron executives were making very strong public statements assuring
that the Projects was sound, they were privately selling their personal stakes in the Projects for
millions and millions of dollars and arranging to protect their personal gains from legal attack through
trusts and assignments. The story of Enron has been told in several books and innumerable articles.
One good one is Power Failure by Mimi Swartz with Sherron Watkins, who was a CPA and a vice
president of Enron who asked a number of questions about some of the entries she saw and ultimately
went to the authorities and the press and spotlighted the problems.
Along the way, a partner in a major public accounting firm was accused of, and later admitted to,
shredding documents and helping hide the circumstances. Later, it became apparent that policies in his
accounting firm, Arthur Andersen & Projects, one of the largest accounting firms in the world,
authorized actions that served to cover up the fraud that was going on. (There are several provisions
of the Sarbanes-Oxley Act of 2002 relating to the role that auditors may play and may not play at
client firms.) It also turned out that Arthur Andersen had many very lucrative consulting contracts with
Enron, raising questions about its ability to be independent in its audit function.
Although this summary is very short and incomplete, it should be obvious that there were many illegal
and inappropriate actions being undertaken. Ultimately, Enron declared bankruptcy, wiping out the
personal wealth of thousands of people who worked for Enron and causing billions of dollars of
investment losses for the individual investors and mutual funds that held the Enron stock.
Outcome
The Enron story is not yet finished at this writing. Several corporate officers have pleaded guilty and
have been sentenced to jail, including Andrew Fastow, former CFO (10 years in jail plus fines), Lea
Fastow, Andrew’s wife and a former Enron executive (1 year in jail), and former Enron Treasurer Ben
Glisan Jr. (5 years in jail), and others. Most recently, Richard Causey, the chief accountant at Enron,
pled guilty to securities fraud and agreed to testify against Jeffrey Skilling (former CEO) and Kenneth
Lay (former CEO and Chairman of the Board). The Board of Directors of Enron has committed to
paying $25 million in restitution funds. Arthur Andersen partner David Duncan, who was accused of
destroying evidentiary documents, pled guilty. His CPA firm, Arthur Andersen & Projects, was found
guilty of obstruction of justice and ordered to pay a substantial fine, was precluded from providing
audit services to any publicly owned Corporation Based Projects s, and was forced to disband as a
major public accounting firm. Its conviction was overturned on appeal in 2005, but that will not enable
the firm to be reconstituted.
WorldCom
WorldCom is another example of success leading to greed leading to fraud leading to massive failure.
WorldCom began as a small regional telecommunications Projects in Mississippi under the leadership of
Bernie Ebbers, who wanted to establish a leading Projects. He began small and grew by aggressive
348
2007, POME, Gautam_Koppala, All Rights Reserved
acquisitions and creative programs that attracted customers and publicity. His Projects, LDDS,
acquired numerous small telecom companies and grew during the booming telecommunications and
high technology period of the 1990s. In the mid-1990s, LDDS acquired MCI, a much larger Projects,
changed its name to WorldCom, and became a major player in the telecommunications industry.
However, in the latter years of the 1990s it became clear that there was severe overcapacity in the
telecommunications industry, and that the demand that had been anticipated was not going to
materialize and competition became fierce within the industry.
Many of the companies in the telecom industry began to have financial difficulties and several failed.
Others merged with competitors, combining in an effort to remain viable. Throughout this time
WorldCom continued to report strong growth and earnings, bucking the trend in the rest of the
industry. Their strong financial results and apparent success attracted a lot of investment and a great
deal of positive analyst commentary. In fact, one analyst, Jack Grubman of Salomon Smith Barney,
wrote exceptionally favorable analyst reports on WorldCom that made it easier for WorldCom to issue
stock and debt to finance growth while the rest of the industry was contracting. It would turn out later
that Grubman received bonuses from his firm and from WorldCom and other benefits as a result of his
writing these very favorable reports. (The relationship of stock analysts and investment bankers to
client companies and the compensation of analysts are addressed directly in the Sarbanes-Oxley Act of
2002.)
After several years of industry-bucking results an internal auditor at WorldCom, Cynthia Cooper, raised
some questions regarding some entries she found. When she did not get satisfactory answers from the
chief financial officer of WorldCom, she pursued her audit surreptitiously until she determined that
there was fraud. She raised her questions publicly and exposed the problems. It turns out that the
WorldCom audit firm was Arthur Andersen & Projects, the same firm that audited the books of Enron.
Again, WorldCom engaged Arthur Andersen & Projects in numerous lucrative consulting and tax
advisory contracts, raising the independence issue again.
Ultimately, it became apparent that WorldCom had been making massive accounting entries to
increase sales, decrease expenses, and overstate its financial performance for years. It became very
clear that WorldCom had told increasingly greater lies to cover up its earlier lies. The final tally was
that WorldCom had constructed false accounting entries totaling more than $11 billion, making its
fraud the largest in history (at the time).
Outcome
The consequence of the WorldCom debacle was that WorldCom declared bankruptcy and Project
Managerial control was transferred to Michael Capellas, formerly president of Hewlett-Packard and CEO
of Compaq, who cleaned up the organization. Eventually, the Projects moved its headquarters from
Mississippi to Virginia, changed its name to MCI, Inc., emerged from bankruptcy, and ultimately
349
2007, POME, Gautam_Koppala, All Rights Reserved
agreed to be acquired by Verizon for approximately $9 billion. Several of the banks and investment
institutions that participated, knowingly or not, in the massive investment fraud paid billions of dollars
in fines. Several executives, including Scott Sullivan, the CFO who oversaw the accounting for the
Projects, pleaded guilty to fraud and were fined and sentenced to jail. Bernie Ebbers was convicted of
fraud in a celebrated trial in New York. Mr. Ebbers was sentenced to 25 years in jail and must serve 85
percent of the term before he is eligible for parole. In addition, Mr. Ebbers has agreed to transfer
nearly all of his personal assets (between $25 and $40 million) to a liquidation trust to settle a civil
suit (Wall Street Journal Online, June 30, 2005). Jack Grubman paid fines of $15 million and has been
barred from the securities industry for life.
Tyco International
The management at Tyco directed a very aggressive acquisition strategy that grew the Projects
dramatically over a relatively short time. Over only a few years, Tyco acquired more than 1,000
companies, absorbing them into the Projects’ divisions and reporting significant sales growth year after
year. The Projects management moved the official corporate headquarters to Bermuda to avoid federal
and state taxes on income. During this time the senior management of Tyco, at least in some cases,
without the approval, or even the knowledge, of the Board of Directors, developed very lucrative loan
and bonus programs for the senior executives. The principal beneficiaries of these programs were the
CEO, Dennis Kozlowski, and the CFO, Mark Swartz, although many other senior Project Managers
received very large loans and bonuses. As part of his Project Managerial prerogative, the CEO, Dennis
Kozlowski, awarded bonuses of millions of dollars to Project Managers and executives he liked or who
provided personal services for him. Kozlowski and Swartz used extraordinarily generous and flexible
“relocation” loan programs to provide themselves with millions of dollars of corporate funds, and then
arranged to have the loans forgiven, creating multimillion-dollar bonuses for themselves. Kozlowski, in
particular, used corporate funds for personal expenditures that caught public attention for their
lavishness.
The scandal first came to light when Kozlowski was accused of purchasing millions of dollars worth of
artwork for his Manhattan apartment with corporate funds and then having the artwork shipped to
New Hampshire to avoid the New York state and city sales taxes. The apartment and its furnishings
were among the daily revelations of excessive personal benefits for key individuals that were reported
during the public analysis of the Tyco scandal.
In all, Kozlowski and Swartz were accused of taking about $600 million in illegal and unauthorized
bonuses and stock sales gains, using their authority and inappropriate accounting transaction to hide
their actions. Kozlowski was also accused of having paid for numerous extremely expensive personal
purchases with corporate funds, obviously failures of internal controls. (Internal controls are
specifically addressed kin the Sarbanes-Oxley Act of 2002.)
Outcome
350
2007, POME, Gautam_Koppala, All Rights Reserved
Kozlowski and Swartz were tried for illegally diverting corporate funds and defrauding stockholders and
other investors. Their first trial ended in a mis-trial when a juror received a death threat after
apparently signaling positively to Kozlowski. In the second trial, both Kozlowski and Swartz were
convicted. In addition to each receiving 25 years in prison, the two men were required to make
restitution to Tyco of a total of $134 million and were fined an additional $105 million.
Adelphia Communications
Adelphia Communications was initially established by John Rigas as a privately owned
telecommunications Projects, providing voice and data services and subsequently cable television
services to several communities in the Northeast. Relatively quickly, the Projects was successful and
grew substantially, in part through acquisitions. Within a few years, the Projects went public, selling
shares to outside investors, providing funds for operations, acquisitions, and even more rapid growth,
although John Rigas and members of his family continued to hold key management positions.
Apparently over many years, John Rigas and other members of his family continued to operate
Adelphia as if it were a private Projects, using corporate resources, which, because it was a publicly
owned Projects, belonged to the shareholders, for personal purposes. The amounts of money so
converted totaled several billion dollars and involved John Rigas, his son Timothy, who served as the
corporate CFO, and several other members of the Rigas family. In 2002 the Rigases were accused of
falsifying financial records from 1999 through 2002 to hide the massive fraud that had taken place.
Their trial included numerous disclosures of financial malfeasance and misuse of corporate funds.
Outcome
After a highly publicized trial, John Rigas and his son Timothy were convicted of fraud, sentenced to
jail, and fined. John Rigas, age 79, was sentenced to 15 years. Timothy Rigas was sentenced to 20
years. Another son, Michael, was found not guilty of conspiracy, but the jury could not reach verdicts
on other counts. The prosecution has not decided at this time whether to retry these other charges.
The former assistant treasurer of Adelphia, Michael Mulcahy, was acquitted of all counts. A quote
attributed to Mulcahy is revealing. In testimony in his own defense, Mulcahy said, “I understand the
Corporation Based Projects is owned by the shareholders. The owners of the Projects are indirectly my
bosses, but that’s not who I reported to.” (Quoted on MSNBC.com
(http://www.msnbc.msn.com/id/5396406), July 8, 2004 from The Associated Press) This statement
reflected the problem and some of the confusion that has led to the financial scandals and the overall
problem.
Parmalat
Included here in part to demonstrate that financial scandal is not just an American phenomenon, the
Parmalat story repeats some of the characteristics of other scandals, but it adds new twists. Parmalat
is an Italian dairy and food products Projects, the largest such Projects in Europe, with subsidiaries in
several countries in Europe as well as in the United States. Over the years, Parmalat has developed a
351
2007, POME, Gautam_Koppala, All Rights Reserved
very complex structure of affiliated companies that, whether intentional or not, obscures its operations
and management organization. Begun as a family business, it grew and expanded, utilizing leverage to
make its equity more valuable. The debt, as well as the equity it raised, was used to acquire
companies, expand the business, and finance the lifestyles of Fausto Tanzi, the original founder, and
his family. Some of the Parmalat money was used to finance a travel business operated, at a
substantial loss, by Tanzi’s daughter, and the Parma football (soccer) team, also a financial disaster.
As the Parmalat story unfolded, it appears that someone (unknown at this time) confirmed on Bank of
America stationery, a deposit of 3.9 billion euros (approximately $5 billion) that did not exist. This
forgery added to the confusion and increased the complexity of the fraud at Parmalat. Also adding to
the confusion is the organizational structure of numerous interrelationships among companies that
loaned money to each other and made cross-Projects investments that have made it difficult to
determine just how much money has disappeared. Estimates have suggested that the amount is in
excess of $12.6 billion, making Parmalat a bigger fraud than WorldCom.
Outcome
Although trials have not yet begun, Fausto Tanzi has already pleaded guilty and been sentenced to
prison. Numerous other people inside Parmalat and in lenders and service providers have pleaded
guilty to participating in the fraud. However, the prison terms in Italy are far shorter and other
sentences are also far more lenient than in the United States and as a result, only a few people will
actually receive any punishment and it will not be severe. There may be less deterrence to similar
crimes in Europe as a result. However, an affiliate of the large U.S. accounting firm Grant Thornton has
come under a great deal of scrutiny, which has carried over to include the U.S. firm as well.
Global Crossing
Global Crossing is another telecommunications Projects that got caught up in the boom and then bust
in the telecom industry. The Projects, originally founded as the result of the merger of two companies
in different sectors of the telecommunications industry, grew rapidly during the boom years, expanding
capacity in anticipation of continued growth. When the growth did not materialize, as a result of
reduced demand and increased competition during the period from 1999 through 2001, Global
Crossing entered into cross-selling agreements with other companies that had the effect of artificially
increasing reported sales and profits.
In addition, as we have seen with several of the other companies, Global Crossing had lucrative and
liberal loan programs for its executives, resulting in substantial (multimillion dollar) loan forgiveness
bonuses, even as the Projects was heading rapidly toward bankruptcy.
Outcome
Global Crossing settled the case against it brought by the SEC, agreeing to cease-and-desist from its
inappropriate accounting activities. The SEC found that the Projects had not complied with certain
352
2007, POME, Gautam_Koppala, All Rights Reserved
reporting requirements and the Projects agreed not to commit any more violations. Three senior
executives were fined $100,000 each and the Corporation Based Projects and its former senior
executives, all having left the Projects, were required to agree to the order. During the SEC
investigation, the Projects cooperated with the investigators and the consequences were far less
onerous than were imposed on other companies.
HealthSouth
HealthSouth is a very large healthcare services provider with both inpatient and outpatient
rehabilitation facilities, outpatient surgical centers, and more than 330 hospitals. The Projects and its
senior executives were accused of falsifying accounting records and inflating revenues and profits
substantially in order to maintain the price of the Projects’s stock. The fraud totaled more than $1.4
billion and the Projects was accused of inflating profits in some years by up to 4,700 percent.
What makes this case important is that it was the first to accuse an executive, in this case the CEO,
Richard Scrushy, of violations of the Sarbanes-Oxley Act. He was charged with knowingly certifying to
false and misleading financial statements in late 2002, after the enactment of Sarbanes-Oxley. During
the trial, five former CFOs testified against Scrushy, insisting that he was not only aware of the fraud,
but was instrumental in its perpetration. His defense was that the CFOs were managing the whole
process and kept the facts and the situation from him. He insisted he was unaware that there was
anything wrong.
Outcome
Richard Scrushy was acquitted of all of the 36 charges remaining of the original 85 indictments against
him. Ten other HealthSouth executives have already pleaded guilty and been sentenced, generally to
minimal penalties. Only one received a jail term, and it was short. One former CFO, who also has
pleaded guilty but has not been sentenced, testified at length against Mr. Scrushy, but the jury
apparently did not believe him. The trial lasted a long time and jury deliberations lasted more than a
month and a half, and in the end, the prosecution did not prove its case, so the provisions of
Sarbanes-Oxley have not yet been successfully applied. According to the Boston Globe (July 6, 2005,
p. C6) the SEC, shortly after the acquittal was announced, planned to file a $785 million civil suit
against Scrushy. It remains to be seen whether the civil suit, which allows for a lower burden of proof
than does a criminal trial, will be more successful. In addition, Scrushy still faces several other civil
charges and lawsuits. In light of his acquittal, he has sued HealthSouth for several million dollars of
lost pay and is seeking to regain involvement in the Projects.
353
2007, POME, Gautam_Koppala, All Rights Reserved
There are obviously many ways that Project Managers and executives, generally in collusion with
others, can make the numbers come out they way they want. However, there is now much more
pressure to deliver proper financial information and to assure that it is correct. Nevertheless, these
cases and others have demonstrated that the system really depends on the integrity of the Project
Managers and executives and the diligence of the directors, auditors, and other interested parties. The
importance of corporate governance—that oversight and guidance that directs businesses—cannot be
overestimated. Clearly, everyone involved has a responsibility to assure that information is clear, well-
understood, and properly analyzed at all levels.
The Sarbanes-Oxley Act of 2002
In light of the corporate scandals of the past few years Congress passed the Sarbanes-Oxley Act in an
effort to restore faith in the accounting and reporting practices of public Corporation Based Projects s.
The Act seeks to direct the behavior of companies and Project Managers according to a legally defined
standard with specifically prescribed requirements for reporting and confirmation of financial
information, mandated senior executive confirmation and certification of reporting accuracy and
reliability, and independent confirmation not only of fair representation of financial information but also
of the systems and procedures that produce that information. The legislation also precludes the
continuation of certain relationships between Corporation Based Projects s and their professional
service providers, auditors, and consultants and imposes harsh penalties for failure to meet these
strict standards. The law has also accelerated public reporting requirements in part to make it more
difficult for companies to effect fraudulent reporting without raising questions and concerns.
A Summary of the Act’s Key Provisions
Section 101. Establishment of the Public Companies Accounting Oversight Board
(PCAOB)
The Act establishes this independent oversight authority as a reflection of Congress’s dissatisfaction
with the effectiveness of the public accounting profession’s ability to assure the integrity of financial
information. The profession has been overseen by the Financial Accounting Standards Board (FASB)
and the American Institute of Certified Public Accountants (AICPA), a membership organization that
has attempted to self-regulate the profession. The Congress, in light of the corporate scandals
described (and others), decided that there needs to be another agency to oversee and regulate the
performance of the accounting profession.
Section 103. Auditing, Quality Controls, and Independence Standards and Rules
Because many of the scandals involved members of public accounting firms serving in multiple and
potentially conflicting roles in serving their corporate clients, the Act sets very specific rules as to what
public accountants may and may not do, how they are to maintain their independence so that they are
354
2007, POME, Gautam_Koppala, All Rights Reserved
in a position to render objective opinions and reports, and so the public will feel that the auditors’
statements can be relied upon in making investment decisions. This section defines audit record
retention rules (in response to document destruction issues at Enron), separate partner confirmation of
audit reports, and internal control procedures confirmed and reported on (described in Section 404)
and focusing attention on audit failures in all of the scandals.
Section 201. Services Outside the Scope of Practice of Auditors
This section prescribes the roles that public accountants may play in relationship with their audit
clients. It precludes many of the services that members of the audit firm have previously provided to
their audit clients, often as a result of the referral from the auditor. Over the years consulting,
advisory, tax guidance, and other services have generated far higher fees for the audit firm than has
the traditional audit work. As a result, more and more emphasis has been placed on generating
consulting assignments, potentially resulting in conflicts of interest, making the audit less likely to
report performance or fraud problems. In several of the scandal Corporation Based Projects s, the
auditors, most notably Arthur Andersen (although it was not the only one involved), were also the
beneficiaries of very large and long-running consulting arrangements. This was certainly true at Enron.
Additionally, Enron and other companies routinely hired former auditors to be senior financial
executives. The Act (in Section 206) specifically addresses the hiring of auditors, making it illegal to do
so for anyone who worked on an audit in any capacity within one year.
Section 302. Corporate Responsibility for Financial Reporting
This section has received some of the most vigorous public discussion. It specifically requires the CEO
and the CFO to personally “certify in each annual or quarterly report” that “based on the officer’s
knowledge, the report does not contain any untrue statement of a material fact . . .” (Quoted from the
Sarbanes-Oxley Act of 2002.) This section holds these senior officers personally responsible for the
accuracy and completeness of financial reporting. It is the requirement that they personally sign the
statements that has created a wave of internal requirements similar to that described in the vignette
at the beginning of this chapter. Before these senior executives will certify, they frequently require
similar internal certifications by their financial and operating subordinates.
Section 404. Management Assessment of Internal Controls
In Section 103, the Act required auditor confirmation of internal controls and internal control
procedures. Section 404 requires a management statement and an auditor’s confirmation that the
internal control procedures in place are sufficient to assure the accuracy and integrity of corporate
financial reporting. Auditors have used this section of the Act to impose extensive documentation
requirements on clients and have enhanced dramatically their review of internal controls before being
willing to attest to their adequacy. The result has been dramatic increases in the time and the cost of
audits to conform to this section and to the Act. The PCAOB and the SEC extended the deadline for
compliance with Section 404 to early 2005 and companies have spent millions and millions of dollars
355
2007, POME, Gautam_Koppala, All Rights Reserved
developing systems and documentation to assure compliance. Although major Corporation Based
Projects s are now required to certify to the effectiveness of their internal control procedures, these
provisions of the Act continue to be delayed, most recently until
July 2006 for public Corporation Based Projects s with less than $125 million in revenues or market
capitalization.
In testing the internal controls, there are three levels of compliance failure:
 Control deficiency, which could adversely affect the Projects’s ability to deliver accurate
financial reporting;
 Significant deficiency, a control deficiency or combination of control deficiencies that result in a
more than remote likelihood of a misstatement of the Projects’s financial statements;
 Material weakness, a significant deficiency or combination of significant deficiencies that result
in more than a remote likelihood of a material mis-statement of the Projects’s financial
statements.
The first tests of Section 404 compliance identified a significant number of companies that reported
“material weaknesses” in their internal control systems. Of the first 2,984 companies to report, 364
companies, more than 12 percent, were recognized as having material weaknesses.
Although several other provisions of the Act also express very strong statements of the anger
Congress felt over the financial scandals, this summary provides a flavor of the Act and its intent.
Many of the specific issues highlighted in the scandals were addressed very specifically in Sarbanes-
Oxley, and Congress sought to send an additional message that it would not tolerate the kinds of
practices that were evident in the aftermath of Enron and WorldCom and these other corporate
examples.
Extended Application of Sarbanes-Oxley
It is interesting to note that Sarbanes-Oxley was enacted specifically to apply to large, publicly owned
Corporation Based Projects s. However, increasingly, smaller public companies, privately held
companies, and not-for-profit organizations are finding that Sarbanes-Oxley applies to them as well. In
order for large Corporation Based Projects s to assure their compliance with the Act, many of them are
requiring their suppliers to assure that they too comply with the Act with regard to the accuracy of
information supplied to the large Corporation Based Projects s. In addition, banks and other lenders,
as well as insurance companies, are requiring Sarbanes-like certifications even from smaller companies
seeking their services. Foundations and other funders, including government agencies, are requiring
similar certifications from their not-for-profit grantees and service providers. Several state legislatures
have considered legislation that would require Sarbanes-type compliance from all entities paying
corporate taxes. Though none of this legislation has yet passed, there is a high likelihood that
356
2007, POME, Gautam_Koppala, All Rights Reserved
additional reporting and control requirements will be imposed on those companies that are not
formally subject to the Sarbanes-Oxley Act.
The Broader Aspects of Corporate Governance
There is much more to corporate governance than just the integrity of financial information, although if
the financial statements are correct and appropriate, it will go a long way toward meeting the
standards for Project Managerial responsibility. Corporate governance also reflects the decision-making
process and the choices that the governing authorities, Project Managers, and members of the Board
of Directors exercise.
Traditional finance courses and finance texts have long described the issues of corporate governance in
terms of “agency,” arguing that corporate Project Managers, because they are not the owners of the
Projects, are responsible to manage the Projects on behalf of the owners, and they are to be
compensated for doing so. These texts spend a fair amount of time describing the “agency problem,”
which is the potential conflict between the interests of the individual Project Managers and those of the
shareholders for whom they are supposed to be working. If a Project Manager will get a bonus for
achieving a specific objective, he or she will concentrate on achieving that objective. If it turns out that
that objective does not really benefit the shareholders, the conflict and the agency problem arise.
Project Managers and Boards make decisions all the time. An examination of those decisions provides
a commentary on the various aspects of corporate governance by which the management is measured.
We are told that the responsibility of management is to assure the integrity of the Projects’s assets
and to maximize the wealth of the shareholders.
However, when decisions are made, it is not always clear how the outcome will affect the wealth of the
shareholders. Just recently, for example, Allmerica Financial Corp. announced its quarterly results. The
announcement indicated that the Projects had a very strong quarter, with sales rising and profits
increasing by nearly 300 percent over the comparable prior year period, significantly outperforming
the analysts’ estimates. The Projects also announced that its outlook for the remainder of the year was
positive. The same day, the Projects’ stock price declined by more than 6 percent and more than two
dollars per share, in a market day that was substantially positive. It certainly seems as if the corporate
management was doing all the right things for shareholder wealth, but the day’s trading activity
suggests that the market was not satisfied, at least for that day.
EVA and MVA
Clearly then, when making decisions, management must be focused on the long term, the ongoing
impact on the Projects, and on wealth. A financial management focus called Economic Value Added
(EVA) was developed by a consulting firm (Stern, Stewart & Co., New York City) and described in a
book by G. Bennett Stewart, The Quest for Value (New York, NY: Harper Business, 1991). EVA is
357
2007, POME, Gautam_Koppala, All Rights Reserved
supposed to measure the contribution to shareholder value made by the Projects. Many companies
have adopted EVA, often giving the program another name, Shareholder Value Added. It measures
NOPAT – k(∆I), that is, Net Operating Profit after Tax (Operating Profit minus Taxes) less the Cost of
Capital (the rate of return required to satisfy the sources of capital) multiplied by the incremental
investment (∆I) required to generate that NOPAT. If the difference NOPAT – k(∆I) is positive, then the
Projects has increased the value the shareholders own, and the mandate has been accomplished.
However, it is often possible to increase NOPAT – k(∆I) significantly by eliminating all capital
investment in the current year. Is this good corporate governance? Is managing for the short term the
appropriate way to manage the Projects?
As a partial answer to such criticism, the developers of the EVA model have carried the performance
analysis further, developing a concept known as MVA, Market Value Added, which attempts to extend
the assessment to the long-term market value, rather than focusing on a single year’s contribution.
MVA measures the difference between the amount of money invested in the Projects and the market
capitalization, the value determined by the number of shares outstanding multiplied by the stock price.
This difference is considered a measure of the long-term value generated by the management of the
Projects; the higher it is, the better the management performance.
A similar type of question can be raised every time management and the Board of Directors of a
Projects agree to merge the Projects or have it acquired. Generally, when such a decision is made, the
most senior executives receive very lucrative severance packages as part of the merger agreement. It
that appropriate? Recently, Procter & Gamble acquired The Gillette Projects for approximately $54
billion in stock, that is, P&G issued .975 shares of P&G stock for each share of Gillette stock. As part of
the acquisition agreement, James Kilts, the CEO of Gillette will receive a severance package worth
many millions of dollars (estimates range to $175 million). Do you think Kilts was objective in his
decision? Whose money does he receive?
Executive Compensation
Advocates and commentators, discussing corporate governance and the agency issues tied to it,
suggest that aligning Project Managerial compensation with the fortunes of the shareholders will go a
long way toward making corporate governance actually beneficial to the shareholders. To achieve such
alignment, companies have issued stock options, contracts that permit the Project Manager to exercise
an opportunity according to a contract to acquire Projects shares, either at a bargain price or at a
stock price equal to the price on the date the option was issued. The theory is that if the Project
Manager is successful, the stock price will have risen from its level when the option was issued and the
option will have a value tied to the improvement in the stock price. On numerous occasions, we have
seen executives exercise options because of a dramatic rise in the stock price, often valued at tens or
hundreds of millions of dollars.
358
2007, POME, Gautam_Koppala, All Rights Reserved
Options, however, require that the stock be purchased when the option is exercised. This leads to
another program that often results in a diminution of the effectiveness of the program in aligning the
interests of the executive with the shareholders. Because executives and Project Managers often do
not have the funds necessary to purchase the stock represented by the options and may not wish to
tie up what capital they do have in buying the stock regardless of the attractiveness of the deal, many
companies facilitate the exercise of options by arranging for the simultaneous exercise and sale of the
stock, meaning that the executive or Project Manager gets a cash windfall without actually having to
pay out any money. The stock is acquired, sold, taxes are withheld, and the remaining cash gain is
paid to the Project Manager or executive. In many cases in the months and years that follow, the stock
price drops and the shareholders lose significant value in their holdings. However, the executive,
having exercised the option and then sold the stock, has retained large sums of money while the
remaining shareholders watch their investments decline.
There is a saying in business that “You get what you incent.” That is, Project Managers will act in a
way that provides the most reward for themselves. Therefore, it is in the shareholders’ interest to
assure that incentives be constructed to achieve the appropriate results. In many instances today,
Project Managers are compensated by salaries, bonuses, perquisites, and stock options. To further
highlight this issue, consider this example of a situation in a Projects with several operating sites. The
Project Manager of each site was considered a division Project Manager and had responsibility for the
operations of that facility, including sales, costs, and gross and operating profits and margins. The
Project Manager in this arrangement earned bonuses for achieving gross profit margins of 30 percent
and operating profit margins of 20 percent. In a particular instance, a good and reliable customer
requested that this division purchase for them five truckloads of a particular raw material and have
these raw materials dropshipped to the customer for an application that was not in conflict with the
division. For this service, the customer was willing to pay a 10 percent premium for having the division
make the purchase. That was the only task to be done. The division Project Manager rejected the
order. It would have lowered the gross and operating margin percentages below the bonus level, even
though it would contribute measurably to the division’s and the Projects’s net profit result.
Many textbooks promote the use of stock grants and stock options as a way to “align” the interests of
the Project Managers with those of the owners. The options are generally awarded for driving up the
stock price, presumably, therefore, benefiting the shareholders. However, quite frequently, when the
options mature, the Project Managers exercise them and immediately sell the stock they have just
acquired, taking the cash. They receive substantial amounts of cash, after taxes, and in subsequent
periods the Projects performance declines and the stock price drops. One can easily ask at that point if
the interests of the Project Managers and the stockholders are really aligned.
359
2007, POME, Gautam_Koppala, All Rights Reserved
The whole area of stock options is under careful review at the present time. The FASB is considering
rules on the valuation of stock options, and companies are reviewing whether they encourage the
desired Project Managerial behavior.
Corporate governance encompasses the oversight and direction of a business. It involves the guidance
provided by the Board of Directors, the commitment to integrity on the part of the Project Managers
and executives, and the attention and diligence of the investors, analysts, and regulators who oversee
the financial reporting systems. Good corporate governance recognizes and supports the ownership
and importance of the stockholders and protects their interests.
Although it also involves all the internal systems and practices of the Projects, it is much more than
that. It also reflects the commitment by everyone involved to continuous care and concern for the
accuracy and validity of the results, regardless of whether they are attractive. However, it also
requires that management direct the business so that the results do represent the best efforts of
everyone to deliver positive—honest and positive— performance.
Corporate governance also requires that investors and directors work to assure that compensation and
incentives focus on delivering the desired results. There is a need to reexamine the options, bonuses,
and salaries of executives to be sure they foster the goals that are appropriate for everyone involved.
POME Prescribe
I
Ignore those who
try to discourage
you.
POME Prescribe
360
2007, POME, Gautam_Koppala, All Rights Reserved
THE ASSET
MANAGEMENT
ASSESSMENT
361
2007, POME, Gautam_Koppala, All Rights Reserved
The Asset Management
Once technology assets are put in place, they can be hard to track .... relocations, staff changes, and
frequent configuration updates, can all transform the overall asset landscape. These changes, when
left uncontrolled, can have a major impact on technology’s ability to support, upgrade and manage
these same assets.
Asset management is a series of policies, procedures and practices for keeping track of technology
assets (hardware and software) by location, ownership, usage, configuration and maintenance. While
technical and organizational requirements will determine the scope and extent of any asset
management program, management methods can range from the simple to the complex --- from
manual inventory lists to integrated software solutions for inventory, problem management, change
control and software distribution.
While it is often assumed that asset management is only worthwhile in the large, corporate
environment, any business can benefit from practices that facilitate technology usage and support.
The key is to develop the right program for your individual circumstances....
POME provides a bridge between the discussion of risk and return and managing long-term assets
Operating Project Managers who want their Projects to invest in a long-term asset that will help them
achieve operating performance objectives are generally asked to “justify” the investment. In other
words, the Project Managers must demonstrate the financial return made possible by the investment.
POME explains how capital investment decision making is done and why it is important and applies the
concepts of time value of money.
POME Case Study:
Addressing Capital Needs
“Morning, Koppala. I was wondering if the group could focus on a problem I’m having today. Sales for
the A600s are still going crazy and the sales forecast estimates another 18 percent increase next year
and the year after that. With this kind of growth, we won’t be able to get enough product through the
plant to keep up with demand.
“I’ve requested that we purchase one of two machines, the Schroeder, which will cost $300,000 over 7
years, or the Worrener, which will cost $450,000 over 10 years. Either machine will eliminate the
362
2007, POME, Gautam_Koppala, All Rights Reserved
bottleneck in this department. Lee Cronin, the plant Project Manager, said the request sounded
reasonable but I’d have to submit a proposal with all the figures documented before he could take it to
senior management. I’ve never prepared this kind of proposal before, so if anyone has any advice, I’d
sure appreciate it.”
“I think that’s definitely worth the group’s time. Does anyone have any ideas?”
“You know, I had to write up a similar proposal last year when we needed some new loading
equipment in the warehouse. I started with an Introduction that described the current situation,
described the anticipated growth, and listed the options. The next section included relevant tables from
the sales forecast and business plan and described the effects of a bottleneck in production. Following
that, I think you should provide calculations for the cost of capital and rate of return for both
alternatives and then state your recommended course of action and the penalties for failing to act
now. You might include some appendixes with machine specs and vendor qualifications.”
“That sounds like a good plan to me. Would you all break up into smaller groups and help prepare the
calculations today? The sooner the proposal is submitted, the sooner Hang Tan can move ahead.”
Before you can begin to develop any long term asset management strategy, you should first size the
effort .... where are you now, and what issues do you need to address....? This is the essence of the
asset management needs assessment.
Asset Transfer:
This is to ensure the correct process is followed for Asset Transfer. And to define the the Inputs,
responsibilities and information flow for Asset Transfer
Step # Who Details
An Asset Transfer Form is the
vehicle by which fixed
asset/CAPEX item/s is/are
Transferred between
departments and other SBU’s
within Company. This may
include a single item, a group of
items or an entire project or
program.
363
2007, POME, Gautam_Koppala, All Rights Reserved
1
Project Managers &
Engineers (Solutions);
Team Leaders
(Service);
Manager
Requestor must complete the
Asset Transfer Form including,
but not limited to the following
information:



• Date Submitted

• Asset Number
• Originator Division, Department &
Branch
• Purchase Price $
• Acceptor Division, Department &
Branch
• Effective date of transfer
• Transfer Price $
• Advise Transfer Reasons
• Originator & Acceptor Department, LOB
• Other supporting documentation where
applicable
• Originator and Acceptor to Authorise
and Date
364
2007, POME, Gautam_Koppala, All Rights Reserved
2 Project Managers & Email completed Asset Transfer
Engineers (Solutions); Request form to Originators
Team Leaders Manager, Acceptors Manager and
(Service); Finance Manager for
Manager authorisation, and where
applicable, Managers Manager or
other. If these individuals are not
authorised in accordance with
the Approval Matrix, an
appropriately authorised
individual should also be
included.
3 Manager; Finance Management to approve Transfer
Manager Request and email to Corporate
finance.
4 Corporate finance •
• Record Transfer of Asset in CAPEX
Register
• Email Transferor and Transferee and
SBU Managers to advise of updated
Asset Register.
• Maintain Asset Register, depreciation
journals, reports and reconciliation of
sub-ledger with GL.
5 Project Managers & • Transfer Asset as per approved Asset
Engineers (Solutions); Transfer Request Form
Team Leaders
(Service);
Manager
365
2007, POME, Gautam_Koppala, All Rights Reserved
The Asset Management Needs Assessment
• Can you readily identify the status of all your technology assets (in service, or out of service)?
• Do you know where all your assets are physically located?
• Are you fully compliant with all software licensing requirements?
• Do you have all the asset information you need for the next upgrade project?
• Have technology services or projects ever been hindered by a lack of asset information?
• Are all assets allocated as efficiently and productively as possible?
• Are all assets configured consistently and according to defined standards?
• Are you sufficiently aware of all configuration variations?
• Does the Help Desk (or relevant support organization) have ready access to all the asset
information needed to solve technical problems and provide quality end-user support?
• Do you have all the asset information needed to properly plan for disaster recovery and
business continuity programs?
If you are unable to answer one or more of these questions in a sufficiently positive fashion, then you
may need to take a careful look at your current methods and strategies for asset management. Your
overall goal should be the creation of a realistic "workable" asset management program.... designed to
meet budgets, technical requirements and internal capabilities.
To meet this goal, you will need to examine the following issues and activities....
1. Define the scope.....
To build an asset management program with sufficient flexibility to keep up with.....
• technology changes
• strategic changes (internal vision, business goals, etc....)
• organizational changes (relocations, staff changes, etc.)
• all of the above....
2. What do you need to track....?
Inventory Data
• model and manufacturer
• software version and patch level
• physical location
• operational state ("in" or "out of use")
Configuration Data
• How is each machine configured in terms of CPU, memory, setup, peripherals, installed
software, etc?
• Do you need to identify and track standardized vs. non-standardized configurations?
366
2007, POME, Gautam_Koppala, All Rights Reserved
Acquisition Data
• Cost
• Supplier
• Date Purchased
• Maintenance Records
• Warranty Information
• Licenses and Registrations
• Accounting Information
3. Getting the job done....
Which management methods will you choose to adopt as you plan and implement your asset
management program?
• Manual tracking methods
• Automated tracking methods (via integrated software tools)
• Documented policies and procedures
How will you use the information that you track?
• To assign assets to end-users.
• To manage configurations and provide change control.
• To facilitate technical support and problem resolution.
• To establish standards and purchasing controls.
• To provide a picture of technology usage and allocation for company management.
• To control costs.
• To better manage mobile assets (handhelds, laptops) and reduce losses.
• To secure assets from theft and related losses.
• To manage software licenses, minimizing exposure for license violations.
Asset Financial Maintenance:
The purpose is to ensure the correct process is followed for the financial maintenance of Assets and to
define the Inputs, responsibilities and information flow for the financial maintenance of Assets.
Note Who Details
#
1 Finance Finance is
responsible for
maintaining
367
2007, POME, Gautam_Koppala, All Rights Reserved
the following:
• Processing
authorised CAPEX,
Asset Transfer, Asset
Disposal Forms
• Allocate CAPEX
number and account
code and
communicating to
Originator
• Maintaining Asset
Register, clearing
account,
depreciation
journals, reports and
reconciliation of sub-
ledger
• Advising Originator
and SBU upon
processing any
approved changes to
asset value
• Ensure that CAPEX
amounts and
procurement are
consistent with
request at all times
• Associated reporting
of Fixed Assets /
CAPEX
• Calculating and
Circulation of
Reports for
Depreciation
368
2007, POME, Gautam_Koppala, All Rights Reserved
2 Managers Ensure
financial
maintenance
of all assets as
follows:
• Ensure that Assets
are appropriately
valued throughout
the lifecycle of the
Asset (not just for
the amortisation
period).
• If Assets need to be
revalued, refer
Finance Manager to
approve and update
value of asset
• Ensure correct
allocation of costs
associated with
Assets amortisation
• Ensure Depreciation
costs are correctly
allocated
• Maintain Assets in
good working
condition
3 Finance Review request to revalue
Manager asset and ascertain if
appropriately valued
4 Finance • Update CAPEX
register and advise
Originator and SBU
when update
369
2007, POME, Gautam_Koppala, All Rights Reserved
complete
370
2007, POME, Gautam_Koppala, All Rights Reserved
Managing Long-Term Assets
Long-term assets are the productive assets of a business. They are generally more expensive and
complex than short-term assets and require several levels of approval before acquisition. Their
management comes under the scrutiny of senior management and the operating Project Manager
needs to understand how performance is judged. POME relating to risk and return, relating to capital
investment decision making.
POME Case Study:
The Basis for Investing in Long-Term Assets
“Koppala, I’ve been checking our Projects financials every month on the intranet and also looking at
the annual reports of some of our competitors on the Internet as well as looking at the budget for my
department every week. It seems to me that the Projects has pretty low depreciation amounts on the
Income Statement compared to some of our competitors. And my department has almost no
depreciation charges assigned to it. Wouldn’t we save a lot on taxes if we bought a couple of new
machines in the finishing area?”
“Let me ask you a question, Pam. How well are the machines you’ve got working? Do you need any
more capacity, or can you keep up with the work that’s coming to you? Are you having problems with
breakdowns or excessive maintenance?”
“Well no, Koppala. The machines we have are old, but they never break down and they can handle all
the work we give them. I just thought you could raise your earnings by taking more depreciation.”
“Pam, do you remember the figures we calculated for Hang Tan at the last meeting? A
new machine has to cover a lot more than depreciation. It needs to bring in more return
than anything else we might invest in.”
Considering Asset Classification
The Balance Sheet is divided into sections. The sections relate to the expected life of the elements
contained within the section. For example, the current assets of Projects are those assets that
individually are expected to be turned into cash within a year. Similarly, the current liabilities are
371
2007, POME, Gautam_Koppala, All Rights Reserved
those obligations that are expected to be paid within one year. The long-term assets of the Projects,
by contrast, are those assets that are not expected to be converted to cash within the next twelve
months.
When we refer to long-term asset, we generally focus on the fixed assets of a business: land,
buildings, equipment, furniture and fixtures, vehicles. However, the term “long-term assets” relates to
these plus investments, intangibles, and any other assets that will not or may not be turned into cash
within one year.
Managing these assets is different from managing the more liquid assets. In many books, these assets
are described as the “earning assets” because they generate the revenues of the Projects. Therefore,
we are concerned with how to make them productive and how to keep them productive. Some of these
answers relate to maintenance management and the assurance that the productive equipment is kept
in good working order. This is not the focus of this chapter.
An issue of consequence in the management of these fixed assets relates to how productive they can
be; that is how much revenue they can generate.When we considered the Asset Turnover Ratio, we
showed that investments in fixed assets that do not generate enough revenue serve as an early
warning of financial difficulty.
In his “Z-formula” work, Altman[*] demonstrated that a low Asset Turnover in a business with
significant asset investment was a clear predictor of bankruptcy. Many companies today reward their
Project Managers in part on managing the investment in assets.
In this chapter, we are particularly concerned with identifying which assets to keep and use and which
to replace or discontinue using. We are also concerned with tying up resources in these expensive
assets if we cannot utilize them effectively.
[*]
Edward I. Altman, a professor at Standard University, in 1968, identified through
scenario analysis, a ratio based formula that provides a prediction of business distress
and failure.
The Investment In Fixed Assets
The decision to invest in fixed assets is based on the expectation that this investment, which is
intended to last a long time, will result in the continuous production of positive income and cash flows.
The application of the principles of time value of money provides the bases for evaluating these
investment choices and making the actual investment decisions. Businesses make capital investment
decisions for the reasons identified in the last chapter:
372
2007, POME, Gautam_Koppala, All Rights Reserved
 replacement
 expansion
 rationalization
 development
___________________________
 mandatory
 other
These choices must fit into the strategy of the Projects and within the capabilities of the Projects.
Then, the judgment as to which are attractive and which are not will be based on the financial and
operational benefits to be derived from the investment. Bearing in mind that because some
investments (Mandatory and Other) do not offer a return, the other investments must pay for the
nonreturn choices. The stockholder will not forgo return just because an investment is attractive or
required.
We demonstrated in the last chapter how to evaluate these investments for financial return and
therefore how to compare alternative investments. In POME, we are more concerned with other ways
to evaluate the investments and the management of the assets.
Because capital investment decisions frequently require more money than can be generated through
operations, the decision to invest in a certain way requires additional consideration as well. For
example, the decision to invest in a particular piece of equipment may mean that the Projects will
follow one business track and abandon another. It may choose one product line and give up on
another; favor one Project Manager’s ideas over another; favor one group of potential customers at
the expense of another. Over the years there have been many such choices, some good and some
very bad. One such example is the decision by Motorola Corporation Based Projects , because it had
significant capital invested in analog technology, to concentrate on analog cell phone technology when
it also had digital technology available. There are many such decisions in business history.
We can see the consequences of investment decisions in the financial statements and ratios of a
Projects. Remembering that in our system of accounting there has to be “another side,” we can
evaluate these investment decisions in terms of their impact. The investment must be paid for. If we
pay for it by reducing our cash position, we save ourselves financing costs, improve our negotiating
position (because we are paying cash), and adversely affect our current ratio and similar
measurements of financial liquidity and strength.
373
2007, POME, Gautam_Koppala, All Rights Reserved
Similarly, if we choose to pay for the asset by extending our accounts payable or even borrowing
short-term, we can complete the transaction fairly quickly, but we hurt our current ratio and decrease
our apparent liquidity. However, by extending our accounts payable or by borrowing short term, we
potentially decrease our interest cost when compared to borrowing long-term, increasing our profit and
return to the shareholders at least in the short run.
If we pay for the asset by borrowing long-term, we match the life of the debt with the life of the asset,
often deemed to be sound business management. However, we incur a higher interest cost than had
we borrowed short-term, reducing the potential income. Such a decision may weaken the Projects’
debt-to-equity position, making the ratio unattractive to the lender. At the same time, the increased
debt, called leverage, may increase the potential return to the stock investor.
A decision to pay for the investment through issuance of additional common stock reduces the
riskiness of the Projects, but also reduces the per share earnings that reward the stockholder. As you
can see, each of these choices has advantages and disadvantages. The final decision is based on which
choice most nearly satisfies management’s concern for risk, return, and shareholder satisfaction.
A closer look at these fixed assets will help us understand the decision choices represented by their
presence on the Balance Sheet. For example, investments in land and buildings in non–real estate
companies reflect a conservative management position. The investment in these high-cost assets puts
additional pressure on performance to generate sufficient return to make these investments attractive.
They also reflect a management philosophy that favors the comfort and security of owning your own
resources and being, therefore, less dependent on others and less vulnerable to increases in operating
costs introduced by others.
Contrast the investment in land and buildings with an investment in machinery and productive
equipment. Here, the investment has a clear impact on revenues and earnings. Therefore, we see in
the more aggressive companies, focused investment in equipment and a reluctance to invest in “bricks
and mortar.” In the 1970s Colgate-Palmolive undertook a concerted effort to sell and lease back its
factories in an effort to increase its liquidity and reduce the concentration of real estate on the
Companie’s Balance Sheet.
In the end, this effort was not successful, but it highlights the type of debate over how best to use
financial resources.
A similar example has been seen often in takeover battles. In the early 1990s Dart Drug sought to
take over Stop & Shop supermarkets so it could sell the valuable real estate that Stop & Shop owned,
374
2007, POME, Gautam_Koppala, All Rights Reserved
planning to lease back the stores but generate substantial amounts of cash. This effort led to the
leveraged buyout of Stop & Shop.
Today, companies are concentrating their investment in high technology types of investments,
recognizing that these investments generally translate into higher productivity, generating strong
return on investment performance. These higher technology investments often have limited life, due to
the rapid changes in technology being presented to the marketplace. This causes the companies to
seek to depreciate or amortize their investments over shorter and shorter useful lives, reflecting more
of the cost in the Income Statement every year.
Depreciation is a cost allowance that permits a Projects to recover the dollars of investment in an
asset over its useful life. The longer the depreciation life, the longer it takes to recover the cost. In the
next section we discuss depreciation and amortization more specifically.
The opportunity to depreciate these assets quickly enables the Projects to recover the cost by reducing
the operating income. One impact of such an action is to lower the taxable income and therefore the
tax expense to the Projects that year. Some people suggest that investment in fixed assets is wise
because it offers higher depreciation and therefore lower taxes. This logic is flawed in that to save on
taxes requires the earlier disbursement of cash or commitment to a liability (debt) in an amount far
greater than the taxes that will be saved.
The only sound basis for investing in fixed assets is that the investment will generate a rate of return
that significantly exceeds the risk adjusted required rate of return and is therefore attractive to the
shareholders. Then the benefits of depreciation or amortization will increase the cash flow resulting
from the investment, making it even more attractive.
Other fixed assets that appear on the Balance Sheet generally represent things needed to make the
Projects work effectively, such as vehicles and furniture and fixtures, or to provide better working
conditions for the employees such as leasehold improvements. These investments are harder to justify
based on return on investment and, as a result, fall into the “Other” category for capital investment
decision making, requiring that the necessary return on investment be provided through the profitable
investments.
Depreciation
Much has been much written about depreciation and its attractiveness or negative consequences to the
performance of a business. The most important point about depreciation and amortization for
intangible assets is that it enables the Projects to recover the cost of the asset over its useful life. It is
375
2007, POME, Gautam_Koppala, All Rights Reserved
important to recognize that depreciation and amortization are not guaranteed. For example, to
recognize depreciation or amortization deductions, the Projects needs to make a profit. Otherwise, the
benefit (if there is one) of deductibility for tax purposes loses its appeal. In addition, an examination of
the legislative history of depreciation suggests that it represents more a reflection of congressional
objectives than of business requirements. Over the past few decades, Congress has approved several
changes to depreciation rules, modifying the impact of depreciation on reported business performance
and on tax revenues. There is every reason to believe that there will be similar actions in the future.
Under the current tax laws, businesses may follow a range of options for depreciation for reporting
purposes and are expected to follow some specific rules for tax reporting purposes. Over the years,
depreciation rules and practices and related taxation rules have been changed to respond to the
impact of taxation, international competition, and other economic forces. Depreciation methods have
ranged from the very simple to understand to complexity that requires specialists to decipher.
Depreciation rules are part of the Internal Revenue Code. Examples of depreciation methods include:
 Straight line: dividing the cost of the asset by the years of its useful life and recognizing
depreciation expense equally each year.
 Sum-of-the-years’-digits: adding the numbers of the years of useful life (10 years = 55) and
depreciating in reverse (the first year is 10/55 of the total asset cost, the second year is 9/55 of
the total asset cost, etc.).
 Double-declining balance: taking twice the straight line rate, but applying it only to the
remaining asset value (for a 10-year asset, using 20 percent, yielding a decreasing expense [.2 ×
100 percent of the cost in the first year, .2 × 80 percent of the cost for the second year, .2 × 64
percent of the cost in the third year, etc.]).
 Accelerated Cost Recovery System (ACRS): applying twice the rate over half the traditional
useful life (40 × 100 percent the first year, 40 × 60 percent the second year, etc.).
 Modified Accelerated Cost Recovery System (MACRS): similar to ACRS except that it
requires the inclusion of a half-year convention, that is, only one-half the otherwise allowable
depreciation may be recorded in the first year.
Many variations including crossover from double-declining balance to straight line, 150 percent
declining balance, and others.
The consequences of such are differences between financial reporting and tax reporting that result in
complex reporting of book-tax differences, appearing on Balance Sheets as deferred tax obligations.
When preparing corporate tax return the tax accountant must complete a schedule that reconciles the
differences between book and tax depreciation.
376
2007, POME, Gautam_Koppala, All Rights Reserved
Depreciation and amortization also have a significant impact on Projects cash flows and cash flow
planning. Because they are non-cash expenses, depreciation and amortization must be added to the
positive cash flows in reconciling the cash account through the statement of cash flows. Also,
depreciation and amortization represent positive contributors to the cash flows identified in computing
the return on investment for capital expenditures. This program does not delve into these issues
further other than to alert the student to be aware of such reporting requirements and financial
consequences.
Fixed Asset Accounting
Because companies have these assets that remain on the books for a long time, it is important that
management be able to assure the shareholders that these assets and the value they represent are
correctly reported on the Balance Sheet. Therefore, the fixed asset records are very detailed and must
be reconciled every year. Companies maintain records by asset showing the acquisition date, cost,
depreciation expense, accumulated depreciation (both book and tax), remaining book value, remaining
life, and often information such as location and classification. Because of the complexity of fixed asset
accounting, many companies set a policy limit of the minimum value required for an asset to be
capitalized. For small companies this limit may be $500; for larger ones it may be $1,000 to $2,500;
and for even larger ones, it will be much larger. One requirement is that whatever the policy adopted,
it must be administered consistently within the year and from year-to-year.
The decision as to which fixed assets to capitalize—to put on the Balance Sheet rather than expense
through the Income Statement—is in part a reflection of Projects management. The decision to
capitalize assets occurs when management wishes to report higher profits. The consequences also
include higher income taxes. The decision to expense these asset purchases reflects a willingness to
report lower profits, a desire to pay lower taxes, and less concern with the market valuation process,
which often is based on earnings per share calculations. Because the effect of these decisions can be
significant, accounting conventions require a policy that is consistent from year to year. It is not
deemed appropriate to decide on your capitalization policy based on the rest of your performance.
In 2002 the collapse of WorldCom, Inc. focused a lot of attention on the accounting for fixed assets.
WorldCom, in an attempt to appear highly profitable and to shore up its stock price in light of the
overall decline in the stock prices of the telecom sector, fraudulently accounted for large amounts of
expenses as increased fixed assets rather than as operating expenses. The result was to significantly
overstate the value of its assets and its profits and understate its expenses. The entries it made, which
exceeded $12 billion over several years, can be described as:
377
2007, POME, Gautam_Koppala, All Rights Reserved
Dr Cr
Fixed Assets
Operating Expenses
In addition to destroying all credibility for the Projects, now known as MCI, the WorldCom scandal led
directly to the passage of the Sarbanes-Oxley Act of 2002, which mandated substantial changes in the
oversight and reporting responsibilities of public Corporation Based Projects s. These changes are the
subject of Chapter 12, Corporate Governance.
Some fixed assets, such as computers, other office equipment, and some machinery, are attractive.
Therefore, keeping track of these assets and taking extra precautions to protect them is important.
Many companies conduct physical inventory counts of the fixed assets, just as they do of the
inventory.
Acquisition of Fixed Assets
The most frequent and obvious method for acquiring fixed assets is to purchase them. However,
because many fixed assets represent very significant investments, the purchase requires financing.
Traditional financial management education emphasized the “matching principle,” that the life of the
financing should be consistent with the life of the asset. Therefore, a long-term asset should be paid
for using long-term financing, either debt or equity.
However, long-term financing is harder to get than short-term financing. It is more expensive than
short-term financing. And, it is often more restrictive than short-term financing. As a result, the
importance of matching is sometimes lost on management. The recession of the early 1990s was, in
part, made more difficult because many companies had financed their long-term assets with short-
term bank loans, acquired when the banks were aggressively seeking more business, but containing a
clause that required immediate repayment if there were any difficulties in the Projects, or, as it turned
out, in the bank. As a consequence, when the banks encountered difficulties, loans were called that
could not be replaced in time to protect the companies, causing or aggravating financial problems for
the companies, and deepening the recession.
In more recent years, we have again seen an increase in the use of short-term notes and lines of
credit being used for the acquisition of fixed assets, raising the possibility of similar challenges again if
the economy should falter. It is important for management to understand the risks that go along with
the benefits of using short-term debt.
378
2007, POME, Gautam_Koppala, All Rights Reserved
Other Long-Term Assets
One category of “Other Assets” that is often present on a Balance Sheet is “Goodwill,” the excess of
the purchase price for an acquisition over the market value of the assets acquired. Goodwill pays for
the value attributed to a business’s success and used to be amortized over a time long enough to
reflect the long-term benefits of the acquisition. The decision to pay a premium over the intrinsic value
of the assets being acquired has real consequences for the rate of return offered to the shareholders.
Recently, the Financial Accounting Standards Board (FASB) changed the rules for accounting for
goodwill. It decided that deducting a portion of goodwill every year was misleading and really did not
have any basis in reality. Rather, it ruled that a Projects must assess the value and validity of goodwill
every year and decide if it is still appropriate or if it has been impaired. If goodwill has been impaired,
the Projects must then assess by how much and write off that impairment all at once. If there has
been no impairment, there is no write-off. This ruling is intended to assure that the value of assets on
the Balance Sheet reflects a real benefit to the shareholders and a real basis for judging the condition
of a Projects. Remember, any journal entry to reduce the value of goodwill will have an equal and
opposite counterpart that will affect the income statement and through the profit line the equity value
on the balance sheet. A write-off of goodwill directly affects the equity value of the business, which
belongs to the shareholders.
Other assets that are included in the long-term assets section of the Balance Sheet include such items
as Cash Surrender Value of Life Insurance, Patents and Trademarks, and Investments. Each
represents a disbursement of Projects cash for an asset that may be difficult to liquidate or to liquidate
for full value. Therefore, it behooves management to think carefully about these assets.
Cash Surrender Value of Life Insurance is an asset, found particularly in small, privately held
companies, that on the surface seems reasonable, but may not be a particularly valuable investment.
The asset occurs when the Projects has purchased a life insurance policy on a key Project Manager or
owner and that policy is accumulating value. The value that accumulates, however, may assume a
much lower interest rate than would be available if the Projects were to purchase term life insurance
and invest the difference. However, it may be even more advantageous to the Projects to purchase
term life insurance and use the remaining cash in the business itself. After all, we have demonstrated
the possibility, particularly in companies with accounts receivable and inventories, that it will be
necessary to borrow funds to provide working capital. The major point here is that management
should consider carefully the utilization of its resources.
379
2007, POME, Gautam_Koppala, All Rights Reserved
Patents and trademarks are similar in that they often represent cash outlays that can only be
recaptured over an extended period of time. The capitalization of these costs moves expenses to
future periods and brings profits forward. It is, therefore, important to account for such expenses very
carefully.
Investments may be very valid and important assets, committing current resources for future gains.
However, in some cases, investments are made for reasons that are personal to the owners and
Project Managers. In some companies, particularly those that are privately held, assets such as boats,
airplanes, and artwork, or loans to shareholders or officers or investments in children’s companies
appear on the Balance Sheet. In these cases investments may be draining resources that are or will be
important to the Projects.
These assets often do not generate a return and may represent a drain on Projects resources. All of
these assets fall into a Miscellaneous Assets classification for financial analysis purposes. The
relationship of these assets to net worth, calculated in a ratio known as “Miscellaneous Assets to Net
Worth (Equity)”[*] may be an indication that resources important for the Projects’ future may not be
available when they are needed. If this ratio is increasing, owners and Project Managers may be using
the Projects’ resources in a way that limits future profitability. This ratio is not evaluated as frequently
as it probably should be, and unfortunately, some companies that could be successful do not succeed
because the financial resources were diverted to less valuable assets.
Long-term assets, which appear on the Balance Sheet in the lower section of the asset side, represent
assets that have a useful life longer than one year. These assets, which generally are more expensive
than short-term assets, require special accounting and record keeping.
Depreciation, which is the means by which the Projects recovers the cost of the asset over its useful
life, is an allowance permitted by the government, but which requires careful computations and
records as well.
There are many methods of depreciation, all of which affect the Income Statement and the Balance
Sheet. Businesses choose based on the laws and the impact that the depreciation expense will have on
financial results. Faster depreciation recovers the asset’s cost sooner, but depresses the profit. It also
decreases the taxes the Projects must pay. However, to benefit from depreciation expense, both in
terms of taxes and cash flows, you first have to spend money for the asset or commit to long-term
financing, both of which require commitment of cash, so depreciation itself is not a reason to invest in
an asset.
380
2007, POME, Gautam_Koppala, All Rights Reserved
Other long-term assets also require cash expenditures, so the decisions should be based on the
potential return to be generated. Examination of the other long-term assets may provide an insight
into management’s philosophies.
POME Prescribe
H
Hang on to your
dreams.
POME Prescribe
381
2007, POME, Gautam_Koppala, All Rights Reserved
SHARES, BONDS AND
SECURITIES
382
2007, POME, Gautam_Koppala, All Rights Reserved
Shares, Bonds and Securities:
POME Lighter Vein:
Normally big projects shares, bonds are been bought by the people for bigger returns. Hence,
protecting the shareholders is the main responsibility for the Project Directors/ Project
Sponsors/ Project managers. Also, being an employee for your organization, your Project would
be providing you the shares, which increases your moral; responsibility towards organization.
Hence, POME recommends understanding the basic concepts. Nothing in the POME went in to
marine deep concepts, but only basic anatomy, which required for the Operations folks.
The equity component of the Balance Sheet contains the information relating to Projects ownership.
Though we have focused almost entirely on the corporate form for our discussion, the structure of the
Balance Sheet and the Income Statement are consistent across all business forms. In today’s
marketplace, increasingly, there are variations on the basic business form based on a broad range of
needs. Where there used to be only Proprietorships, Partnership Based Projects s, and Corporation
Based Projects s as business forms, today there are also Limited Partnership Based Projects s, Limited
Liability Partnership Based Projects s, Limited Liability Companies, Real Estate Investment Trusts,
Corporation Based Projects s, Trusts, Associations, and other entities structured to meet particular
needs or situations. Although each of these entity types has different characteristics, the generalized
financial statement formats we have discussed are applicable to them all. Each has an Income
Statement, a Balance Sheet, and a Cash Flow Statement, and although they may or may not be
383
2007, POME, Gautam_Koppala, All Rights Reserved
available to the public, they will be interpreted consistently and will respond to the same management
actions.
When we deal with other than the corporate form, the Equity section takes on a different appearance,
describing the ownership’s financial interests with terms such as Owner’s Capital, Partners’ Capital,
and similar words. These correspond to Common Stock and Additional Paid-in Capital. Retained
Earnings are interpreted consistently.
POME Case Study:
The Rewards for Success
“As you all know, the Board of Directors met last week. They’re thrilled with the results we’ve posted
for the year, and they’ve asked me to talk to you about the stock purchase plan they’re putting in
place. This year for the first time you’ll be able to purchase Projects stock as part of the Projects
savings and investment program. ”
“That’s great, Koppala, but why are they making us purchase the stock? If we’re doing so well, why
don’t they just distribute stock along to us?”
“There are a couple of reasons, Aleksei. If it were a gift, you might not value it so highly. And some
people might not want to hold a lot of stock in the Projects. It’s very risky to have all of your resources
dependent on one source. So we think some people will want to stick with the large, professionally
managed mutual funds that are already available.”
“I understand what you’re saying, Koppala, but why are they making this offer? Won’t it lessen the
control of the current owners?”
“It will do that, Enrique. But it will make owners out of a lot of people in the Projects. Do you
remember when we started these sessions, Enrique, that the purpose of a for-profit business is to
maximize the wealth of the shareholders in the long run?”
“I do. And that’s why I’m asking: Why would they want to share the wealth?”
“They want to share the wealth, so to speak, so that the people who work here have the same long-
term objectives as the other shareholders. It’s the people who work here—Project Managers and staff
and line workers—who really determine how well the Projects does. By letting you purchase a piece of
the Projects, the board hopes that your interests will be the same as theirs. Everyone will strive their
hardest to make sure the Projects increases in value.
384
2007, POME, Gautam_Koppala, All Rights Reserved
“Let’s spend some time talking about this, so that you can go back and share the news with your
department. People are going to have a lot of questions about why this is happening and whether it’s
good for them. You need to be prepared to answer those questions. We’ll post an outline of the plan on
the intranet at 11:30. People can check out the mechanics and the details there. But be sure you meet
with everyone in your department today.”
Equity and Business Structure
Although several forms of business structure exist and more are being developed almost daily, the
principal structures are Proprietorships, Partnership Based Projects s, and Corporation Based Projects s
as described The differences in form appear in financial statements primarily in the equity section of
the Balance Sheet. All these businesses have traditionally structured Income Statements with
revenues and expenses, interest, and tax computations. All have current assets and fixed assets,
current liabilities and, at least potentially, long-term debt. When it comes to equity, the terminology
changes and some of the treatment changes as well. Additionally, and more importantly, each of these
business types has distinguishing characteristics that make it more or less attractive under differing
circumstances.
Proprietorships are businesses with one owner who is responsible for everything. The Proprietorship
Based Projectsform does not really distinguish the business from its owner, as the owner takes on all
responsibility for the obligations of the business, the management decisions for the business, and the
financial control of the business. The Proprietorship Based Projectsis easy to form, requiring minimal
registration and legal filings. In fact, there may be no filing required at all unless the business is
subject to some local tax reporting, such as sales or meals tax reporting. All of the income and
expenses of the business are considered to be an extension of the proprietor, who includes the
financial activities of the business in his or her personal income tax returns. The owner undertakes
personal liability for the obligations of the Projects and its existence continues only as long as the
proprietor chooses to continue it. A Proprietorship Based Projects technically does not survive the
proprietor although the owner may transfer the business to another proprietor. There are many, many
more proprietorships in the United States than any other business form, but they represent only a very
small percentage of the business volume and business wealth.
A Partnership Based Projects , belonging to two or more partners, often has more strength and more
flexibility than a Proprietorship Based Projects because it draws from the financial and Project
Managerial resources of more than one person and can, therefore, achieve greater size and complexity
than most proprietorships. General Partnership Based Projects s involve all the partners in the
385
2007, POME, Gautam_Koppala, All Rights Reserved
obligations of the business, and in most general Partnership Based Projects s, each partner is
responsible for all of the obligations of the business. Therefore, if one partner is unwilling, unable, or
unavailable to pay for obligations of the business, the other partner or partners are obligated to cover
them. This has led to a number of problems, which have been addressed by creating limited
Partnership Based Projects s (LPs) and limited liability Partnership Based Projects s (LLPs). These
entities, based on their structures, provide for protection for partners who are, in the first case, only
financial partners, not active in the business, and in the second case, partners who were not involved
in the situations that led to the liabilities. The establishment of limited Partnership Based Projects s
and limited liability Partnership Based Projects s has defined special rules and characteristics that
dictate the way these entities are treated for legal and tax purposes. Partnership Based Projects s are
taxed only at the partner level, with the profits of the Partnership Based Projects assigned to the
partners on the basis of their Partnership Based Projects agreement. Generally, there is a carefully
constructed Partnership Based Projects agreement detailing the management relationships as well as
the financial participation of all partners. A Partnership Based Projects technically does not survive the
departure of a partner, although the major Partnership Based Projects entities have defined the
procedures for automatic reestablishment if a partner leaves or dies.
Corporation Based Projects s represent a relatively small percentage of the business entities in the
United States, but they are responsible for the vast majority of all economic wealth and activity. In
recent years tax considerations as well as issues related to congressional desire to foster economic
development have resulted in a number of variations to the traditional corporate form and structure.
The basics remain, however. A Corporation Based Projects is considered an entity unto itself, separate
and distinct from its ownership. Therefore, its life is not limited by the lives of its owners; the
ownership may be transferred without any effect on the Corporation Based Projects . As a
consequence, the capacity of a Corporation Based Projects to borrow money, for example, is not
limited by the financial strength of the owners, a problem that faces proprietorships and Partnership
Based Projects s. The liabilities of the Corporation Based Projects are the responsibility of the
Corporation Based Projects ; the owners’ obligations are limited to the amounts of money they have
invested and if the obligations of the Corporation Based Projects exceed the capabilities of the
Corporation Based Projects to pay, the owners are not responsible for them.
Because Corporation Based Projects s are not limited the way other business types are, they offer
more ways to reward Project Managers, notably through the opportunity to achieve an ownership
position, making it easier for a Corporation Based Projects to fill out its management staffing. In the
1990s the dramatic rise in high-tech start-up companies, led to the popular use of stock as
compensation. As with access to equity investment, Corporation Based Projects s have more access to
386
2007, POME, Gautam_Koppala, All Rights Reserved
debt capital because the entity can be expected to continue, without a limit imposed because of the
owners.
Recently, the Financial Accounting Standards Board (FASB), a major rule-making body
overseeing the accounting rules used in the United States, has moved to require public companies that
offer stock options as incentives to management to recognize an expense equal to the perceived value
of the options. They argue that if options were not valuable, people would not want them. In the past
stock options, the opportunity to purchase Projects stock in the future at a price defined when the
option is granted, often were perceived to have zero value when they were granted. This issue is being
actively debated as this text is being written. (In the Sarbanes-Oxley Act of 2002, the FASB has had
some if its oversight responsibilities curtailed and reassigned to a quasi-government agency called the
Public Companies Accounting and Oversight Board [PCAOB]).
Employee stock options, and particularly incentive stock options for executives, have come under
increased scrutiny as a result of Sarbanes-Oxley. Companies are required to establish a value for
them, which can be very difficult. There is a complex options valuation theory, known as the Black-
Scholes Option Valuation Model, but it is difficult and confusing to compute and more confusing for
shareholders to understand. Many companies have eliminated incentive stock option programs as a
result of these regulations and the problems of valuation. Perhaps the most important consequence of
all is that, when stock options are assigned value, when options are issued, they reduce the
Corporation Based Projects ’s earnings, directly affecting the value of shareholders’ ownership.
Corporation Based Projects s are taxed on their earnings. The owners are not taxed on these earnings
unless the earnings are distributed as dividends. The owners are only taxed on the cash dividends they
receive (or could receive if they were not reinvested at the direction of the stockholder), which are
generally paid out of the after-tax earnings. This is often referred to as the problem of “double
taxation,” and it is one of the characteristics that differentiate Corporation Based Projects s from other
business forms. In 2003 Congress passed a change in the taxation of dividends as part of a major
change in the tax law, significantly reducing the taxes to individuals on corporate dividends they
receive.
Over the past half-century a consensus has formed among experts about the way to run the finances
of a company. During the same time period a consensus also formed about the way to manage a
portfolio of stocks and bonds. The principles that have emerged all relate to the relationship between
investors and the companies that issue securities. That relationship is subtle, and studying it has been
fruitful. Each new breakthrough about how to choose securities for a portfolio has had implications for
387
2007, POME, Gautam_Koppala, All Rights Reserved
how corporate financial managers should run the finances of a company, and has given insights into
which securities the company should issue and which projects it should undertake.
The principles of portfolio optimization and the principles of corporate financial management have
developed during the same time frame and in tandem with each other. This half-century of
development has identified several main principles, each of which has shown its validity and its
usefulness. Together they constitute a paradigm that has gained widespread acceptance. In this
chapter we call that paradigm the Standard Model, and we show these principles and how they work.
Each individual principle makes sense, and statistical evidence shows it adds value. These principles
work synergistically, so a company that follows them all does better than a company that follows only
one of them.
These principles did not immediately revolutionize the practices of corporate financial managers
everywhere. First they gained universal acceptance among theoreticians, and then they gained
acceptance among portfolio managers. Among corporate financial managers, they gained acceptance
more slowly.
Among financial managers at large corporations, this set of principles has become the completely
dominant view. The recent wave of financial scandals illustrates in a perverse way how completely
dominant this view has become. Managers at Enron and WorldCom were trying so hard to apply the
set of principles, and were so determined to be the best at applying them, that they broke laws and
reported fraudulent data. They went to extremes to create the appearance that they were especially
successful at applying the principles.
As U.S. financial markets attempt to rebuild the credibility they lost and recover from the blows they
suffered, and as U.S. corporations attempt to rally their stock prices, leaders reaffirm their conviction
that the set of principles is valid. As large U.S. corporations replace top managers and directors, each
newly appointed person makes a point of affirming and endorsing the Standard Model.
Outside the United States, top managers of large publicly-traded corporations have been slower to
accept the validity of the Standard Model, and some still express disagreement with the principles.
They argue that the Standard Model is inappropriate for one reason or another and condemn the
extreme behavior that sometimes occurs when managers slavishly follow the principles. Outside the
United States, old paradigms of financial management and old rules of thumb still have some shreds of
legitimacy. Their days are numbered, however, and the old rules will soon pass from the scene. These
non-U.S. managers may express resistance, but despite the merit of some of their arguments, the
388
2007, POME, Gautam_Koppala, All Rights Reserved
Standard Model will eventually triumph completely over all competing paradigms that dictate how to
run a corporation’s financial affairs.
The Standard Model has inexorably become dominant for a simple reason: Applying these principles
lowers a company’s cost of capital. Every company needs to lower its costs, whether those costs are
for raw material, labor, or obtaining capital. No company can willingly give its competitors a cost
advantage, so if one company lowers its cost of capital, the others in the same industry sector have to
lower theirs, too.
The first practitioners to adopt the Standard Model were institutional portfolio managers. There are
several reasons they were quicker to grasp its advantages than corporate financial managers. One is
that the first breakthrough was a scientific analysis of the tradeoffs involved in selecting securities for
a portfolio. Another is that their performance was in plain view, and it was easy to measure and rank.
They were supposed to earn high returns without taking excessive risks. Hundreds of institutional
portfolio managers were trying to do the same thing and trying to outperform each other. Any
observer could easily see which ones were particularly successful or unsuccessful. For managing
portfolios of securities, the Standard Model’s guiding principles are much better and much more helpful
than the old rules of thumb that in bygone days institutional portfolio managers attempted to apply.
how to use the Capital Asset Pricing Model to explore the relationship between risk and return as you
calculated the required rate of return on an investment. You saw the problems that can occur when
you try to assess the relative riskiness of different investments. This same problem exists when you
look at business investments, whether they be acquisitions of fixed assets or acquisitions of whole
companies. This problem is compounded by the need to acknowledge and accommodate the
requirements of different providers of funding to the Projects. One way to address this issue is through
a computation known as the cost of capital.
The cost of capital is the return required to satisfy the provider of a particular type of capital to be
used in the business. For providers of debt financing this cost is interest. For the provider of preferred
stock financing the cost is the dividend that the stock receives. The provider of common stock
financing measures his or her return in terms of earnings per share and evaluates that return as a
percentage of the price paid for the stock.
In finance textbooks, the return to the shareholder is described as the dividend on the common stock.
It is used in a valuation model, known as the Gordon Model or the Dividend Capitalization Model or
more recently as the Free Cash Flow (the amount of money that can be withdrawn from a business)
Model, as the basis for valuing common stock. However, these descriptions become problematic for
389
2007, POME, Gautam_Koppala, All Rights Reserved
those companies that pay no dividends or that are growing and consuming all the funds generated,
leaving no money that could reasonably be withdrawn. For these reasons, we look at the return to the
common shareholder as the earnings of the business, whether paid out or retained. After all, the
earnings really do belong to the shareholders.
Cost of capital recognizes that each source of funds has its own cost. By calculating each element’s
cost and weighting the costs according to the weighting of the funding sources, you can easily
compute the weighted average cost of capital (WACC).
Financial Markets
Stocks and Investors
Bonds
Projects securities
Money Bob Sue
money
Primary Market
Secondary
Market
Investing includes many terms with which every investor should become familiar in order to
make educated decisions. Additionally, the different shares, such as authorized, treasury,
outstanding and etc. have different characteristics. Thus it is important to become acquainted
with the different types of shares so that you make successful investment choices.
Types of Shares:
390
2007, POME, Gautam_Koppala, All Rights Reserved
Some of the major types of shares include:
 Authorized Shares
When a Macro Project is created it is authorized to issue a total number of shares of stock,
which is what is called authorized shares. The number is liable to changes under the
agreement of the shareholders. Additionally, not all authorized shares have to be offered to
the public and many companies decide to keep some of the shares for later uses.
 Treasury Shares
These are the shares that the Macro Project doesn't offer to the public or the employees.
They are kept for other uses.
 Restricted Shares
This type of shares is used in different compensation plans. Additionally, companies use
restricted shares as part of various incentive plans for their employees. In order to sell a
restricted share, the holder should ask for the permission of the SEC.
 Float Shares
Float shares are the shares that are traded on the open market. These are actually the
shares that investors trade with.
 Outstanding Shares
These shares include all the shares that a particular Macro Project has issued. These include
float shares as well as restricted shares.
391
2007, POME, Gautam_Koppala, All Rights Reserved
Stock statement Sample Format:
Bonds:
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt
and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.
Other stipulations may also be attached to the bond issue, such as the obligation for the issuer
to provide certain information to the bond holder, or limitations on the behavior of the issuer.
Bonds are generally issued for a fixed term longer than ten years.
A bond is simply a loan, but in the form of a security, although terminology used is rather
different. The issuer is equivalent to the borrower, the bond holder to the lender, and the
coupon to the interest. Bonds enable the issuer to finance long-term investments with external
funds.
Note: The certificates of deposit (CDs) or commercial paper are considered to be money market
instruments and not bonds.
392
2007, POME, Gautam_Koppala, All Rights Reserved
In some nations, both terms bonds and notes are used irrespective of the maturity. Market
participants normally use the terms bonds for large issues offered to a wide public and notes for
smaller issues originally sold to a limited number of investors. There are no clear demarcations.
There are also "bills" which usually denote fixed income securities with terms of three years or
less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest
risk, and bills have the least risk. This is due to a statistical measure called duration, where
lower durations mean less risk and are associated with shorter term obligations.
Valuation of Securities
• Time Value of Money
• Valuation of Bonds – NCD, PCD & FCD
• Coupon Rate, Current Yield and YTM
• Computation of Current Yield & YTM
• Valuation of Shares
• Shares with constant Dividend
• Shares with constantly growing Dividend
• Fundamental Analysis & Technical Analysis
393
2007, POME, Gautam_Koppala, All Rights Reserved
Computation of Current Yield & YTM
Current Yield Annual Interest Income
p.a.
for a Bond = Current Market Price
Yield to Maturity for a Bond is that yield for which -
Market Price = Sum of the Present Values of all
Inflows from the Bond till its maturity
Annual Interest Redemption Value – Market Price
Income + Residual maturity in years
YTM (approx.) =
Market Price + Redemption Price
2
Investment Decisions
• Intrinsic Value & Market Price
• If Market Price > Intrinsic Value,
Security is overvalued, sell it
• If Market Price < Intrinsic Value,
Security is undervalued, buy it
Bonds and stocks are both securities, but the major difference between the two is that stock-
holders are the owners of the Macro Project (i.e., they have an equity stake), whereas bond-
holders are lenders to the issuing Large Project. Another difference is that bonds usually have a
defined term, or maturity, after which the bond is redeemed, whereas stocks may be
394
2007, POME, Gautam_Koppala, All Rights Reserved
outstanding indefinitely. An exception is a consol bond, which is perpetuity (i.e., bond with no
maturity).
Features of Bonds:
The most important features of a bond are:
• Nominal, principal or face amount—
The amount on which the issuer pays interest, and which has to be repaid at the end.
• Issue price—
The price at which investors buy the bonds when they are first issued, typically $1,000.00. The net
proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the
nominal amount.
• Maturity date—
The date on which the issuer has to repay the nominal amount. As long as all payments have been
made, the issuer has no more obligations to the bond holders after the maturity date. The length of
time until the maturity date is often referred to as the term or tenor or maturity of a bond. The
maturity can be any length of time, although debt securities with a term of less than one year are
generally designated money market instruments rather than bonds. Most bonds have a term of up to
thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even
do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty
years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
o short term (bills): maturities up to one year;
o medium term (notes): maturities between one and ten years;
o long term (bonds): maturities greater than ten years.
• Coupon—
The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life
of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more
exotic. The name coupon originates from the fact that in the past, physical bonds were issued which
coupons had attached to them. On coupon dates the bond holder would give the coupon to a bank in
exchange for the interest payment.
• Coupon dates—
395
2007, POME, Gautam_Koppala, All Rights Reserved
The dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-
annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and
pay only one coupon a year.
• Indenture or covenants—
A document specifying the rights of bond holders. commercial laws apply to the enforcement of those
documents, which are construed by courts as contracts. The terms may be changed only with great
difficulty while the bonds are outstanding, with amendments to the governing document generally
requiring approval by a majority (or super-majority) vote of the bond holders.
• Optionality:
A bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
o Callability—some bonds give the issuer the right to repay the bond before the maturity
date on the call dates.. These bonds are referred to as callable bonds. Most callable
bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay
a premium, the so called call premium. This is mainly the case for high-yield bonds.
These have very strict covenants, restricting the issuer in its operations. To be free from
these covenants, the issuer can repay the bonds early, but only at a high cost.
o Puttability—some bonds give the bond holder the right to force the issuer to repay the
bond before the maturity date on the put dates; Also, known as put option.
 Call dates and put dates—the dates on which callable and puttable bonds can
be redeemed early.
• sinking fund provision
Of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The
entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is
called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds
in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
• Convertible bond
Lets a bondholder exchange a bond to a number of shares of the issuer's common stock.
• Exchangeable bond
Allows for exchange to shares of a corporation other than the issuer.
396
2007, POME, Gautam_Koppala, All Rights Reserved
Types Of Bonds:
 Fixed rate bonds
Bonds have a coupon that remains constant throughout the life of the bond.
 Floating rate notes (FRN's)
Bonds have a coupon that is linked to a money market index, such as LIBOR. for example three
months USD LIBOR + 0.20%. The coupon is then reset periodically, normally every three months.
 High yield bonds
Bonds that are rated below investment grade by the credit rating agencies. As these bonds are
relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds.
 Zero coupon bonds
Bonds do not pay any interest. They trade at a substantial discount from par value. The bond holder
receives the full principal amount as well as value that has accrued on the redemption date.
 Inflation linked bonds,
Bonds, in which the principal amount is indexed to inflation. The interest rate is lower than for fixed
rate bonds with a comparable maturity. However, as the principal amount grows, the payments
increase with inflation.
 indexed bonds,
Bonds, for example equity linked notes and bonds indexed on a Projects indicator (income, added
value) or on a country's GDP.
 Asset-backed securities
They are bonds whose interest and principal payments are backed by underlying cash flows from other
assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized
mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
 Subordinated bonds
They are those that have a lower priority than other bonds of the issuer in case of liquidation. In case
of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc.
The first bond holders in line to be paid are those holding what is called senior bonds. After they have
been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore,
subordinated bonds usually have a lower credit rating than senior bonds. The main examples of
397
2007, POME, Gautam_Koppala, All Rights Reserved
subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are
often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
 Perpetual bonds
They are also often called perpetuities. They have no maturity date. The most famous of these are the
UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were
issued back in 1888 and still trade today. Some ultra long-term bonds (sometimes a bond can last
centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are
sometimes viewed as perpetuities from a financial point of view, with the current value of principal
near zero.
 Bearer bond
It is an official certificate issued without a named holder. In other words, the person who has the
paper certificate can claim the value of the bond. Often they are registered by a number to prevent
counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or
stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an
opportunity to conceal income or assets.
 Registered bond
It is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a
transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon
maturity, are sent to the registered owner.
 Municipal bond
It is a bond issued by a state, Country, local government, or their agencies. Interest income received
by holders of municipal bonds is often exempt from the federal income tax and from the income tax of
the state in which they are issued, although municipal bonds issued for certain purposes may not be
tax exempt.
 Book-entry bond
It is a bond that does not have a paper certificate. As physically processing paper bonds and interest
coupons became more expensive, issuers (and banks that used to collect coupon interest for
depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of
a paper certificate, even to investors who prefer them.
 Lottery bond
398
2007, POME, Gautam_Koppala, All Rights Reserved
It is a bond issued by a state. Interest is paid like a traditional fixed rate bond, but the issuer will
redeem randomly selected individual bonds within the issue according to a schedule. Some of these
redemptions will be for a higher value than the face value of the bond.
 War bond
It is a bond issued by a country to fund a war.
 Gilt-edged bonds:
Highly rated bonds, whose issuers have a long-standing reputation of paying interest on time.
 Term bonds: Bullet bonds
Bonds, whose principal is payable at maturity.
 Back bond: Virgin Bond
A Eurobond created by the exercise of a warrant.
 Cushion bonds:
High-coupon bonds which sell at only a moderate Premium because they are callable at a price
below.
 Junk bonds:
High-risk bonds issued by companies with credit ratings below investment grade (a ranking
given by the credit rating agencies). Such bonds are also called high-yield bonds as they offer
investors higher yields than bonds of financially sound companies. They are usually issued to
finance leverage buy-out operations.
 Collateral bonds:
An American term, to indicate those bonds which are secured by collateral, such as the pledging
of mortgages (collateral mortgage bonds).
 Eurobond:
A Bond issued by a company or a government in a market other than that of its currency of
denomination. Eurobonds are then sold internationally and not in just one domestic market (e.g.
a German corporation may issue euro-dollar bonds on the London capital market). The main
Eurobonds include the Eurodeutsche Mark bonds, Eurodollar bonds, Euro French Franc bonds,
Euro sterling bonds and Euro yen bonds, although the nationally denominated European
Eurobonds will be phased out within Europe.
 Convertible bond; convertibles:
399
2007, POME, Gautam_Koppala, All Rights Reserved
Bonds issued by a corporation which may be converted into the corporation's Common
stock/Ordinary shares within a specified time period and at a specific price, at the option of the
holder.
 Guaranteed bond:
A bond issue where a third party (e.g. parent company) guarantees the fulfillment of the terms
of the issue.
 Clip and strip bonds:
These are bonds whose principal and coupon portions may be split and sold separately.
 Debenture:
A term indicating a fixed-interest Bond secured against the issuing Project’s assets (these may
consist either of specific assets of the Project or of its assets in general). Debenture bonds are
distinct from ordinary bonds, the latter being unsecured. Debentures will be paid whether the
issuing Project makes a profit or not and, in case of Liquidation, debenture holders have priority
over ordinary bond holders on the Project's remaining assets. Debentures can be bought and
sold on a stock Exchange.
Preferred Stock
We continue our discussion of equity focusing on corporate form, so the discussion that follows looks
at owners’ equity specifically from a corporate perspective. In some Corporation Based Projects s, the
first line of the Equity section is Preferred Stock. Corporation Based Projects, whose management
wishes to distinguish owners from other investors who may not have an ownership role, issue
Preferred Stock.
Preferred Stock is so named because it has certain preferences under special circumstances. For
example, preferred stock does not generally have a vote on corporate matters or actions. However,
under certain circumstances, such as if the Projects has not paid any preferred stock dividends for a
specified number of periods, preferred stock owners may not only have votes, but may actually control
the voting process. This preference for ownership of the interests of the preferred stockholders gives
these investors some control over the management of their investment.
Other preferences include the right to receive cash dividends before any cash dividends may be paid to
common stockholders. If the preferred stock is “cumulative,” preferred shareholders have the right to
receive all back dividends that were not paid before any cash dividends may be paid to common
stockholders; and the right to receive repayment of invested amounts before any such redemption
400
2007, POME, Gautam_Koppala, All Rights Reserved
payments may be made to common stockholders if the management decides to liquidate the Projects.
Unlike common stock dividends, dividend amounts for preferred stock are generally specifically
defined, providing a clear value for each share. These preferences are really not very important,
except if there is some prospect of financial difficulties.
However, some investors are interested in specific and predictable cash flows, and the dividends for
preferred stock are generally higher than is interest on debt, because preferred stock, falling below
debt in the repayment hierarchy, is riskier than debt, even subordinated debt. Therefore, the
predictable dividends offered by companies through their preferred stock may be attractive to
investors. Another reason for investing in preferred stock is a tax preference offered to Corporation
Based Projects s that invest in the stock of other Corporation Based Projects s. The Internal Revenue
Code offers a “dividends received deduction” equal to 70 percent of the value of such a dividend to the
receiving Corporation Based Projects , increasing the after-tax value of such dividends. As a result,
Corporation Based Projects s with excess cash that they expect to be able to hold for at least 46 days,
to satisfy a qualification rule, may choose to invest in the preferred stock of other Corporation Based
Projects s, purchasing the preferred stock so as to qualify for the dividend, holding the stock for the
requisite time period, and selling the stock to reestablish the cash position in advance of its
requirement. Thus, we can see how the marketable securities investment practices of one type of
Projects relate to the capital funding needs of another.
Preferred stock has some hybrid characteristics that make issuing it interesting and complex. From a
lender’s perspective, preferred stock looks like equity: its return is paid out of after-tax income and is
paid after interest is paid on debt, its claim on assets is subordinate to that of the lender, and it
provides capital to the Projects that serves as security for the loans. However, to the common stock
holder preferred stock looks much like debt: it receives its payment before any payment to the
shareholders, it has a higher priority claim on assets in the event of financial distress, and under
normal circumstances its owners have no say in corporate decisions.
Some preferred stock issues offer another type of opportunity for investors. Convertible preferred
stock, in addition to the preferences identified above, may also offer the shareholder the opportunity,
if desired, to convert the preferred stock into common stock at a defined rate. Often, this conversion
privilege is offered when the stock price is low but expected to increase. The shareholder has the
option to convert or not as he or she chooses, but receives the higher dividends as long as the
investment is held in preferred stock form. Therefore, if the common stock price is well below the
conversion price, preferred stock will be held. If the common stock price rises, the shareholder has the
choice, but can continue to hold the preferred stock and receive the dividends. If, at some point, the
common stock price rises enough, the shareholder may opt to convert the preferred stock into
401
2007, POME, Gautam_Koppala, All Rights Reserved
common stock and then may choose to sell all of the common stock for cash that will be significantly
higher than the original investment, or sell some of the common stock in order to recover the
investment while continuing to hold some of the common stock in order to continue to benefit from the
rising market price.
As you can see, understanding how finance works contributes to the shareholder’s ability to judge
investment alternatives. Obviously, the investor’s ability to anticipate what will happen to the Projects
and to its stock also helps. This ability comes from understanding financial management and financial
reporting and being able to interpret the information contained in the financial statements and
explanatory information provided by the Projects.
Common Stock
Common stock represents the actual ownership of the Projects. The shares of common stock, if there
is only one class, each signify an equal portion of the Projects. There may be a few shares, each with a
relatively large portion or millions or billions of shares outstanding, each of which owns an infinitesimal
part of the ownership. However, in widely held companies a relatively small percentage may represent
a substantial and influential position.
Common stock may be issued for cash investment or as a reward for effort on behalf of the Projects.
In the stock market of 1999, for example, there were numerous examples of companies entering the
public market through an Initial Public Offering (IPO) and instantly making employees of the Projects,
who received part of their early pay in stock, extremely wealthy. These employees, who may own a
very small percentage of the Projects, benefit from the sale to the public of a large number of shares,
resulting in a significant dilution of their ownership position, but also translating into very substantial
increases in their wealth in terms of the market price of the shares after offering multiplied by the
number of shares they hold.
Common stock ownership conveys certain rights to the owner, including the right to vote on certain
corporate matters including the membership of the Board of Directors, the right to vote on the number
of shares to be issued, the right to vote on matters that guide management, and sometimes the right
to preserve their ownership position in the event the Projects issues additional stock. This last right,
included in the by-laws of some Corporation Based Projects s and mandated by law in some states, is
called a preemptive right, and assures that a shareholder cannot be diluted from a position of
influence to one without influence without his or her consent. Perhaps the most important ownership
right is to vote for the Board of Directors and through that vote to influence the direction of the
Projects.
402
2007, POME, Gautam_Koppala, All Rights Reserved
The value of the common stock shown on the Balance Sheet reflects only the par value of a share of
common stock multiplied by the number of shares outstanding. It does not represent the amount paid
for the common stock unless either the par value and the amount paid per share are the same or there
is no par value for a share. The par value represents the minimum per share value that a share owner
would be responsible for if the Projects fails. If the shareholder has already paid that amount, then the
entire amount that he or she could lose is the amount already invested. This differs from the exposure
to risk of proprietors or general partners in the other principal forms of Projects organization structure.
Additional Paid-In Capital
The difference between the par value and the issue price of a share goes into the line identified as
“Additional Paid-in Capital.” On some balance sheets Additional Paid-In Capital is identified as “Paid In
Surplus” or “Capital in Excess of Par.” Regardless of its identification, Additional Paid-In Capital is
positioned on the balance sheet immediately below Common Stock and represents the rest of the
capital invested by the shareholders that was received by the Projects. It has nothing to do with the
price of a share paid on any stock exchange, over the counter, or between shareholders. For example,
if a Projects issues shares having a par value of $1.00 for $25.00 each, the $24.00 difference between
issue price and par value would be Additional Paid-in Capital. For shares issued in a public stock
offering, after the initial sale, when a second investor purchases the shares from the first shareholder
(through a broker) for $40.00 per share, the shareholder receives the whole $40.00 and recognizes a
capital gain of $15.00 (net of commissions and fees), reflecting the difference between the issue price,
$25.00, and the purchase price, $40.00, and no additional money goes to the Projects.
Retained Earnings
The amount of profit that the Projects earns and retains in the business, that is, does not pay out in
dividends, is recorded as Retained Earnings. These amounts, adjusted each period for the profits after
taxes and dividends, reflect the perceived success of the Projects and enhance the “shareholders’
wealth.”
The section of the Balance Sheet made up of Common Stock, Additional Paid-in Capital, and Retained
Earnings represents the book value of the shareholders’ ownership. The relationship of the book value
to the market value is determined by the price-earnings ratio. Although it has less to do with the book
value of the shares than the current market atmosphere, it is generally felt that those Corporation
Based Projects s that are performing well and increasing the book value of the shares are also going to
perform well in the market. Therefore, the measures of performance and financial success generally
focus on Balance Sheet and Income Statement performance measures.
Stock Repurchase Plans
403
2007, POME, Gautam_Koppala, All Rights Reserved
More and more frequently companies are establishing stock repurchase programs, arranging to buy
back common stock from shareholders, generally at prices higher than the current market prices.
These programs enable the companies to transfer cash and value to only those shareholders who want
it, whereas a dividend would be distributed to all shareholders, possibly costing the Projects more and
requiring the shareholders to deal with tax and investment issues on their own. If a stock repurchase
takes place at a price higher than the shareholder paid, it results in capital gains, and may offer a tax
benefit (although as a result of the tax changes in 2003, taxes on dividends and on capital gains are
approximately the same). Other consequences of stock repurchase programs include concentrating
ownership in management and shareholders who support management, raising earnings per share and
therefore possibly raising the stock price in the market, and utilizing excess cash for a purpose that
enhances the return on equity.
The Investment Marketplace
Companies that are looking for equity, whether for the first time or the umpteenth time, often look to
the public for funding. The sale of common stock is the most frequent method of raising substantial
capital. The first time stock of a particular Projects is sold to the public is called the Initial Public
Offering (IPO) and it often occurs with substantial publicity. Because these companies are often
unknown to the investing public, a complex series of meetings and presentations are arranged to bring
the Projects to visibility in the investment community. The IPO process is a very exciting and
challenging time for the Projects, and provides a unique opportunity for the management to tell its
story to the investment press and the investment bankers and brokers who will help make the offering
successful. There is a lot written about the IPO process, a very specialized marketing effort.
Subsequent offerings, to add more equity and provide funding for expansion or acquisitions, generate
less publicity and are managed carefully to provide capital and not disrupt the orderly market for the
stock. In some cases the additional equity is marketed to one or a limited number of institutional
investors in a private placement that effectively brings substantial capital into the Projects and limits
the disruption to management inside or the existing market outside.
When companies go public, that is, issue stock in a public offering, they often seek to be listed in a
stock market that provides a place or a system for the orderly purchase and sale of the Projects’s
stock from shareholder to shareholder. These markets do not directly involve the Projects at all,
although the management is very aware of the value placed on the shares in the market. There are a
number of organized exchanges where Projects shares are traded. The largest and most well known of
these is the New York Stock Exchange (NYSE). The NASDAQ (National Association of Securities Dealers
Automated Quotation) market has become the center for much stock market activity. Daily trading
404
2007, POME, Gautam_Koppala, All Rights Reserved
volume on NASDAQ is comparable to that on the NYSE and is increasing. More recently, an alternative
marketplace has arisen through the Internet and it is likely that electronic stock trading will become
the predominant means of exchanging shares in the years to come. In fact, a number of smaller
companies have issued their shares to the public over the Internet, bypassing the traditional markets
entirely.
Accounting For Equity
One of the ways to consider the accounting effect of different transactions is to consider what will
happen to equity as a result. For example, if a Projects incurs a loss, the ultimate effect, through the
closing of the Income Statement into retained earnings is a reduction in shareholders’ equity.
Similarly, if a Projects increases its sales and profits, the ultimate effect will flow through the Income
Statement to affect the owners’ wealth. Though many analysts focus on the effect on cash of different
actions, the real concern should be directed toward the net worth of the Projects
Consider this flo Assume that the sales department wants the Projects to carry more inventory in order
to satisfy customers’ desires for faster delivery. To purchase more inventory, the Projects will have to
either use its cash or borrow funds from a bank. If it uses the cash, the Projects reduces its ability to
invest the cash and increase its income. If the Projects borrows money, it incurs interest expense,
lowering both profits and retained earnings. The cost of carrying the inventory, as we saw, results in
higher expenses and therefore has a depressing effect on profits until it is sold. The test of the
suggestion, therefore, must be to assess whether the higher investment in inventory will add to or
detract from the profits of the Projects, ultimately affecting the equity on the Balance Sheet.
To complicate this analysis a bit, consider whether the impact will be to lower profits this year, but
increase them in future years. Now we must add time value of money considerations as well as
assessment of the likelihood of the forecast to the assessment. These kinds of considerations are a
significant part of the financial management of a business and require that the Project Managers
understand the financial implications of such decision making.
The equity on the Balance Sheet reflects the ownership of the Projects. Whether the Projects is a
proprietorship, Partnership Based Projects , or Corporation Based Projects , or some variation on one
of these, the equity remains the reflection of the ownership values.
The principal forms of business structure are:
1. Proprietorship
 single owner
405
2007, POME, Gautam_Koppala, All Rights Reserved
 general liability
 limited access to capital
 ease of establishment and dissolution
 single level of taxation
2. Partnership Based Projects
 multiple owners
 general liability
 somewhat limited access to capital
 Partnership Based Projects agreement usually required
 automatic dissolution when partner leaves
 single level of taxation
 Corporation Based Projects
 one or more owners
 limited liability
 required legal documentation for establishment
 easier access to capital
 unlimited life
 double taxation of earnings on distribution
Common Stock represents ownership and has certain rights, such as voting for directors and on major
corporate actions.
Preferred stock is investment that may include an ownership interest under certain circumstances and
provides certain preferences, predominantly related to the distribution of corporate assets.
Most accounting transactions eventually have an impact on equity, generally through the Income
Statement, where the net income after taxes and dividends becomes the change in retained earnings.
POME Prescribe:
About Planning
 Plan ahead: Before you plunge headlong into work, spend some time planning your project.
 Break down work into tasks(WBS): Breaking down the project into smaller tasks (and mini-tasks if required)
ensures that you have a systematic approach.
 Keep it visible and visual: Plotting a chart or graph about work progress and tacking it in a prominent place on
your soft board (or keeping the softcopy on your desktop) ensures that your progress is visible to you.
406
2007, POME, Gautam_Koppala, All Rights Reserved
 Infrastructure: A reliable server lays the foundation for efficient work. Good infrastructure and equipment
translate to smooth functioning for any task.
 A step-by-step plan is the best way to ensure you know where you are going.
 In project management, the bulk of the work happens after the planning phase. How well this implementation
of the plan happens depends on how thorough and specific the planning and documentation was. Bad
planning translates to bad implementation.
 Good planning alone does not ensure good implementation. Follow-through becomes vital here. As the
leader, the project manager ensures that the team sticks to the plan.
 As a project manager, you need to check that everyone is following the functional spec and style guide, that
they are using the proper naming conventions and version controls, and that backup files are being saved on
the server. Rules are useful only insofar as they are implemented and followed.
 Be prepared: Know your stuff front-wards, back-wards, and every way in between. This does not mean that
you need to say everything you know. Being prepared helps you to quickly answer questions and convey that
you know what you are talking about.
 Understanding the goals: A project is truly successful only when you are meeting the need for which it was
created. Identifying the scope and requirements at the outset and also acknowledging that in the real world,
these can change is a good starting point.
 Getting it right from the outset: The most important part of a project’s life cycle is the identification of its
requirements.
407
2007, POME, Gautam_Koppala, All Rights Reserved
F
Family and friends are
hidden treasures, seek
them and
enjoy their riches. POME Prescribe
POME LIGHTER VEI&:
Too many Meetings:
Finally! Meetings get a purpose (other than boredom).
408
2007, POME, Gautam_Koppala, All Rights Reserved
409
2007, POME, Gautam_Koppala, All Rights Reserved
ACCOUNTING
SCHEDULE’S
410
2007, POME, Gautam_Koppala, All Rights Reserved
Accounting Schedules:
What is accounting management?
Normally the small and medium Project managers wont be involving in the Accounting
schedules of their respective Organizations, but for a macro Projects of a company, do decide
the fate of the company, and hence Project Managers involve in the accounting schedules,
especially a Projects like International AirPort, large refineries and space programmes.
It also involves the Project Managers of the Business Implementation Projects, which starts with an
opportunity, with a business concept. And concludes When the process is operational, When the
process has been running smoothly for a defined period, When the business benefits are starting to
become visible( assessed through accounting) Which evaluates When the process has been running
smoothly( sustained accounting figures) for a defined period and When the business benefits are
starting to become visible. Over the lifetime of the process. The project produces an operationally
effective process, through the figures of accounting.
Though the small time managers does not involve in accounting schedule, but recommended
to study the accounting schedule in this POME Chapter in order to know hoe we are directly or
indirectly responsible to stake holders, how the Property of our organization is asses, how the
financial statements denote, where the future of the organization to be.
Accounting information is generally used for three distinct purposes:
411
2007, POME, Gautam_Koppala, All Rights Reserved
• Internal reporting to project managers for day-to-day planning, monitoring and control.
• Internal reporting to managers for aiding strategic planning.
• External reporting to End Users, government, regulators and other outside parties.
To complete this introduction to accounting, some additional terms and concepts need explanation.
The first of these is GAAP, generally accepted accounting principles.
From time to time you will hear people talk about GAAP (pronounced “gap”), perhaps asking if such
and such has been handled according to GAAP. GAAP has been defined by the Accounting Principles
Board as follows: “Generally accepted accounting principles encompass the conventions, rules, and
procedures necessary to define accepted accounting practice at a particular time.”
This definition is not particularly helpful, especially to the nonaccountant. However, because all public
companies and most others prepare their financial statements and accounting information according to
GAAP, what it means, and what GAAP really does, is assure that financial information is prepared
consistently and may be understood in the same way as other financial information similarly prepared.
Therefore, GAAP assures that analysts and other readers of financial statements should understand the
same structures and descriptions the same way and can compare financial statements and arrive at
reasonable and supportable conclusions.
Other accounting terms such as accrual accounting, materiality, and auditor’s opinion also create
confusion. This is an appropriate place to define some of these terms as well.
Accruals and accrual accounting recognize that it is important to match revenues and expenses in
the same time period. They also acknowledge that the recording of accounting transactions cannot
always be completed quickly enough to produce timely, usable financial statements. Accruals,
therefore, are accounting transactions that estimate revenues, or more probably, expenses so that the
period’s financial reports will reflect that period’s results appropriately. Accruals also reflect
transactions that were not really complete at the end of the accounting period but that should be
reported. An example of such is Accrued Wages, wages earned during the period, but not due or
payable at the end of that period. For example, assume that December 31 falls on a Wednesday and
that payday is Friday. The wages earned in December should be reported as December transactions,
but the amount so earned is not due or payable on December 31, the end of the accounting period.
The wages earned through December 31 will, therefore, be accrued, charged into the December
accounting period.
Materiality is another attempt to make the accounting process reasonable. Some transactions are
really very small relative to the operations of the entire business, but to be perfectly accurate, need to
412
2007, POME, Gautam_Koppala, All Rights Reserved
be recognized. The concept of materiality acknowledges that if we try to account for all the
transactions at the end of a period, we may spend far more time or energy than will be worthwhile
when compared to the value of the transactions involved. Therefore, GAAP recognizes that if not
accounting for such a transaction properly will not change the quality or usefulness of the overall
financial information, the transaction may be deemed “not material.” Accountants have agreed that if a
transaction is not material, it does not have to be completed or reported if such reporting will delay the
completion of the reporting. Therefore, you may hear people talk about some information as not being
material.
The auditor’s opinion is one place where GAAP and materiality come together. All public companies and
many other companies employ outside auditors to review the accounting information to assess their
accuracy and completeness. The auditor reviews the records and transactions of the company and
provides an opinion as to whether or not they “present fairly, in all material respects, the financial
position of the company as of December 31, XXXX.” Analysts, investors, management, and others use
this opinion as an assurance that a competent outsider has reviewed the accounting information and
found it sound. These people then feel they can rely on the information to make Project Managerial or
investment decisions.
Sometimes, the auditors believe that there is a problem with the company or its records. They will,
under those circumstances, issue a “qualified” opinion and explain the qualification they have
identified. The users of the financial statements, thus informed, can make appropriate decisions. The
management, after receiving a qualified opinion, will be under great pressure to correct whatever
deficiency has been identified.
Similarly, auditors may decline to express an opinion, known as a “Disclaimer,” if they do not feel
there is sufficient assurance of accuracy and completeness in the financial information provided by the
company. In the most negative circumstances, the auditor may issue an “Adverse Opinion,” stating
that in their opinion the financial statements presented by the company do not “present fairly” the
financial condition as at the identified dates. Adverse opinions have all kinds of negative consequences
and companies try to avoid them if at all possible.
External reports are constrained to particular forms and procedures by contractual reporting
requirements or by generally accepted accounting practices. Preparation of such external reports is
referred to as financial accounting. In contrast, cost or managerial accounting is intended to aid
internal managers in their responsibilities of planning, monitoring and control.
413
2007, POME, Gautam_Koppala, All Rights Reserved
Project costs are always included in the system of financial accounts associated with an organization.
At the heart of this system, all expense transactions are recorded in a general ledger. The general
ledger of accounts forms the basis for management reports on particular projects as well as the
financial accounts for an entire organization. Other components of a financial accounting system
include:
• The accounts payable journal is intended to provide records of bills received from vendors,
material suppliers, subcontractors and other outside parties. Invoices of charges are recorded in
this system as are checks issued in payment. Charges to individual cost accounts are relayed or
posted to the General Ledger.
• Accounts receivable journals provide the opposite function to that of accounts payable. In
this journal, billings to clients are recorded as well as receipts. Revenues received are relayed
to the general ledger.
• Job cost ledgers summarize the charges associated with particular projects, arranged in the
various cost accounts used for the project budget.
• Inventory records are maintained to identify the amount of materials available at any time.
We use some consistent and easily applied tools to provide a context and a framework for conducting
the analysis. Keep these questions in mind throughout this POME Chapter and whenever you are
looking at financial information.
Comparative Analysis
Financial analysis is generally cast as a comparative analysis, in a comparative analytical structure.
The comparisons are based on the current company information and either industry or competitive
information or historic company information. When the comparison is to other companies in the
industry, whether identified as direct and specific competitors or as averages drawn from industry
summaries, the analysis is described as cross-sectional or competitive analysis. It serves to
benchmark a company against other members of its industry and gives management an idea of the
company’s relative performance.
This kind of analysis, however, is often of limited Project Managerial use because the companies in an
industry are frequently not comparable, particularly if the company is relatively small. In addition,
companies often define their data differently, making comparisons difficult. Also, management
philosophies differ, resulting in different practices and choices of financing and operations, again
making comparisons difficult.
414
2007, POME, Gautam_Koppala, All Rights Reserved
If you choose to undertake an industry or competitive analysis, it is important to have reliable source
data and to understand their limitations. There are a number of published sources for industry data
and they are presented in a number of ways. Here are a few industry data sources:
Dun & Bradstreet (D&B)
Drawn from corporate filings and company-provided information, D&B statistics provide information by
North American Industry Classification System (NAICS) code, which in 2002 officially replaced the
Standard Industrial Classification (SIC) code system, which had been in place for many years as a
classification system used by the United States Census Bureau to categorize companies by the type of
business they do. NAICS, first adopted in 1997, was updated in 2002 and will be updated again in
2007. It was developed to “provide new comparability in statistics about business activity across North
America,” according to the U.S. Census Bureau’s web-site. However, whereas company-provided data
are summarized and presented by D&B, they are not independently validated or confirmed.
Risk Management Association (RMA), formerly Robert Morris Associates (RMA)
Drawn from information provided by the bank members of RMA, industry data are presented in
quartile form. (Exhibit below illustrates a quartile presentation.) There is some belief that, because
they come from filings made with their banks, the company-provided data may be more reliable than
data from some other sources. RMA also segregates its quartile data into company-size quartiles as
well.
Exhibit: Financial Ratios as Quartile Data
Trade Associations
Trade association data may be more specific than D&B or RMA data by general NAICS code, but it may
be of limited value because of reporting rules. For example, the trade association, mindful of the
confidential nature of proprietary information, may restrict data that would identify a specific company.
This renders the comparisons of limited value.
415
2007, POME, Gautam_Koppala, All Rights Reserved
Investment Analysts
Investment analysts publish industry data as part of the investment research function. Here, too, the
particular opinions and biases of the analysts may influence the presentation of data. Investment
analysts are frequently employed by investment advisory firms and their use of ratios and other
performance data may be chosen to bolster their analysis and the opinions they are expressing.
Financial ratios are frequently presented as quartile data. The quartiles represent the average ratios for companies
falling at the respective quartiles, in terms of annual sales volume, within their industry, usually determined by NAICS.
Trend Analysis
By contrast to industry comparison, comparing a company to itself over time, called historic or trend
analysis, permits the analyst to track progress. In most cases, whether financial or not, an analyst
looking at historic analysis knows whether the company is improving. If a company is improving year
after year, that is good. Even if it trails the industry averages, continuous improvement is a predictor
that it won’t be behind for long.
The chart in Exhibit below highlights the limitations of an industry comparison and the clarity of
historic analysis at the same time. For this reason, many analysts try to incorporate elements of both
types of analysis into their assessment.
Exhibit: Comparative Performance
Assumptions in the below Accounting Schedules for better understanding:
1. GG ORG(“the POME assumed Company”) financial statements, assumed the year ended
31 March 2006, taken to illustrate the methodology in normal Operations in big
corporates.
416
2007, POME, Gautam_Koppala, All Rights Reserved
2. ‘Accounting Standards’ issued by the Institute of Chartered Accountants of India have
been implemented in the presentation of these financial statements.
3. Work in progress (WIP) to be valued at material cost.
4. Finished goods are always to be valued at the lower of cost or net realisable value.
Cost is determined on the basis of first in first out method and includes labour cost
absorbed on a pre-determined basis.
5. Traded goods are to be valued at lower of cost and net realisable value. Cost is
determined on the basis of first in first out method and includes expenses incurred in
bringing the same to its current location.
6. Raw Materials and components are to be valued at the lower of cost and net realisable
value. Cost is determined on the basis first in first out method and includes all costs in
bringing the inventories up to its present location and condition.
7. ‘Cost’ is defined as being all expenditure which has been incurred in bringing the
product or service to its present location and condition
8. Consumables and stores as and when purchased are expensed as consumption. The
value of such items at the period end is not significant.
9. The manufacturing overheads are not absorbed for the purpose of inventory valuation
as the same is not material.
10. Stocks do not include:
a. goods purchased for which liabilities have not been provided; and
b. Goods returned by customers without credit to their accounts.
11. Provision, when material, has been made for :
a. loss to be sustained in the fulfilment of, or inability to fulfil, any sales
commitments.
b. loss to be sustained as a result of purchase commitments for inventory or other
assets at quantities in excess of normal requirements or at prices in excess of
prevailing market prices.
c. loss resulting from defaults in principal, interest, sinking fund or redemption
provisions with respect to any issue of share or loan capital or credit
arrangement, or any breach of covenant of an agreement.
417
2007, POME, Gautam_Koppala, All Rights Reserved
1. Significant accounting Schedule policies
 Basis of preparation of financial statements
The financial statements must have been prepared and presented under the historical cost convention
on the accrual basis of accounting and comply with the Accounting Standards issued by the Chartered
Accountants of respective regions and the relevant provisions of the respective regions Companies
Acts and norms, to the extent applicable.
 Assumptions:
The preparation of financial statements in conformity with generally accepted accounting principles
(GAAP) requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent liabilities on the date of the financial statements.
Actual results could differ from those estimates. Any revision to accounting estimates is recognised
prospectively in current and future periods.
418
2007, POME, Gautam_Koppala, All Rights Reserved
The financial statements in this POME Chapter are presented in thousands of Indian rupees.
 Fixed assets and depreciation
Fixed assets are to be carried at cost of acquisition or construction less accumulated depreciation. The
cost of fixed assets also includes the exchange differences (favorable as well as unfavorable) arising in
respect of foreign currency liabilities incurred for the purpose of their acquisition or construction from a
country.
Borrowing costs related to the acquisition or construction of the qualifying fixed assets for the period
up to the completion of their acquisition or construction are capitalized. Acquired intangible assets are
recorded at the consideration paid for acquisition.
Leases under which the Company assumes substantially all the risks and rewards of ownership are
classified as finance leases.
Depreciation is provided on the straight-line method from the beginning of the month in which the
asset is ready for use. If the management’s estimate of the useful life of a fixed asset at the time of
acquisition of the asset or of the remaining useful life on a subsequent review is shorter than that
envisaged in the aforesaid schedule, depreciation is provided at a higher rate based on the
management’s estimate of the useful life/remaining useful life. Pursuant to this policy, depreciation on
assets has been provided at the rates based on the following POME estimated useful lives of fixed
assets:
Asset Category Useful life
(Years)
Buildings 30
Plant and machinery 12
Office equipment 16
Air conditioner 8
Data processing equipment 5
Computer software 3
Furniture and fixtures 10
419
2007, POME, Gautam_Koppala, All Rights Reserved
Vehicles 5
Licenses and technical knowhow 5 to 6
Equipment leased to others 12
Freehold land is not depreciated. Assets individually costing certain specified amount, are depreciated
fully in the year of purchase. Depreciation is charged on a proportionate basis for all assets purchased
and sold during the year.
Leased assets to be depreciated over the lease term or the useful life, whichever is shorter.
Advances paid towards acquisition of fixed assets and the cost of assets acquired but not ready for
use as at the balance sheet date are disclosed under capital work-in-progress.
 Investments
Long-term investments to be carried at cost less any other-than-temporary diminution in value,
determined separately for each individual investment.
 Inventories
(i) Inventories to be carried at the lower of cost and net realizable value.
(ii) Cost comprising purchase price and all incidental expenses incurred in bringing
the inventory to its present location and condition. The method of determination
of cost is as follows:
 Raw materials and components - on a first in first out method.
 Work-in-progress – includes cost of conversion.
 Stores and spares - on a first in first out method.
 Manufactured finished goods - includes costs of conversion.
 Traded finished goods - at landed cost on a first in first out method.
420
2007, POME, Gautam_Koppala, All Rights Reserved
(iii) The comparison of cost and net realizable value is made on an item-by-item
basis.
(iv) The net realizable value of work-in-progress is determined with reference to the
net realizable value of related finished goods. Raw materials and other supplies
held for use in production of inventories are not written down below cost except
in cases where material prices have declined, and it is estimated that the cost of
the finished products will exceed their net realizable value.
(v) The provision for inventory obsolescence is assessed on a quarterly basis and is
provided as considered necessary.
 Retirement benefits
Contributions to superannuation fund, which is a defined contribution scheme, are to be made at
pre-determined rates to the Life Insurance Corporations of the respective regions, on a monthly basis.
Gratuity and leave encashment costs, which are defined benefit schemes, are accrued based on
actuarial valuation at the balance sheet date, carried out by an independent actuary.
Contributions payable to the recognized provident fund, which is a defined contribution scheme, are
charged to the profit and loss account.
 Revenue recognition
Revenue from sale of both manufactured and traded goods, including scrap, is to be recognized on
transfer of all significant risks and rewards of ownership to the buyer. The amount recognized as sale
is exclusive of sales tax and trade and quantity discounts. The Company must provide for probable
sales returns on an estimated basis based on past trends as a reduction from revenue. Revenue from
sale of goods has been presented both gross and net of excise duty, if applicable.
421
2007, POME, Gautam_Koppala, All Rights Reserved
The Balance-Sheet Model of the
Project
The Capital Budgeting Decision
(Investment Decision)
Current
Current Liabilities
Assets Long-Term
Debt
Fixed What
Assets long-term Shareholder
1 Tangible investmen s’ Equity
2 Intangible ts should
the firm
engage
in?
Software services comprise income from time and material contracts. Revenue from time and material
contracts is recognized on the basis of software developed and billable in accordance with the terms of
the contract with the clients.
Income from annual maintenance contracts is recognized on a pro-rata basis over the period of
the contract, over which the service is delivered.
Commission on sales comprises income earned on sales orders procured on behalf of its group
companies and is recognized on shipment of goods by such group company.
Lease rental income is recognized when billable in accordance with the terms of the contract with
the clients.
Interest on deployment of surplus funds is recognised using the time proportionate method based
on underlying interest rates.
422
2007, POME, Gautam_Koppala, All Rights Reserved
 Foreign exchange transactions
Foreign currency transactions are recorded at the rates of exchange prevailing on the dates of the
respective transaction. Exchange differences arising on foreign exchange transactions settled during
the year are recognized in the profit and loss account of the year, except that exchange differences
related to acquisition of fixed assets from a country outside India are adjusted in the carrying amount
of the related fixed assets.
Monetary assets and liabilities denominated in foreign currencies as at the balance sheet date are
translated at the closing exchange rates on that date; the resultant exchange differences are
recognized in the profit and loss account except those related to acquisition of fixed assets from a
country outside India which are adjusted in the carrying amount of the related fixed assets.
 Warranties
Warranty costs are estimated by the management on the basis of a technical evaluation and past
experience. Provision is made for estimated liability in respect of warranty costs in the year of sale of
goods.
 Provisions and contingent liabilities
The Company must recognize, a provision when there is a present obligation as a result of a past
event that probably requires an outflow of resources and a reliable estimate can be made of the
amount of the obligation. A disclosure for a contingent liability is made when there is a possible
obligation or a present obligation that may, but probably will not, require an outflow of resources.
Where there is a possible obligation or a present obligation that the likelihood of outflow of resources is
remote, no provision or disclosure is made.
 Income taxes
Income-tax expense comprises current tax (i.e. amount of tax for the period determined in accordance
with the income-tax law) and deferred tax charge or credit (reflecting the tax effects of timing
differences between accounting income and taxable income for the year). The deferred tax charge or
credit and the corresponding deferred tax liabilities or assets are recognized using the tax rates that
have been enacted or substantively enacted by the balance sheet date.
423
2007, POME, Gautam_Koppala, All Rights Reserved
Deferred tax assets are recognised only to the extent there is reasonable certainty that the assets can
be realized in future; however, where there is unabsorbed depreciation or carried forward loss under
taxation laws, deferred tax assets are recognised only if there is a virtual certainty of realization of
such assets.
Deferred tax assets are reviewed as at each balance sheet date and written down or written-up to
reflect the amount that is reasonably/virtually certain (as the case may be) to be realized. The
Company offsets, on a year on year basis, the current tax assets and liabilities, where it has a legally
enforceable right and where it intends to settle such assets and liabilities on a net basis.
 Impairment of assets
The Company must assess at each balance sheet date whether there is any indication that an asset
including goodwill may be impaired. If any such indication exists, the Company estimates the
recoverable amount of the asset. If such recoverable amount of the asset or the recoverable amount
of the cash generating unit to which the asset belongs is less than its carrying amount, the carrying
amount is reduced to its recoverable amount. The reduction is treated as an impairment loss and is
recognised in the profit and loss account. If at the balance sheet date there is an indication that if a
previously assessed impairment loss no longer exists, the recoverable amount is reassessed and the
asset is reflected at the recoverable amount. In respect of goodwill the impairment loss will be
reversed only when it was caused by specific external events and its effect has been reversed by
subsequent external events.
424
2007, POME, Gautam_Koppala, All Rights Reserved
The Balance-Sheet Model of the Project
The Capital Structure Decision
(Financing Decision)
Current
Current Liabilities
Assets
Long-Term
Debt
How can the
firm raise the
money for the
Fixed Assets
required
1 Tangible Shareholders’
investments?
2 Intangible Equity
 Earnings/loss per share
The basic and diluted earnings/(loss) per share are computed by dividing the net profit/(loss)
attributable to equity shareholders for the year by the weighted average number of equity shares
outstanding during the year. The Company did not have any potentially dilutive equity shares
outstanding during the year.
In traditional bookkeeping systems or PMIS, day to day transactions are first recorded in journals.
With double-entry bookkeeping, each transaction is recorded as both a debit and a credit to particular
accounts in the ledger. For example, payment of a supplier's bill represents a debit or increase to a
project cost account and a credit or reduction to the company's cash account. Periodically, the
425
2007, POME, Gautam_Koppala, All Rights Reserved
transaction information is summarized and transferred to ledger accounts. This process is called
posting, and may be done instantaneously or daily in computerized systems.
In reviewing accounting information, the concepts of flows and stocks should be kept in mind. Daily
transactions typically reflect flows of dollar amounts entering or leaving the organization. Similarly, use
or receipt of particular materials represents flows from or to inventory. An account balance represents
the stock or cumulative amount of funds resulting from these daily flows. Information on both flows
and stocks are needed to give an accurate view of an organization's state. In addition, forecasts of
future changes are needed for effective management.
Information from the general ledger is assembled for the organization's financial reports, including
balance sheets and income statements for each period. These reports are the basic products of the
financial accounting process and are often used to assess the performance of an organization. Table
below shows a typical income statement for a small construction firm, indicating a net profit of $
330,000 after taxes. This statement summarizes the flows of transactions within a year.
TABLE Illustration of an Accounting Statement of Income
Income Statement
for the year ended December 31, 20xx
Gross project revenues $7,200,000
Direct project costs on contracts 5,500,000
Depreciation of equipment 200,000
Estimating 150,000
Administrative and other expenses 650,000
Subtotal of cost and expenses 6,500,000
Operating Income 700,000
Interest Expense, net 150,000
Income before taxes 550,000
Income tax 220,000
Net income after tax 330,000
Cash dividends 100,000
Retained earnings, current year 230,000
Retention at beginning of year 650,000
Retained earnings at end of year $880,000.</< td>
426
2007, POME, Gautam_Koppala, All Rights Reserved
Table below shows the comparable balance sheet, indicated a net increase in retained earnings equal
to the net profit. The balance sheet reflects the effects of income flows during the year on the overall
worth of the organization.
TABLE Illustration of an Accounting Balance Sheet
Balance Sheet
December 31, 20xx
Assets Amount
Cash $150,000
Payments Receivable 750,000
Work in progress, not claimed 700,000
Work in progress, retention 200,000
Equipment at cost less accumulated depreciation 1,400,000
Total assets $3,200,000
Liabilities and Equity
Liabilities
Accounts payable $950,000
Other items payable (taxes, wages, etc.) 50,000
Long term debts 500,000
Subtotal 1,500,000
Shareholders' funds
40,000 shares of common stock
(Including paid-in capital) 820,000
Retained Earnings 880,000
Subtotal 1,700,000
Total Liabilities and Equity $3,200,000
Notes to the accounts
As a result, complementary procedures to those used in traditional financial accounting are required to
accomplish effective project control, as described in the preceding and following sections. While
financial statements provide consistent and essential information on the condition of an entire
organization, they need considerable interpretation and supplementation to be useful for project
427
2007, POME, Gautam_Koppala, All Rights Reserved
management. 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
The first main section of this POME Chapter, General Guidelines and Definitions, is intended to address
the overarching concepts found throughout this POME Chapter. The second section, Financial Reports
and Metrics, addresses the standard reports required by Corporate including account names and metric
calculation detail. The Key Concepts section provides links to term definitions used throughout the
POME Chapter.
The Corporate Business Analysis and Planning organization owns the content of this POME Chapter.
Any questions or suggestions should be directed through the SBG Controller/FP&A Leader.
Company has an existing Corporate Controllers’ Policy that may help clarify some of the points made
within this document.
Any exceptions or deviations to these policies and procedures require prior, written consent by the
Corporate Controllers and Corporate Business Analysis and Planning (BAP) departments. General
Guidelines and Definitions
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.
Financial Management
Financial Management (FM) is Company’s standard financial reporting system. It is the source of all
financial data used for external reporting and internal management reporting purposes. The FM
account code structure is based on Company’s common Chart of Accounts (COA) and uses the
convention of parent and child accounts.
“External” View
428
2007, POME, Gautam_Koppala, All Rights Reserved
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.
“Measurement Basis”
The term “Measurement Basis” is used to identify key SBG Income Statement financial data such as
Operating Income Measurement Basis or Net Income Measurement Basis. This term simply indicates
that standard General Ledger Income Statement components have been adjusted to reflect
adjustments approved by the Corporate Controller’s department (i.e. Corporate assessments).
Company’s Corporate Financial Management (FM) system facilitates the adjustments and reporting of
“Measurement Basis” financial data which is used for measuring the SBG’s operating results.
Comparative Analysis Formats
Comparison data shown in dollar amounts or percentages uses the convention of positive numbers or
percentages equating to favorable variances, and negative numbers or percentages equating to
negative variances versus the comparison period(s).
Financial Reports and Metrics
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). Report examples are provided.
Key Financial Reports and Metrics
Report Name Responsibility Date Issued Distribution List
10. Sales Flash BAP CEO/CFO
11. Income Statement BAP CEO/CFO
12. Free Cash Flow BAP CEO/CFO
Statement
13. Orders BAP CEO/CFO/SBG
Presidents
14. Working Capital BAP CEO/CFO
15. Income Variance SBG FP&A CFO/BAP/IR
429
2007, POME, Gautam_Koppala, All Rights Reserved
16. Functional Census & Cost FT Finance CEO/CFO/Corporate
Sr. VPs/SBG
Functional VPs and FT
Leaders
17. General & Administrative FT Finance CEO/CFO/Corporate
Expense Sr. VPs
18.Indirect Spend BAP CEO/CFO/Corporate
Sr. VPs/SBG
Presidents
1. Contingent liabilities and capital commitments ( POME Sample)
31 March 31 March
2006 2005
Rs ‘000 Rs ‘000
(i) Estimated amount of contracts remaining
to be executed on capital account (net of 1,569 1,636
advances) and not provided for
(ii) Contingent liabilities:
a) Bills receivable discounted and not
87,400 373,889
matured
b) Letter of credit 217,779 29,060
c) Bank guarantees including 189,559 150,805
commitments
d) Claims against the Company not
acknowledged as debts (including
interest and penalty demanded)
- Customs duty
430
2007, POME, Gautam_Koppala, All Rights Reserved
- Sales tax 6,970 208,065
- Central Excise 19,500 29,496
- Service tax 3,130 -
- Income tax (additionally refer to 70,000 -
note (g),(h) and (i) below)
741,488 12,450
- Others
21,946 11,194
e) Sundry debtors factored with recourse
/ put option for the buyer outstanding
1,000,000 1,000,000
at the year end (additionally refer to
note (j) below)
f) Potential liability of provident fund
payable on leave encashment for the
period October 1994 to April 2005 2,881 -
which is pending final decision by
appropriate authorities
g) Also, the notices in the previous years including an interest component from
the Income Tax Authorities relating to the assessment year to be checked.
h) Even, a Notice of Demand for the amount towards tax and interest from the
Income Tax Authorities relating to that assessment year The demand towards
tax comprising amount, on account of transfer pricing adjustment and also the
other amount on account of denial of tax holiday benefit and other
adjustments.
i) The Company factors its receivables with the banks. As per the factoring
agreement, the bank shall have the right to immediate recourse upon
happening of the following events:
i. If there is a shortfall, due to non-payment by the customer, which will
trigger the exercise of the “PUT” option by the bank and shall be exercised
by debit to the Company’s bank account; and
431
2007, POME, Gautam_Koppala, All Rights Reserved
ii. Upon termination of this agreement.
Further, the factored debtors have been adequately provided for.
2. Legal and professional fees include auditors’ remuneration (POME Sample)
31 March 31 March 2005
2006
Rs ‘000 Rs ‘000
Statutory audit fees 2,836 2,350
Tax audit fees 135 126
Out-of-pocket expenses 85 86
_____ _____
2,562
3,056
3. Leases
 Finance leases ( POME Sample):
The Company taken vehicles, computers and office equipment under finance lease. Future minimum
lease payments under finance lease obligations as at 31 March 2006 is:
Rs ‘000
Minimum lease Future Present value of
Period
payments interest minimum lease
Not later than 1
year 54,120 5,928 48,191
Later than 1 year
and not later than 5 57,234 3,456 53,778
432
2007, POME, Gautam_Koppala, All Rights Reserved
years
111,354 9,384 101,969
 Operating leases
The Company leasing office and housing facilities under cancellable operating lease agreements. The
Company if intends to renew such leases in the normal course of business. Total rental expenses, sub-
lease income incurred also to be incorporated for the assessed year.
 Deferred taxation ( POME Sample)
Deferred taxes included in the balance sheet comprise the following:
31 March 31 March
2006 2005
Rs ‘000 Rs ‘000
Deferred tax assets
Inventories 53,346 48,859
Sundry debtors 82,218 140,623
Loans and advances 129,282 130,526
Current liabilities 76,175 50,146
Provisions 11,882 14,953
Unabsorbed depreciation and carry forward - 62,487
losses
Total deferred tax assets 352,903 447,594
Deferred tax liability
Fixed assets (82,903) (102,594)
Total deferred tax liabilities (82,903) (102,594)
433
2007, POME, Gautam_Koppala, All Rights Reserved
Deferred tax asset, net 270,000 345,000
“Virtual certainty”--the Company has reassessed the carrying value of the deferred tax asset arising
from unabsorbed depreciation, carry forward business losses and other timing differences and has
accordingly reduced the deferred tax asset from Rs 345,000,000 as at 31 March 2005 to Rs
270,000,000 as at 31 March 2006.
The Board of Directors believe that based on business circumstances as at 31 March 2006, the
Company would be able to realise the carrying value of the deferred tax asset of Rs 270,000,000
through generation of sufficient taxable profits in the future years based on the profits arising from the
Company’s software business with the parent company and the profits arising from the export of
certain ultra sound equipment manufactured by the Company, for distribution to other others. The
software profits that were exempt from tax under section 10A of the Income Tax Act 1961 became
taxable from the year ended 31 March 2004. Based on current business circumstances, the Company
expects to realize sufficient future taxable profit to recover the carrying value of the deferred tax asset
at 31 March 2006. The deferred tax balance is periodically evaluated for the appropriateness of its
carrying value in light of business circumstances at the evaluation date.
 Provisions, Contingent Liabilities and Contingent Assets
a. Provision for warranty (POME Sample)
Warranty provision is utilised to make good the amount spent on spares, labor, and all other related
expenses on the event of failure of equipment. All the amounts are expected to be utilized in the
ensuing year. Outflows are expected to maintain the same trend as that of past years. No amount is
expected as a reimbursement towards this cost.
31 March 2006 31 March 2005
Particulars Rs ‘000 Rs ‘000
Opening balance 149,244 104,439
Add: Provision 245,223 225,718
Less: Utilisation 168,161 180,913
434
2007, POME, Gautam_Koppala, All Rights Reserved
Closing balance 226,306 149,244
b. Provision for legal cases (POME Sample)
The provision for legal cases is utilised to make good any amount payable in the event of any adverse
judgement on the Company. The provision is based on informed advice obtained by the Company.
The Company, however, could not estimate with reasonable certainty the period of utilization of the
same.
31 March 2006 31 March 2005
Particulars Rs ‘000 Rs ‘000
Opening balance 2,400 2,250
Add: Provision 3,675 150
Less: Utilisation - -
Closing balance 6,075 2,400
 Expenditure and earnings in foreign currency (POME Sample)
31 March 2006 31 March 2005
Rs ‘000 Rs ‘000
(a) Expenditure in foreign currency
Royalty (Gross of TDS) 157,059 89,005
Travel (including daily allowances) 22,927 18,470
Communication 7,702 13,789
Personnel costs 52,767 45,245
Others 34,885 28,253
275,340 194,762
435
2007, POME, Gautam_Koppala, All Rights Reserved
(b) Earnings in foreign currency
FOB value of export of goods and 4,265,386 3,618,726
services
Software 521,060 443,859
Commission on sales 64,251 53,808
Scrap sale 132,586 75,383
4,983,283 4,191,776
 Value of imports on C.I.F. basis (POME Sample)
Raw materials and components 2,012,909 1,806,881
Traded goods 2,895,124 2,504,077
Capital goods 33,988 67,740
4,942,021 4,378,698
a) The following is the summary of significant transactions with related
parties by the Company; (POME Sample)
Particulars For the year ended 31 March 2006
For the year ended 31 March 2005
Rs ‘000
Holding Fellow
Shareholder
company subsidiaries
Rs Rs Rs
Sale of goods, 462,174 3,970,787 Nil
436
2007, POME, Gautam_Koppala, All Rights Reserved
services and scrap
347,728 3,353,240 Nil
Purchase of goods & 146,719 3,646,176 115,620
services
114,588 2,747,888 96,943
Expenses reimbursed 3,675 47,391 Nil
by GG ORG
535 231,420 Nil
Expenses reimbursed 4,778 107,500 Nil
to GG ORG
14,532 135,748 Nil
Purchase of fixed Nil Nil Nil
assets
16,927 5,478 Nil
Inter –corporate Nil 560,000 Nil
deposits given
Nil Nil Nil
Rent received Nil Nil Nil
Nil 2,649 Nil
Rent paid Nil 4,802 Nil
Nil 25,696 Nil
Commission on sales Nil 64,251 Nil
Nil 53,809 Nil
Royalty 59,615 97,444 61,999
Nil 89,005 Nil
b) Salary to key managerial personnel (POME Sample)
Personnel cost includes salary paid to Managing Director:
Particulars For the year For the year
ended 31 March ended 31 March
437
2007, POME, Gautam_Koppala, All Rights Reserved
2006 2005
Salary including ESOP cost 7,916 9,940
Company’s contribution to 422 -
provident fund and family pension
fund
Total 8,338 9,940
c) Transactions entered with GG INC, Bangladesh – Subsidiary (POME
Sample)
Particulars For the year ended 31
March 2006
For the year ended 31 March
2005
Rs ‘000
Trade advances 26,653
6,829
d) The balances receivable from and payable to related parties are as follows
(POME Sample)
Particulars For the year ended 31 March 2006
For the year ended 31 March 2005
Rs ‘000
Holding Fellow Shareholder
company subsidiaries
438
2007, POME, Gautam_Koppala, All Rights Reserved
Sundry debtors 109,008 365,481 Nil
Nil 60,535 Nil
Advances/Inter Nil 560,000 Nil
corporate deposits
Nil 8,411 Nil
Sundry creditors 22,446 755,358 14,985
25,278 550,575 13,688
Amount receivable from or invested in GG INC, Bangladesh - Subsidiary
(POME Sample)
Particulars For the year ended 31 March
2006
For the year ended 31 March
2005
Rs ‘000
Trade advances 71,191
44,538
Provision for 32,795
advances
22,618
Investments 211
211
439
2007, POME, Gautam_Koppala, All Rights Reserved
 Segment reporting (POME Sample)
If the primary segments of the GG ORG Company are its business segments as follows:
a) Equipment segment – includes manufacture and trading in diagnostic ultrasound systems,
computer tomography systems, medical electronic diagnostic imaging products, high
power x-ray including image intensifier TV Systems and medical electronic diagnostic
equipments and accessories.
b) Services segment – includes annual maintenance contracts.
c) Software segment – includes development of software for medical equipments.
The accounting policies consistently used in the preparation of the financial statements are also applied
to record revenue and expenditure in individual segments.
Revenue and direct expenses in relation to segments are categorised based on items that are
individually identifiable to that segment, while other costs, wherever allocable, are apportioned to the
segments on an appropriate basis. Certain expenses are not specifically allocable to individual
segments as the underlying services are used interchangeably. The Company therefore believes that
it is not practicable to provide segment disclosures relating to such expenses and accordingly such
expenses are separately disclosed as ‘unallocated’ and directly charged against total income.
Assets and liabilities in relation to segments are categorised based on items that are individually
identifiable to that segment. Certain assets and liabilities are not specifically allocable to individual
segments as these are used interchangeably. The Company therefore believes that it is not
practicable to provide segment disclosures relating to such assets and liabilities and accordingly these
are separately disclosed as ‘unallocated’.
Rs ‘000
31 March 31 March
Primary segment information
2006 2005
Segment revenue
440
2007, POME, Gautam_Koppala, All Rights Reserved
Equipment, net of excise duty 7,494,775 6,529,982
Services 1,239,175 1,115,158
Software 521,060 443,859
9,255,010 8,088,999
Segment profit
Equipment 337,802 341,686
Services 246,170 146,504
Software 156,182 126,077
740,154 614,267
Other unallocable expenditure, net of
unallocable income
(290,427)
(215,690)
Profit/(loss) before tax 524,464 323,840
Income taxes (98,106) (66,316)
Profit/(Loss) after taxation 426,358 257,524
Segment assets
Equipment 1,723,614 1,268,646
Services 599,803 372,880
Software 263,660 155,730
2,587,077 1797,256
Corporate – Unallocated 2,675,560 1,757,997
5,262,637 3,555,253
Segment liabilities
Equipment 702,735 1,396,845
Services 75,068 691,350
Software 33,203 4,973
441
2007, POME, Gautam_Koppala, All Rights Reserved
811,006 2,093,168
Corporate – Unallocated 2,987,494 424,459
3,798,500 2,517,627
Capital expenditure (capitalised during
the year)
52,951
Equipment
27,511
1,215
Services
2,263
37,958
Software
22,742
35,239
Unallocable
61,448
127,363
113,964
Depreciation
Equipment 107,159 105,821
Services 3,162 6,602
Software 28,574 31,587
Unallocable 44,142 26,050
183,036 170,061
Secondary segmental reporting is performed on the basis of the geographical location of customers. The
geographical segments include:
a) Domestic
b) Exports
Rs ‘000
442
2007, POME, Gautam_Koppala, All Rights Reserved
31 March 31 March
Secondary segment information
2006 2005
Segment revenue
Domestic 4,026,354 4,483,554
Exports 5,228,656 3,605,445
9,255,010 8,088,999
Segment assets
Domestic 4,280,195 2,737,922
Exports 982,442 817,331
5,262,637 3,555,253
The names of small-scale industrial undertaking and others to whom the Company owes a sum, which is
outstanding for a period of more than 30 days, alos to be included in the schedule of accounts.
 Details of raw materials and components consumed
31 March 2006 31 March 2005
Class of goods * Rs ‘000 Rs ‘000
Raw materials and components for
computer tomography / ultrasound /
high power X-ray including image 2,916,353 2,692,489
intensifier TV Systems and medical
electronic diagnostic equipments
* There has been no item consumed during the year whose individual value is higher
than 10% of the total consumption value.
 Details of imported and indigenous raw materials and components consumed
443
2007, POME, Gautam_Koppala, All Rights Reserved
Particulars 31 March 2006 31 March 2005
% Value % Value
Rs ‘000 Rs ‘000
Imported 61 1,778,975 60 1,615,493
Indigenous 39 1,137,378 40 1,076,996
100 2,916,353 100 2,692,489
 Details of traded goods
31 March 2006 31 March 2005
Class of goods Quantity Value Quantity Value
Nos. Rs ‘000 Nos. Rs ‘000
Diagnostic ultrasound
systems, equipment and
accessories
Opening stock 1,380 141,634 1,276 313,410
Purchases 9,529 1,174,235 6,373 683,206
Closing stock 2,143 168,742 1,380 141,634
Sales 8,766 1,395,874 6,269 1,236,669
Computer tomography
systems, equipment and
accessories
Opening stock * - 67,241 - 90,899
Purchases 1,189 765,947 66 385,848
Closing stock 917 44,587 - 67,241
Sales 1,332 954,145 66 622,783
444
2007, POME, Gautam_Koppala, All Rights Reserved
Medical electronic
diagnostic imaging
products
Opening stock 4,608 418,758 3,518 277,261
Purchases 14,024 2,362,118 16,163 2,274,809
Closing stock 2,932 534,551 4,608 418,758
Sales 15,700 2,863,023 15,073 2,216,621
Notes:
1. Quantities stated above are exclusive of stores and spares, as these do not constitute
individually more than 10% of the respective categories. However, the values of
stores and spares have been included in the above figures.
2. Sales include sales of stores and spares, which is a part of ‘income from annual
maintenance contracts’.
3. * The quantities were not presented since, it is not determinable by management
 Capacity and production
Class of Goods Installed Capacity * Production
31 March 31 31 March 31 March
2006 March 2006 2005
2005
Nos. Nos. Nos. Nos.
Diagnostic
ultrasound
systems, 23,500 30,000 15,552 27,326
equipment and
accessories
Computed
100 100 - -
tomography
445
2007, POME, Gautam_Koppala, All Rights Reserved
systems,
equipment and
accessories
Medical electronic
diagnostic 22,800 22,800 21,724 21,711
imaging products
Notes:
1. Company products are not covered under licence and are accordingly not disclosed.
2. * Installed capacities and production are as certified by the management and have not
been verified by the auditors as this is a technical matter.
 Details of turnover of manufactured items
Class of goods 31 March 2006 31 March 2005
Quantity Value Quantity Value
Nos. Rs ‘000 Nos. Rs ‘000
Diagnostic
ultrasound systems,
14,840 1,854,071 27,422 1,469,879
equipment and
accessories
Medical electronic
diagnostic imaging 21,434 1,666,837 21,770 1,674,132
products
3,520,908 3,144,011
 Details of opening inventories of manufactured items
446
2007, POME, Gautam_Koppala, All Rights Reserved
Class of goods 1 April 2005 1 April 2004
Quantity Value Quantity Value
Nos. Rs ‘000 Nos. Rs ‘000
Diagnostic
ultrasound systems,
9 205 105 7,374
equipment and
accessories
Computed
tomography
- - 1 5,848
systems, equipment
and accessories
Medical electronic
diagnostic imaging 42 11,609 101 11,002
products
11,814 24,224
 Details of closing inventories of manufactured items
Class of goods 31 March 2006 31 March 2005
Quantity Value Quantity Value
Nos. Rs ‘000 Nos. Rs ‘000
Diagnostic
ultrasound systems,
721 15,228 9 205
equipment and
accessories
Medical electronic
332 18,917 42 11,609
diagnostic imaging
447
2007, POME, Gautam_Koppala, All Rights Reserved
products
34,145 11,814
 Royalty
Royalty which pertains amounts accrued in excess of the prescribed limits under the relevant rules.
The Company has made an application to appropriate authorities seeking approval for the payment of
the same.
 Employee stock options
If certain employees of the Company have received some restricted stocks from the parent company.
The exercise price of these restricted stocks is nil. These restricted stocks will vest in four equal
installments through continued employment certain years. The intrinsic value method debiting
personnel cost with a corresponding credit to “General reserve” account. The proforma disclosures
have not been presented as the intrinsic value approximates fair value.
448
2007, POME, Gautam_Koppala, All Rights Reserved
The Balance-Sheet Model of the Project
Total Value of Project Total Project Value to Investors:
Assets:
Current
Current Liabilities
Assets
Long-Term
Debt
Fixed Assets
1 Tangible Shareholders’
2 Intangible Equity
449
2007, POME, Gautam_Koppala, All Rights Reserved
POME BALANCE SHEET SAMPLE:

GG ORG

Balance Sheet as at 31 March 2006

As at As at

31 March 2006 31 March 2005

Rs '000 Rs '000

SOURCES OF FUNDS

Shareholders' funds

Share capital 100,000 100,000

Reserves and surplus 1,364,137 937,626

1,464,137 1,037,626

Loan funds

Secured loans 104,595 67,218

450

2007, POME, Gautam_Koppala, All Rights Reserved


1,568,732 1,104,844

APPLICATION OF FUNDS

Fixed assets

Gross block 1,626,544 1,506,457

Less: Accumulated depreciation (927,997) (759,223)

Net block 698,547 747,234

Capital work-in-progress 9,430 4,399

707,977 751,633

Investments 211 211

Deferred tax asset 270,000

451

2007, POME, Gautam_Koppala, All Rights Reserved


345,000

Current assets, loans and advances

Inventories 899,909 775,446

Sundry debtors 1,176,661 295,896

Cash and bank balances 970,815 903,708

Loans and advances 1,237,064 483,359

4,284,449 2,458,409

Current liabilities and provisions

Current liabilities 3,403,118 2,254,263

Provisions 290,787 196,146

3,693,905 2,450,409

Net current assets 590,544

452

2007, POME, Gautam_Koppala, All Rights Reserved


8,000

1,568,732 1,104,844

Significant accounting policies and

Notes to the accounts

The accompanying schedules form an integral part of these financial


statements

(0)

As per our report attached

for POME

Chartered Accountants

POME PROFIT AND LOSS SAMPLE STATEMENT:

GG ORG

Profit and loss account

453

2007, POME, Gautam_Koppala, All Rights Reserved


For the year For the year
ended ended

31 March 2006 31 March 2005

INCOME Rs '000 Rs '000

Revenues 9,265,088 8,119,459

Less: Excise duty 10,078 30,460

Revenues, net of excise duty 9,255,010 8,088,999

Other income 342,146 265,983

9,597,156 8,354,982

EXPENDITURE

Materials cost 6,929,795 6,108,865

Personnel costs

454

2007, POME, Gautam_Koppala, All Rights Reserved


600,575 538,593

Other expenses 1,264,911 1,158,757

Finance expense 133,848 89,336

Depreciation (Refer to footnote on Schedule 5) 143,563 135,591

9,072,692 8,031,142

Profit before tax 524,464 323,840

Income taxes

- Current (6,800) (5,466)

- Deferred (75,000) (60,850)

- Fringe benefit tax (16,306) -

Profit / (loss) after tax 426,358 257,524

Balance in profit and loss account brought


forward 727,146 469,622

455

2007, POME, Gautam_Koppala, All Rights Reserved


Balance in profit & loss account carried
forward 1,153,504 727,146

Earnings per share (par value Rs 10 each)

Basic and diluted 42.64 25.75

Weighted average number of equity shares

Basic and diluted 10,000,000 10,000,000

Significant accounting policies and

Notes to the accounts

POME SHARE CAPITAL SAMPLE STATEMENT:

GG ORG

Schedules forming part of the financial statements

As at As at

456

2007, POME, Gautam_Koppala, All Rights Reserved


31 March 2006 31 March 2005

2 Share capital Rs '000 Rs '000

Authorised

10,000,000 (31 March 2005 : 10,000,000) equity shares of Rs.10


each 100,000 100,000

Issued, subscribed and paid up

10,000,000 (31 March 2005 : 10,000,000) equity shares of Rs. 10


each fully 100,000 100,000

paid up

[Of the above 5,100,000 (31 March 2005 : 5,100,000) equity shares
of Rs.10

each are held by GG org U.S.A., the holding company]

3 Reserves and surplus

Capital reserve 4,034 4,034

General reserve

Balance, beginning of the year 206,446 206,446

Add: Additions during the year ( Refer to note 21 of schedule 19 )

457

2007, POME, Gautam_Koppala, All Rights Reserved


153 -

Balance, end of the year 206,599 206,446

Profit and loss account 1,153,504 727,146

1,364,137 937,626

4 Secured loans

Cash credits from banks 2,626 -

Finance lease obligation ( Refer to note 18 of schedule 19 ) 101,969 67,218

104,595 67,218

1 Cash credit from banks are secured by hypothecation, a pari passu charge, of stock and book debts, both present
. and future.

Finance lease obligation is secured by hypothecation of assets taken


2 on lease.

POME BALANCE SHEET (OTHERS THAN THE MAIN) SAMPLE STATEMENT:

458

2007, POME, Gautam_Koppala, All Rights Reserved


GG ORG

Schedules forming part of the financial statements

As at As at

31 March 2006 31 March 2005

Rs '000 Rs '000

6 Investments

Unquoted, long-term and non-trade; at cost

Investment in subsidiary company :

25,000 (31 March 2005 : 25,000) equity shares of Bangladesh Taka 10 211 211

each, fully paid up, in GE Medical Systems Limited, Bangladesh

7 Inventories

Raw materials and components 237,312 239,807

Stores and spares 395,129 286,862

Work in progress 41,844 41,606

459

2007, POME, Gautam_Koppala, All Rights Reserved


Finished goods

-Traded 352,751 340,771

-Manufactured 34,145 11,814

1,061,181 920,860

Less: Provision for obsolescence (161,272) (145,414)

899,909 775,446

8 Sundry debtors

Unsecured

Debts outstanding for a period exceeding six months

- considered good 251,996 120,178

- considered doubtful 472,234 411,461

Other debts

- considered good

460

2007, POME, Gautam_Koppala, All Rights Reserved


924,665 175,718

1,648,895 707,357

Less: Provision for doubtful debts (472,234) (411,461)

1,176,661 295,896

9 Cash and bank balances

Cash in hand 11 1

Cheques in hand 57,147 -

Balances with scheduled banks

- Current accounts 73,854 273,915

- Deposit accounts 831,002 620,198

- Margin money deposit accounts 2,291 1,595

Balances with non-scheduled banks

- Current account with M&I Marshall & Ilsley Bank, Milwaukee,USA - 427

461

2007, POME, Gautam_Koppala, All Rights Reserved


- Current account with Standard Chartered Bank, Dhaka,Bangladesh 6,510 7,011

- Current account with Standard Chartered Bank, Colombo,Srilanka - 561

970,815 903,708

Maximum balance at any time during the year with non-scheduled banks was as follows:

M&I Marshall & Ilsley Bank, Milwaukee,USA 3,111 2,896

Standard Chartered Bank, Dhaka,Bangladesh 13,290 7,825

Standard Chartered Bank, Colombo,Srilanka 762 3,064

10 Loans and advances

Unsecured

Considered good

Advances recoverable in cash or in kind or for value to be received 393,685 292,421

Advance tax and tax deducted at sources, net of provision for tax of

462

2007, POME, Gautam_Koppala, All Rights Reserved


Rs 8,307 thousands ( 31 March 2005 : Rs 8,340 thousands) 68,873 29,799

Inter Corporate Deposits *


560,000 -

Deposits 156,112 118,578

Balances with excise/ customs authorities 19,998 20,641

Advances to GG Org, Bangladesh* 38,396 21,920

Considered doubtful

Advances (recoverable in cash or in kind or for value to be received) 330,580 368,179

Advances to GG Org, Bangladesh* 32,795 22,618

1,600,439 874,156

Less: Provision for doubtful advances ( net of write offs ) (363,375) (390,797)

1,237,064 483,359

* Maximum balance at any time during the year

Advances to GG Org, Bangladesh 71,191 44,538

463

2007, POME, Gautam_Koppala, All Rights Reserved


Inter Corporate Deposits

- GG Org Country wide consumer financial services 130,000 -

- GG Org Capital Transportation financial services Limited 430,000 -

11 Current liabilities

Acceptances 148,156 50,972

Book overdraft 158,422 -

Sundry creditors

- Outstanding dues to small scale industrial undertakings (Refer to note


10 of schedule 19) 13,105 10,955

- Capital goods 1,802 2,652

- Others 1,246,206 864,961

Other liabilities

- Provision for expenses 1,695,230 1,228,286

464

2007, POME, Gautam_Koppala, All Rights Reserved


- Statutory liabilities * 31,026 34,020

Advances received from customers 109,171 62,417

3,403,118 2,254,263

* Includes liability in respect of provident fund of Rs 4,118 thousands ( 31 March 2005 : Rs 2,481 thousands )

POME FIXED ASSETS STATEMENT SAMPLE:

GG ORG

Schedules forming part of the financial


statements

5. Fixed Assets

Rs’000

Gross block

As at As at
Deletions /
Particulars Additions 31 March
(Adjustement)
1 April 2005 2006

A. Intangible Assets

465

2007, POME, Gautam_Koppala, All Rights Reserved


Computer software 40,125 1,467 - 41,592

Licenses and technical know-


how 205,706 - - 205,706

Total ( A) 245,831 1,467 - 247,298

B. Tangible Assets

1. Owned Assets

Freehold land 13,850 - - 13,850

Buildings 88,909 593 - 89,502

Plant and machinery 414,831 42,022 - 456,853

Air conditioners and office


equipment 75,491 215 - 75,706

Data processing equipment 392,768 6,522 - 399,290

Furniture and fixtures 53,657 742 - 54,399

Vehicles 1,237 - - 1,237

466

2007, POME, Gautam_Koppala, All Rights Reserved


Equipment leased to others 98,882 953 - 99,835

Total ( B ) 1,139,625 51,047 - 1,190,672

2. Leased Assets

Leased vehicles 121,001 20,874 27,796 114,079

Leased computers and office


Equipment ( Refer to note 18 of
schedule 19 ) - 40,576 (33,919) 74,495

Total ( C) 121,001 61,450 (6,123) 188,574

Total ( A+B+C) 1,506,457 113,964 (6,123) 1,626,544

Previous year 1,396,018 127,363 16,924 1,506,457

Accumulated depreciation

467

2007, POME, Gautam_Koppala, All Rights Reserved


As at Charge for As at
Particulars Deletions
1 April 2005 the year 31 March 2006

A. Intangible Assets

Computer software 33,794 4,103 - 37,897

Licences and technical knowhow 64,863 32,128 - 96,991

Total ( A) 98,657 36,231 - 134,888

B. Tangible Assets

1. Owned Assets

Freehold land - -

Buildings 18,434 2,977 - 21,411

Plant and machinery 183,336 36,760 - 220,096

Air conditioners and office equipment 41,763 4,501 - 46,264

Data processing equipment 298,256 45,183 - 343,439

Furniture and fixtures 32,002 4,403 - 36,405

Vehicles 1,237 - - 1,237

Equipment leased to others 25,427 8,841 - 34,268

Total ( B ) 600,455 102,665 - 703,120

468

2007, POME, Gautam_Koppala, All Rights Reserved


2. Leased Assets

Leased vehicles 60,111 28,000 23,677 64,434

Leased computers and office Equipment ( Refer


to note 18 of schedule 19 ) - 16,140 (9,415) 25,555

Total ( C) 60,111 44,140 14,262 89,989

Total ( A+B+C) 759,223 183,036 14,262 927,997

Previous year 595,462 170,061 6,300 759,223

Net block

As at As at
Particulars
31 March 2006 31 March 2005

A. Intangible Assets

Computer software 3,695 6,331

Licenses and technical know-how 108,715 140,843

Total ( A) 112,410 147,174

B. Tangible Assets
469

2007, POME, Gautam_Koppala, All Rights Reserved


1. Owned Assets

Freehold land 13,850 13,850

Buildings 68,091 70,475

Plant and machinery 236,757 231,495

Air conditioners and office equipment 29,442 33,728

Data processing equipment 55,851 94,512

Furniture and fixtures 17,994 21,655

Vehicles - -

Equipment leased to others 65,567 73,455

Total ( B ) 487,552 539,170

2. Leased Assets

Leased vehicles 49,645 60,890

Leased computers and office Equipment


( Refer to note 18 of schedule 19 ) 48,940 -

Total ( C) 98,585 60,890

Total ( A+B+C) 698,547 747,234

Previous year 747,234

470

2007, POME, Gautam_Koppala, All Rights Reserved


POME SALES, COGS AND OTHER INCOME SAMPLE STATEMENT:

GG ORG

Schedules forming part of the financial statements

For the year For the year


ended ended

31 March 2006 31 March 2005

Rs '000 Rs '000

13 Revenues

Sale of equipment 7,504,853 6,560,442

Software services 521,060 443,859

Income from annual maintenance contracts 1,239,175 1,115,158

9,265,088 8,119,459

14 Other income

Commission on sales

471

2007, POME, Gautam_Koppala, All Rights Reserved


64,251 53,809

Scrap sales 139,822 82,693

Sales tax refund * 27,098 -

Interest income 65,155 39,593

(Tax deducted at source Rs.7,691 thousands ( 31


March 2005 : Rs 6,079 thousands )

Sub lease rentals 6,746 12,007

Lease rentals 4,193 5,946

Old debts recovered - 71,935

Liabilities no longer required written back 12,047 -

Foreign exchange gain, net 18,721 -

Miscellaneous income 4,113 -

342,146 265,983

472

2007, POME, Gautam_Koppala, All Rights Reserved


* Includes prior period income of Rs 27,098 thousands ( 31 March 2005 :
Nil )

15 Materials cost

Cost of traded goods sold 3,202,554 2,698,316

Stores and spares consumed 833,457 699,485

4,036,011 3,397,801

Raw material and components consumed 2,916,353 2,692,489

(Increase)/decrease in inventories of manufactured finished

goods and work-in-progress (22,569) 18,575

6,929,795 6,108,865

16 Personnel costs

473

2007, POME, Gautam_Koppala, All Rights Reserved


Salaries, wages and bonus 538,676 457,032

Contribution to provident and other funds 27,197 46,552

Staff welfare expenses 23,993 23,321

Recruitment and training expenses 10,709 11,688

600,575 538,593

POME OPERATING EXPENSES SAMPLE STATEMENT:

GG ORG

Schedules forming part of the financial statements

For the year


For the year ended ended

31 March 2006 31 March 2005

Rs '000 Rs '000

17 Other expenses

Warranty cost 245,223 225,718

474

2007, POME, Gautam_Koppala, All Rights Reserved


Provision for doubtful debts 60,773 212,335

Travel and conveyance 176,785 128,028

Provision for doubtful advances


(27,422) 68,685

Provision for doubtful advances written off 48,857 -

Provision for stock obsolescence


15,858 14,348

Royalty 219,058 89,006

Freight outward 77,929 67,541

Communication 36,410 38,396

Commission to sales agents 32,520 28,557

Rent 13,409 28,453

Legal and professional fees 62,266 26,318

Advertisement and business promotion 39,398 19,829

475

2007, POME, Gautam_Koppala, All Rights Reserved


Rates and taxes 10,712 19,380

Power and fuel 19,647 17,161

Consumables 26,637 16,115

Insurance 13,279 11,381

Printing and stationery 8,991 8,025

Research and development expenses 5,220 6,832

Repairs and maintenance

- buildings 2,014 6,238

- plant and machinery 8,956 5,420

- others 6,496 8,847

Foreign exchange loss, net - 2,352

Miscellaneous expenses 161,895 109,792

476

2007, POME, Gautam_Koppala, All Rights Reserved


1,264,911 1,158,757

18 Finance expense

Cash credit and factoring charges 117,634 75,592

Finance lease 6,951 5,516

Bank charges 9,263 8,228

133,848 89,336

POME BALANCE SHEET ABSTRACT AND BUSINESS PROFILE SAMPLE STATEMENT:

GG ORG

Balance Sheet Abstract and Company's Business Profile

477

2007, POME, Gautam_Koppala, All Rights Reserved


Particulars

I Registration details

Registration number 08/16063

State code 08

Balance sheet date 31-Mar-06

II Capital raised during the year (in thousand Rs.)

Public issue NIL

Rights issue NIL

Bonus issue NIL

Private placement NIL

Position of mobilisation and deployment of funds (in thousand


III Rs.)

Total liabilities - 1,568,732

Total assets 1,568,732

Sources of funds (in thousand Rs.)

478

2007, POME, Gautam_Koppala, All Rights Reserved


Paid up capital 100,000

Application money pending allotment -

Reserves and surplus 1,364,137

Secured loans 104,595

Unsecured loans -

Deferred tax liability -

Application of funds ( in thousand Rs.)

Net fixed assets 698,547

Capital work in progress 9,430

Investments 211

Deferred tax asset 270,000

479

2007, POME, Gautam_Koppala, All Rights Reserved


Net current assets 590,544

Miscellaneous expenditure -

IV Performance of the Company ( in thousand Rs.)

Turnover (including other sources income) 9,597,156

Total expenditure 9,072,692

Profit/(loss) before tax 524,464

Prior period adjustments -

Profit/(loss) before tax 524,464

Earning/(loss) per share ( in Rs.) 42.64

Dividend rate % NIL

Generic names of three principal products/ services of the


V Company

Item code no. ( ITC Code) 9018.12.00

480

2007, POME, Gautam_Koppala, All Rights Reserved


Product description Ultrasound scanning apparatus

Item code no. ( ITC Code) 9018.13.00

Magnetic resonance imaging


Product description apparatus

Item code no. ( ITC Code) 9022.12.00

Product description Computed tomography apparatus

For GG ORG

POME CASH FLOW WORKINGS SAMPLE STATEMENT:

GG ORG

Workings for cash flow statement for the year ended 31 March 2006

Sl.
No. Particulars 31st March 2006 31st March 2005 NET CY

1 Debtors 1,648,895 707,357 941,538

Less: Reserve (472,234) (411,461) (60,773)

481

2007, POME, Gautam_Koppala, All Rights Reserved


1,176,661 295,896 880,765

2 Inventories 1,061,181 920,860 140,321

Reserve (161,272) (145,414) (15,858)

899,909 775,446 124,463

3 Loans and advances 1,600,439 874,156 726,283

Less: Reserve (363,375) (390,797) 27,422

Net Loans and advances 1,237,064 483,359 753,705

Less: interest accrued on FD (33,258) (9,550) (23,708)

Less: Advance tax(net of provision) included


above (68,873) (29,799) (39,074)

1,134,933 444,010 690,923

4 Current liabilities 3,403,118 2,254,263 1,148,855

Less creditors for capital goods (1,802) (2,652) 850

482

2007, POME, Gautam_Koppala, All Rights Reserved


3,401,316 2,251,611 1,149,705

5 Provisions 290,787 196,146 94,641

Less: Provision for MAT/FBT (23,106) (5,466) (17,640)

267,681 190,680 77,001

Net Change in current liabilities & provisions 1,226,706

6 Income tax expense for the year 23,106

Add : Income tax liability at the beginning 5,466

Less : tax liability at the end of the year (23,106)

Add :Advance tax at the end of the year 68,873

Less : Advance tax at the beginning of the

483

2007, POME, Gautam_Koppala, All Rights Reserved


year (29,799)

44,540

7 Purchase of fixed assets

Additions as per Fixed Assets schedule 113,964

Less: Additions made to leased assets (61,450)

Add : Closing subsidiary companies 9,430

Less :Opening subsidiary companies (4,399)

Add: Opening capital creditors 2,652

Less: Creditors of capital goods (1,802)

58,395

8 Sale of fixed assets

Deletions in Gross block 27,796

Deleions in Acc. Depreciation (23,677)

Profit on sale of assets

484

2007, POME, Gautam_Koppala, All Rights Reserved


1,618

Net realisation 5,737

9 Repayment of cash credit (net) 2,626

10 Principal repayment under finance lease

Opening 67,218

Additions 61,450

Leases prior to 1st April 2005, taken as


finance lease during the year 33,919

Adjustment made to lease obligation on


leases prior to 1st April 2005 (9,339)

Closing (101,969)

51,279

13 Interest income 65,155

Add: interest accrued in the previous year 9,550

Less: interest accrued (33,258)

485

2007, POME, Gautam_Koppala, All Rights Reserved


41,447

Provision for the year - charge 16,306

Movement in provsion for the year (10,840)

Movement in advance tax 39,074

44,540

486

2007, POME, Gautam_Koppala, All Rights Reserved


Corporate Governance
Board of Directors
Management Debt-
holders
Shareholders
Debt
Assets
Equity
Results/ Accomplishments in Accounting Schedules:
1. Accounting Schedules tests and procedures would not necessarily detect fraud, irregularities or
error, should any exist. Also, acknowledges that control over and responsibility for the prevention and
detection of fraud, irregularities and error remains with us.
2. The financial statements to be free of material errors and omissions and present fairly the
financial position of the Company, its Projects, Products, services and the results of its operations in
accordance with generally accepted accounting principles.
3. The material transactions that been properly recorded in the accounting records underlying the
financial statements.
4. The Company’s accounting principles and the practices and methods followed in applying them,
are as disclosed in the financial statements.
FIXED ASSETS
5. To ensure that the Company has a satisfactory title to all owned assets.
6. To check that the Company has a programme of physical verification of its fixed assets by
which all fixed assets are verified once in two years.
7. The fixed assets have been depreciated over appropriate useful life, to reassessed.
487
© 2007, POME, Gautam_Koppala, All Rights Reserved
CAPITAL COMMITMENTS
8. Whether the Company is contractually committed or not.
INVESTMENTS IN SUBSIDIARIES
9. to check the investments in the company subsidiaries
INVENTORIES
10. Stocks and work in progress shown in the Balance Sheet at a total value comprise the whole of
the Company’s stocks and work in progress wherever situated, including stocks held by third parties.
No stocks are held on behalf of other parties.
11. All quantities were determined by actual physical count, weight or measurement as on the end
of financial year.
12. The inventory records have been updated after physical verification and material discrepancies
which would been adjusted in the books of account.
13. The Management is of the opinion that the age of inventory and consequent provision for
obsolescence on the basis of the aforementioned age to be accurate and adequate.
14. The Management believes that adequate provision has been made in the books of account for
probable future losses on account of slow, non-moving, buy back, demo and obsolete inventory. The
provisions are made based on the certain estimates made by Management and that are specific to
each modality. The estimates may differ for each modality.
15. The quantitative details are accurately disclosed in the financials statements.
16. The discrepancies noticed on verification between physical stocks and the book records were
not material and have been properly dealt with in the books of account.
DEBTORS
17. Debtors do not include charges for goods shipped on consignment or on approval basis.
18. to check whether the Adequate provision has been made for sales returns, allowances and
losses on collection of debts.
488
© 2007, POME, Gautam_Koppala, All Rights Reserved
19. Provisions for doubtful debts to been made in accordance.
20. Factored debtors have been appropriately disclosed in the financial as net of amount received
there from.
OTHER CURRENT ASSETS
21. To ensure that no provisions required for current assets as at financial year end other than
those disclosed in the financial statements.
22. The Management believes that the earnest money deposits, other than the balance provided is
recoverable and hence no provision is considered necessary for the same.
PLEDGED OR ASSIGNED ASSETS
23. to ensure that no liens or encumbrances on the Company’s assets nor have assets been
pledged, mortgaged or assigned as security for liabilities, performance of contracts, etc.
LIABILITIES
24. All known material liabilities are included in the accounts or not.
25. to check for the transactions with Small Scale Industrial (SSIs) Undertakings.
26. We confirm that all the disputed and unreconciled amounts with group companies and other
creditors have been disclosed to you and there are no further provisions required on claims made.
27. makes Adequate provision has been made towards warranty cost.
TAXATION
28. To make sure that the tax been paid accordingly.
Transfer pricing
29. The Management believes that the prices at which the international transactions have been
entered into with associated enterprises/ group companies, during the financial year end, are at arm’s
length;
30. The Management would ensure that adequate documentation is retained at the Company’s end
in respect of the associated enterprise(s) transactions so as to comply with the requirements of law.
489
© 2007, POME, Gautam_Koppala, All Rights Reserved
31. to check for the Business Strategy:
32. Contract Manufacturer: All manufacturers in the supply chain are contract manufacturers.
Contract manufacturers determine Transfer Prices based on their total manufacturing costs.
Others
33. The Company has provided all notices and orders received from the tax authorities.
CONTINGENT LIABILITIES
34. All known contingent liabilities are disclosed in the notes to the accounts.
35. There have been no violations or possible violations of laws or regulations the effect of which
should be considered for disclosure in the financial statements as the basis for recording a contingent
loss.
LEGAL MATTERS
36. There are no claims that are outstanding, or possible claims, which have not been disclosed to
you, whether or not discussed with legal counsel.
CONTRACTS
37. Information has been made available to you regarding all significant contractual obligations.
PROFIT AND LOSS ACCOUNT
38. checking in the accounts, the results for the period were not materially affected by:
a. transactions of a nature not usually undertaken by the Company; and
b. circumstances of an exceptional or non-recurrent nature.
c. charges or credits relating to prior years.
COMPANIES AUDITORS REPORT ORDER (CARO)
490
© 2007, POME, Gautam_Koppala, All Rights Reserved
39. The Company must have a regular programme of physical verification of fixed assets by which
all fixed assets are verified once in two years.
40. The transactions of purchase of goods and materials and sale of goods, materials and services,
made in pursuance of contracts entered in the register maintained, have been made at prices which
are reasonable having regard to prevailing market prices for such goods, materials or services or the
prices at which transaction for similar goods or services have been made with other parties.
41. The Company has an adequate internal control system commensurate with the size of the
Company and the nature of its business, for the purchase of inventory and fixed assets and for the
sale of goods and services. There is no continuing failure to correct major weaknesses in internal
control.
42. to comply that The Company has not accepted any deposits from the public and consequently,
43. The Company has an internal audit system commensurate with its size and nature of its
business.
44. To provide a complete list of undisputed statutory dues outstanding on the balance sheet date
as well as of disputed statutory dues at the aforesaid date.
45. check the Company has granted loans and advances on the basis of security by way of pledge
of shares, debentures and other securities.
46. details of the shares, securities, debentures and other investments.
47. The funds raised on short-term basis have not been used for long-term application.
48. to check for the fraud on or by the Company has been noticed or reported during the year.
POST BALANCE SHEET EVENTS
49. to check that there are no events that have occurred, or matters been discovered, subsequent
to the balance sheet date that would require adjustment to or disclosure in the financial statements.
POME Prescribe:
About Self-Management:
 Use impatience to your advantage: Channel the energies generated by your impatience to propel the process
faster.
491
© 2007, POME, Gautam_Koppala, All Rights Reserved
 Procrastinators don’t make good project managers. Find a way around your weakness (procrastination) if you
want to achieve your targets.
 24X7 availability for the project is not the way to effective achievement of targets. It will only end up
overwhelming you. “The key is to schedule and set boundaries so you don't need to be accessible 24/7.”
 Do you like what you are doing? If not, why are you still doing it? Money is not compensation enough for
being trapped in a role you do not like. Because for every hour you spend doing something you don’t enjoy,
you are giving up doing something that you do.
 Be Informed: Know not only what is happening in your organization, but also keep track of changes within
other organizations that may impact your team members.
 Analyze after the event: A postmortem offers valuable insights for future reference.
 Ask yourself
(1) Do I know what is expected of me?
(2) Do I expect I can perform that which is expected of me?
(3) Do I expect a reward of value to me personally?
492
© 2007, POME, Gautam_Koppala, All Rights Reserved
WE CAME, WE SAW, WE
CO&QUERED, A&D WE
RULE
493
© 2007, POME, Gautam_Koppala, All Rights Reserved
Any Questions?
Comments? For
better
improvement
Contact:
georgegautam@gmail.com
00918912550564
494
© 2007, POME, Gautam_Koppala, All Rights Reserved
495
© 2007, POME, Gautam_Koppala, All Rights Reserved
Heated gold becomes ornament. Beaten copper becomes
wires. Depleted
stone becomes statue. So the more pain you get in life you
become more valuable.

But year's later collection of


mistakes is called experience,
which leads to success.
496
© 2007, POME, Gautam_Koppala, All Rights Reserved
497
© 2007, POME, Gautam_Koppala, All Rights Reserved