LESSON 1: FINANCIAL CONTROLLERSHIP
Financial Controllership is a management function that
supervises the accounting and financial reporting of an organization.
It is responsible in the implementation and monitoring of internal
controls.
What are Risks?
For all businesses there are risks that exist and that need
to be identified and addressed in order to prevent or minimize
losses.
Risk is the threat that an event, action, or non-action will
adversely affect an organization’s ability to achieve its business
objectives and execute its strategies successfully. Risk is measured
in terms of consequences and likelihood.
The following process is used for assessing risks:
identifying risks, sourcing risks and measuring risks. Overall, you
should focus on the high risks affecting your operations.
Identifying Sourcing Prioritizing
Risks Business Risks
Risks
Risk Considerations
Considerations
• Evaluate the nature and types of errors and omissions that could
occur, i.e., “what can go wrong”
• Consider significant risks (errors and omissions) that are common
in the industry or have been experienced in prior years
• Information Technology risks (i.e. - access, backups, security, data
integrity)
• Volume, size, complexity and homogeneity of the individual
transactions processed
through a given account or group of accounts (revenue, receivables)
• Susceptibility to error or omission as well as manipulation or loss
• Robustness versus subjectiveness of the processes for
determining significant estimates
• Extent of change in the business and its expected effect
• Other risks extending beyond potential material errors or
omissions in the financial statements
What are Internal Controls?
Management must control identified risks to help the
Company:
• achieve its performance and profitability targets,
• prevent loss of resources,
• ensure reliable financial reporting, and
• ensure compliance with laws and regulations, avoiding damage to
its reputation and other consequences.
-In summary, internal controls can help our company get where it
wants to go, and avoid pitfalls and surprises along the way.
DEFINITION OF INTERNAL CONTROL
Internal control is a process, effected by an entity’s board of
directors, management and other personnel, designed to provide
reasonable assurance regarding the achievement of objectives in
the following categories:
• Effectiveness and efficiency of operations
• Reliability of financial reporting
• Compliance with applicable laws and regulations
Concepts and Objectives
Control definition reflects certain fundamental concepts:
• Internal control is a process. It's a means to an end, not an end in
itself.
• Internal control is affected by people. It's not merely policy manuals
and forms, but people at every level of an organization.
• Internal control can be expected to provide only reasonable
assurance, not absolute assurance, to an entity's management and
board.
Objectives of Internal Control
Internal controls are established to further strengthen:
• The reliability and integrity of information.
• Compliance with policies, plans, procedures, laws and regulations.
• The safeguarding of assets.
• The economical and efficient use of resources.
• The accomplishment of established objectives and goals for
operations or programs.
Internal Control Myths and Facts
MYTHS:
1.Internal control starts with a strong set of policies and procedures.
2.Internal control: That’s why we have internal auditors!
3.Internal control is a finance thing.
4.Internal controls are essentially negative,
like a list of “thou-shalt-nots.”
5.Internal controls take time away from our core activities of making
products, selling, and serving customers.
FACTS:
1.Internal control starts with a strong
control environment.
2.While internal auditors play a key role in the system of control,
management is the primary owner of internal control.
3.Internal control is integral to every aspect of business.
4.Internal control makes the right things happen the first time.
5.Internal controls should be built “into,” not “onto” business
processes.
Control Focus COSO Components Defined

Redefining the control focus The Committee of Sponsoring Organizations of the Treadway
Commission (COSO), was formed in 1985 to improve the quality of
-The new approach to controlling business risks may be financial reporting through business ethics, effective internal
characterized by the “new rules” of “prevent and monitor” and “build controls and corporate governance. Based on these principles, they
in quality” as opposed to the “old rules” of “detect and correct” and developed and published the COSO framework in 1992 as a
“inspect in quality.” This means a paradigm shift in the traditional foundation for establishing internal control systems and determining
viewpoint of control as illustrated in the following table: their effectiveness.
Old Paradigm New Paradigm Control Environment
Only AUDITORS and EVERYONE, including
TREASURY are concerned operations, is concerned • The control environment sets the tone of an organization,
about risks and controls about managing business influencing the control consciousness of its people. It is the
risks
foundation for all other components of internal control, providing
FRAGMENTATION – Every Business risk assessment
function and department do and control discipline and structure. Control environment factors include the
its own thing are FOCUSED and integrity, ethical values and competence of the entity's people;
(“SILO MANAGEMENT”) COORDINATED management's philosophy and operating style; the way
with senior level management assigns authority and responsibility and organizes and
OVERSIGHT develops its people; and the attention and direction provided by the
NO BUSINESS RISK FORMAL BUSINESS RISK board of directors.
CONTROL POLICY CONTROL POLICY
approved by management Risk Assessment
and the board
INSPECT for and DETECT ANTICIPATE and • Every entity faces a variety of risks from external and internal
business risk and REACT PREVENT business sources that must be assessed. A precondition to risk assessment
to it risk at the source and
MONITOR business risk is establishment of objectives, linked at different levels and internally
controls continuously consistent. Risk assessment is the identification and analysis of
Ineffective PEOPLE are the Ineffective PROCESSES relevant risks to achievement of the objectives, forming a basis for
primary source of business are the primary source of determining how the risks should be managed. Because economic,
risk business risk industry, regulatory and operating conditions will continue to
change, mechanisms are needed to identify and deal with the
special risks associated with change.
Internal Control Structure
Control Activities
In many cases, you perform controls and interact with the control
-Control activities are the policies and procedures that help ensure
structure every day, perhaps without even realizing it. management directives are carried out. They help ensure that
necessary actions are taken to address risks to achievement of the
Monitoring:
entity's objectives. Control activities occur throughout the
• Monthly reviews of performance reports organization, at all levels and in all functions. They include a range
• Internal audit function of activities as diverse as approvals, authorizations, verifications,
Information & Communication: reconciliations, reviews of operating performance, security of assets
and segregation of duties.
• Vision and values survey
• Issue resolution calls Information and Communication
• Reporting
• Pertinent information must be identified, captured and
• Corporate communications (e-
communicated in a form and timeframe that enables people to carry
mail, meetings)
out their responsibilities. Information systems produce reports,
Control Activities:
containing operational, financial and compliance-related
• Purchasing limits information, that make it possible to run and control the business.
• Approvals They deal not only with internally generated data, but also
• Security information about external events, activities and conditions
• Reconciliations necessary to informed business decision-making and external
• Specific policies reporting. Effective communication also must occur in a broader
Risk Assessment: sense, flowing down, across and up the organization. All personnel
must receive a clear message from top management that control
• Monthly Risk Control meetings responsibilities must be taken seriously. They must understand their
• Internal audit risk assessment own role in the internal control system, as well as how individual
Control Environment: activities relate to the work of others. They must have a means of
• Tone from the top communicating significant information upstream. There also needs
• Corporate Policies to be effective communication with external parties, such as
• Organizational authority customers, suppliers, regulators and shareholders.

An internal control structure is simply a different way of viewing the Monitoring

business – a perspective that focuses on doing the right things in
• Internal control systems need to be monitored -- a process that
the right way.
assesses the quality of the system's performance over time. This is
accomplished through ongoing monitoring activities, separate
evaluations or a combination of the two. Ongoing monitoring occurs
in the course of operations. It includes regular management and
supervisory activities, and other actions personnel take in
performing their duties. The scope and frequency of separate
evaluations will depend primarily on an assessment of risks and the
effectiveness of ongoing monitoring procedures. Internal control
deficiencies should be reported upstream, with serious matters
reported to top management and the board.
Control Techniques
Prevention techniques are designed to provide reasonable
assurance that only valid transactions are recognized, approved
and submitted for processing. Therefore, many of the preventive
techniques are applied before the processing activity occurs. In
most situations, preventive techniques are likely to be more effective
in a strong control environment, when management authorization
criteria are well-defined and properly communicated.
Control type definitions:
Preventive - Manual
Preventive - System
Examples of preventive controls include:
• Segregation of duties
• Business systems integrity and continuity controls, e.g., application
design standards, change controls, security controls, systems
backup and recovery
• Physical safeguard and access restriction controls (human,
financial, physical and information assets)
• Effective planning/budgeting process
• Effective "whistle blowing" processes
Detection techniques
-are designed to provide reasonable assurance that errors and
irregularities are discovered and corrected on a timely basis.
Detection techniques normally are performed after processing has
been completed. They are particularly important in an environment
that has relatively weak preventive techniques. That is, when front-
end approval and processing techniques do not provide reasonable
assurance that unacceptable transactions are prevented from being
processed or do not assure that all approved transactions are
processed accurately. In this case, after-the-fact techniques become
more important in detecting and correcting processing errors.
Control type definitions:
Detective - Manual
Detective – System
Examples of detection techniques include:
• Reconciliation of batch balance reports to control logs maintained
by originating departments.
• Reconciliation of cycle inventory counts with perpetual records.
• Review and approval of reference file maintenance (“was-is”)
reports.
• Comparison of reported results with plans and budgets.
• Reconciliation of subsidiary ledger balances with the general
ledger.
• Reconciliation of interface amounts exiting one system and
entering another.
• Review of on-line access and transaction logs.
Cash and bank accounts
• Do not allow a single employee to handle a cash transaction
from beginning to end.
• The cash handling function should be separated from the
function of recording cash transactions.
• Bank reconciliations should be performed on a timely basis
at the end of each month.
• Employees not involved with cash processing should
prepare bank reconciliations.
Cash activities
Cash receipts
The receipt of cash should be centralized and customers should
obtain a receipt at the conclusion of each sale. Cash receipts should
be deposited to the bank intact on a daily basis.
Cash disbursements
All cash disbursements should be made by check and petty cash
fund system should be maintained for minimal operating expenses.
Sales and receivables
• Check sales figures from their individual source (e.g. invoices)
• If sales staff work on commission ensure that their sales
figures are valid and commissions are not paid until customer’s
accounts are settled
• Reconcile sales register with takings and credit card receipts
• Make sure that goods are sent COD or with a tax invoice and
obtain evidence of delivery
• Ensure credit and collection policies are in writing
• Conduct credit checks on new credit customers
• Regularly age accounts and have an independent review and
follow-up on individual accounts on a monthly basis
• Ensure credit purchases are recorded as soon as the
transaction occurs
• Establish an accurate accounting system that maintains
agreement between the subsidiary and the general ledgers
• adequate segregation of duties on the following functions
- credit authorization
- collection (cash receipts)
- write-off of accounts
- record-keeping
-
Inventories
-Reconciling inventory to general ledger
Implement an inventory system that tracks all information
so that returns, damaged items, sales, and purchases would each
be accounted for and currently recorded.
-Inventory count
Document the procedures for performing its physical
inventory counts. These instructions should include specific tasks to
be performed by personnel. (e.g. completion of tags and control
sheets)
-Valuation of inventory
Establish a capitalization policy on all inventoriable items
and determine their unit cost, monitor sales activity and profitability
and then analyze slow-moving or obsolete items.
-Disposal of obsolete items
Establish a policy on the disposal of obsolete items since
storage cost are still being incurred if these are maintained.
Property and equipment
• A subsidiary ledger or schedule that records important identifying
information for individual fixed asset components.
• Authorizations for approvals for the acquisition of new fixed assets
from senior management.
• Periodic physical inventory of all fixed assets and reconciliation
with the subsidiary ledger.
• A written policy regarding capitalization of fixed assets and
expensing.
• Authorizations for approvals of dispositions of fixed assets.
Disbursements and payables
• Document purchasing and accounts payable procedures
• Ensure payments are on original invoices only – not copies or
faxes otherwise they may be paid more than once
• After payment is made, stamp or perforate the original invoice to
prevent reuse
• Put in place controls to check for identical payments
• Ensure refund checks from suppliers are handled by someone
other than the person processing the invoices
• Ensure the person who approves new vendors is different from
the person responsible for the payment process
• Check rapidly increasing purchases from one vendor
• Check vendors billings more than once a month
• Look out for large billings broken into multiple smaller invoices
each of which is for an amount that would not attract attention
• Once a month select a type of vendor and review each line
total and number of invoices for each vendor
• Check out the competitors' prices if you rely heavily on
one supplier
Your Role as Process Owner
✓ General Expectations
• Acknowledge your responsibility for the design, implementation
and maintenance of the control structure within your business
processes
• Contribute direction to identify, prioritize and review risks and
controls
• Remove obstacles for compliance; remedy control deficiencies
• Continue or begin a program of self-assessment and testing to
monitor the controls within your processes
LESSON 2: The Role of Financial Analysis
FINANCIAL ANALYSIS
-Financial analysis is the process of evaluating businesses, projects,
budgets, and other finance-related transactions to determine their
performance and suitability.
-It is used to analyze whether an entity is stable, solvent, liquid, or
profitable enough to warrant a monetary investment.
-Internally conducted, financial analysis can help managers make
future business decisions or review historical trends for past
successes.
-Financial analysis is used to evaluate economic trends, set financial
policy, build long-term plans for business activity, and identify
projects or companies for investment. This is done through the
synthesis of financial numbers and data. A financial analyst will
thoroughly examine a company's financial statements—the income
statement, balance sheet, and cash flow statement.
Role of Controller
-the primary purpose of the accounting department has been to
process transactions: billings to customers, payments to suppliers
-review company operations, evaluate investments, report problems
and related recommendations to
management, and fulfill requests by the management team for
special investigations
-financial review of company’s operational and investment activities.
Operational Review
-Target measurements. It is best to carefully review operations,
with a particular view of where problems are most likely to arise, and
create a set of measurements that will track those specific problems.
-Revise measurements. No measurement will be applicable
forever. This is because a company’s operations will change over
time, which calls for the occasional review of the current set of
measurements, with an inclination to replace those that no longer
yield valuable information with new ones that focus on new
problems that are of more importance in the current operating
environment.
-Educate management about the measures used. The controller
should work hard not only to educate managers about the contents
of financial analysis formulas, but also to keep re-educating them to
ensure that explanations do not fade in their memories.
-Add commentary to measurements. A controller should add a
short commentary to any published set of measurements. This is an
excellent way to convert a numerical report into a written one, which
many people find much easier to understand.
Investment Review
-The analysis of securities. When a company either has or is
contemplating investing its excess funds in various investment
vehicles, such as bonds or stocks, the controller can evaluate the
rate of return on each one and render an opinion regarding it. The
controller may also evaluate the relative risk of each investment.
The controller must have an excellent knowledge of the liquidity of
an investment, as well as its risk of default.
-The analysis of financing options. The controller review the cost
of various financing options when a company is considering
acquiring assets. The controller must not only be able to provide an
accurate and well-documented answer that clearly reveals the least
expensive alternative, but also have a sufficient knowledge of
available options.
-The analysis of capital expenditures. When a company wishes
to make a capital expenditure, the ultimate test of whether the right
decision was made is if the acquisition eventually creates a cash
flow that exceeds the cost of financing it. The controller is called on
to analyze predicted cash flows in advance, determine the cost of
capital, calculate the net present value of cash flows, and pass
judgment on the reasonableness of the acquisition. These tasks
require not just a knowledge of cash flow analysis and discounting
methods, but also how to rationally judge the accuracy of predicted
cash flows and estimate the risk associated with them.
3 Main Points on the Role of Financial Analysis
-proper financial analysis requires a solid grounding in
financial analysis tools
-ability to convert the results of a financial analysis into a
format that can be easily communicated to and understood by
the targeted recipient
-use of judgment in several areas
A controller must be able to correctly discern what
question is being asked by management so that the resulting
financial analysis work is focused on the collection of the correct
data and its interpretation with the correct formulas. A controller
must exercise judgment in interpreting the results and deciding if
additional work is needed to ensure that the root causes of any
problems have been found. Judgment is needed to ensure that the
most critical results are quickly and forcefully communicated to
management.

LESSON 4: EVALUATING FINANCIANG OPTIONS
-In a larger corporation, the choice of how to fund the purchase of
assets falls on the chief financial officer (CFO). However, there is
generally no CFO in a smaller organization, so this task falls on the
controller. Also, the funding for smaller purchases, even in a larger
company, will frequently be left up to the controller to decide.
-The controller in making the correct determination of which types of
financing options to select under different circumstances, must
consider the following:
-funding options available
-related cost, risk, and
-control issues
TYPES OF FUNDING OPTIONS
DEBT – the funding is contingent on some obligation to pay interest
in exchange for the use of the invested funds, which are also to be
returned at the end of a stipulated period.
long-term loan - the most pure version of debt, usually
collateralized against some group of company assets, carries a
stated interest rate that may move with an underlying interest rate
or pricing indicator, and must be paid back either in instalments' or
in total on a specified date.
Variations on this concept are the lease, in which the creditor may
own the underlying asset, and preferred stock, in which there is no
obligation to pay back the funds on a specific date, but there is an
interest payment obligation.
TYPES OF FUNDING OPTIONS
EQUITY – the funding is not contingent on any specified interest
payment, but the holder of the underlying common stock expects
either a periodic dividend payment, an appreciation in the share
price on the open market, or a combination of the two.
-Equity has no underlying collateral, so the holder is at much
greater risk of losing the invested funds, which is why the expected
return is much higher for equity than for debt.
-Preferred stock is a variation on equity, because it is not
collateralized and there is no obligation to pay it back on a specific
date.
-Stock rights, which can be issued to current shareholders, giving
them the right to purchase more shares of stock.
-Warrants a debt instruments to make them more attractive; give
the holder the right to buy common stock at a specific price.
TYPES OF FUNDING OPTIONS
-It is also possible to convert debt into equity. This is called a
convertible security and is sometimes used when selling bonds,
so that buyers can later switch their bonds over to debt if a specific
stock price point is reached at which the conversion is an attractive
one. A hybrid form that shifts from debt to equity at the buyer’s
option.
-Preferred stock can also be considered something of a hybrid,
because it contains characteristics of both debt (with a fixed interest
payment) and equity (with no specified payback date for the
underlying investment).
COSTS OF FUNDING OPTIONS
DEBT
-an interest payment must be paid to the lender on specified dates.
The interest rate charged will vary greatly, depending on the
willingness of the borrowing organization to put up its assets as
collateral.
-no significant assets to use as collateral, the risk of the lending
institution is correspondingly greater, the interest rate can be a few
percentage points higher than the prime rate charged by local
lending institutions
-spotty earnings or debt payment record, lenders will charge the
highest possible interest rates for use of their funds.
-penalty payments will also be charged (late payment)
-It can be extraordinarily inexpensive for those companies with a
large base of available assets for use as collateral.
-A borrowing company is a very large one with an excellent financial
credit rating, it can borrow well below the prime rate, are the lowest
rate of interest at which money may be borrowed commercially,
perhaps only a fraction of a percent above the London Interbank
Offer.
-Rate (LIBOR), which is the minimum borrowing rate available.
-SIBOR is a reference rate based on the interest rates used by
banks in Singapore when lending unsecured funds to other banks
in the Singapore wholesale money market (or interbank market).
The interest rate used for interbank lending in Asia is set by the
Association of Banks in Singapore (ABS). The SIBOR is
reflective of the state of Asian financial markets, and is used instead
of the LIBOR as a reference point for borrowing and lending in the
region.
-For these institutions, it makes a great deal of sense to use debt as
a major financing source as much as possible.
-In the case of equity, there is a free money, because the company
receiving the equity is under no specific obligation to pay it back or
to issue dividends.
-However, this is not the case for two reasons.
-First, the investments of shareholders are not secured by any form
of collateral, if the company falls into financial difficulty and is
liquidated, shareholders are likely to lose all their funds. Because of
this increased level of risk, they want an inordinately high level of
return, which they can receive either through dividend payments,
stock appreciation, or a combination of the two.
-Second, interest payments on debt are tax deductible, whereas
dividend payments are not, thereby making payments to
shareholders more expensive than payments to creditors. Thus, the
more expensive option is equity.
-“The management team may have to lean toward the acquisition
of more debt, because it is less expensive than equity”.
RISKS ASSOCIATED WITH FUNDING OPTIONS
All forms of financing involve some degree of risk. A controller must
be aware of all the forms of risk to ensure that management
recognized the potential shortcomings.
1. Risk of not paying interest on debt.
-If a company acquires more debt than it can support through the
cash from its continuing operations, there is a high risk that it will be
unable to pay even the periodic interest payments, which will result
in either renegotiation of the debt or a default that can result in the
liquidation of the company as a whole or the assets that were used
as collateral for the debt.
2. Risk of not paying principal on debt.
-Many companies roll their debt over into new debt instruments as
soon as the old ones become due and payable. However, for those
companies whose financial capability have significantly declined
there may be no lenders available who are willing to take the risk of
issuing new debt to cover the now-due principal on the old debt. If
so, a company can face dissolution or liquidation of any assets used
as collateral.
3. Risk of experiencing a loan acceleration.
-Lenders have the option to force the acceleration of payments on
debt. This is brought about by a change in the lender’s perception
of the ability of a company to do business, such as a string of poor
earnings reports. A company is obligated to pay off the debt by
means of refinancing or liquidation of any assets used as collateral.
If it cannot meet the lender’s demand, it may be necessary to take
the company into bankruptcy.
4. Risk of shareholder revolt.
-Common stockholders own a company, and if they are dissatisfied
with the existing level of return on their investment, then they can
band together and replace the board of directors, which in turn can
replace the management team. Thus, the consequences of not
generating an adequate return for shareholders is severe.
CONTROL PROBLEMS ASSOCIATED WITH FINANCING
OPTIONS
-The control problem relates to the acquisition of new funding in a
combination of close control of an organization as well as the ability
of the current owners to put more equity into a company as needed.
LEASING
-The company pays a lessor for the use of equipment that is owned
by the lessor. A leasing arrangement tends to be rather expensive
for the lessee, because it is paying for the interest cost, profit, taxes,
maintenance, and decline in value of the asset.
-A lease is useful when a company can acquire more expensive
equipment than it could otherwise afford. Examples are autos,
airplanes, copiers, and computers.
LEASING
-Another use of the leasing concept is the sale and leaseback. They
sell their real estate holdings to a leasing company for a cash
payment, and then lease the property back from the lessor for a
guaranteed minimum period.
LOANS
-A company can obtain a loan either by borrowing funds from a
lending institution or by issuing its own bonds to investors and
paying interest to all of them on payment dates. The cost of a loan
is based on the interest rate. Debt is generally the least expensive
form of financing, the interest expense is tax deductible.
COMMON STOCKS
-When shareholders purchase shares from a company, the money
they pay becomes equity in that organization. This cash can be used
for any operational purpose, and is not restricted for a specific use
unless so authorized by the board of directors. This type of funding
carries with it no immediate payment obligation. The shareholders
elect all members of the board of directors, which in turn is
empowered to authorize periodic dividend payments to the
shareholders. The shareholders expect to see the earnings per
share increase over time, which increases the value of their shares
and allows them to sell their shares for a profit.
COMMON STOCKS
Common stock is a useful funding source for three reasons
1. It can raise an unduly large amount of money if the public believes
that the company has a strong potential to increase its value in the
future (even if it is losing money in the present).
2. A company may have borrowed as much money as possible from
lenders, who are not reluctant to lend anything more, unless the
owners match some share of the debt burden with equity.
3. Current shareholders may liquidate some or all of the shares they
already own, increasing their net personal value, but not that of the
company.
CONVERTIBLE SECURITIES
-A convertible security is a bond that can be converted into common
stock. The common stock price at which the bond can be converted
is based on the conversion ratio, which is the ratio of the number of
shares that can be purchased with each bond. For example, if a
P1,000 bond has a conversion ratio of 10, then it can be converted
into 10 shares, which translates into a share price of P100.
A convertible security is worthy if a company does not want to pay
back the underlying principle on its bonds.
CONVERTIBLE SECURITIES
-This is most common in a high-growth situation in which all cash
will be needed for the foreseeable future. Also, by converting debt
over to equity, a company can improve its debt/equity ratio, which
will improve relations with lenders, while also eliminating the need
to pay interest on the bonds that no longer exist.
PREFERRED STOCK
-When a company accepts payment for its preferred stock, its only
obligation is to pay a prespecified interest rate on that investment in
perpetuity, or until the shares of preferred stock are bought back by
the company.
PREFERRED STOCK
-Preferred stock cannot be collateralized with company assets to
give the shareholders some degree of protection in the event of a
default, the interest rate on the stock is higher than the amount that
a lender would charge for collateralized debt.
STOCK RIGHTS
-A stock right is an authorization to purchase additional shares of
common stock at a set price, with a specified termination date to the
offer. It is offered to existing shareholders in the same proportions
as their stock holdings in the company.
STOCK RIGHTS
-This approach is designed to retain the existing proportions of
company ownership, while also raising funds only from existing
shareholders, who are assumed to be friendly to the corporation.
WARRANTS
-A warrant is a right to purchase common stock at a fixed price and
usually has a distant termination date, if any. It is usually linked to
the sale of a debt instrument, such as a bond, for the express
purpose of making the purchase of those bonds appear more
attractive to bond purchasers.
WARRANTS
-A warrant is not a good tool for raising funds by itself, because it is
attached to some other debt instrument, but it can be an exceedingly
useful tool if the issuing company’s objective is to avoid a high
interest expense.
-For example, if a warrant allows the holder to buy a share for P10,
even though the current market price is P11, then the warrant has a
value of P1.
Chapter 5
EVALUATING CASH FLOW
Compilation and analysis of company’s cash flows
forms the basis for cash forecasting, project analysis and
incremental cash flow analysis, which make it crucial for many
of the most common analyses that a controller is expected to
complete.
Evaluating Working Capital
Creating a cash flow model for a capital investment
Seeing profit at the end of the income statement is one
of the most inexplicable event for a senior level manager, yet
they should obtain more cash on hand to meet all current cash
requirements. A controller is frequently called on to review the
elements of this key investments area and tell management why
increases have occurred and how to reduce them.
Three components of Working Capital
Accounts Receivable and Inventory – net usage of
cash
Accounts Payable – a source of cash
Total amount of working capital is accounts receivable
plus inventory, minus accounts payable
1. Accounts Receivable
• Credit granting problems – some customers will take
advantage if finance staff is doing poor job of credit
granting to new customers, they might purchase more
 than what they can pay for that result into a greater
accounts receivable.
• Credit review problems- there should be at least a
yearly exercise of review on customers, to spot those
who have difficulties in paying on time and reduce their
credit.
• Credit hold problems – a company is still in danger of
shipping to customers with poor credit ratings if the
shipping department is not inform of any customers
being on credit hold, shipments will go to the customers
who are not paying on time that results to an increased
company investment in accounts payable.
• Collection problems – it is the job of the collection staff
to contact the customers to determine the nature of any
problems, correct them, and follow up with the
customers to ensure that payment is made.
• Product return problems–the lapse from return products
can be solve by creating an effective return
authorization program that rejects all other returned
goods.
• Billing problems – if a company cannot send its
customers error-free invoices, then the customers will
refuse to pay them until the errors are corrected, the
time lag associated with it result to increase in
company’s investment in accounts receivable.
• Sales growth – as company sales increase the
investment in accounts receivable will inevitably
increase because there is a high chance that instead of
profit it can be a loss.
2. Inventory
• Production obsolescence problems–some inventory
will not be use, maybe due to its withdrawal from the
market or poor sales of a specific product, for which all
related finished goods, work-in-process, and raw
materials will now languish.
• Engineering design change problems–as part of
changing new features the engineering department
switched to a new component prior to using up all
available stocks of the old parts, the old parts will never
be use and stay in the inventory.
• Purchasing overage problems–purchasing order
parts in extra large quantities to fetch a lower per-unit
price, which leads to much larger stock of raw material
items in inventory as well as increased risk in inventory
obsolescence.
• Costing methodology problems–altering the
inventory costing method can have an impact on the
total investment in inventory, like using FIFO (first in-first
out) from LIFO (last in-first out).
• Sales forecasting problems–if sales staff incorrectly
forecasts an excessive quantity of sales, then the
production scheduling staff will order the production of
an excessive quantity of finished goods that will
increased inventory until eventually sold.
• Production methodology problems–using production
system that tends to require more inventory, there will
be excess amount of raw materials and work in process
inventory on hand, example is just-in-time (JIT)
manufacturing system.
• Overload absorption problems–management team
are tempted to increase the level of inventoryeven if
there is no need for excess amount, if it spread over
more units of production and charged to cost of goods
sold, it increases profit.
• Distribution problems–if a company has a distribution
policy of having inventory as close to the customers
possible for rapid servicing issues, the result will be
additional inventory.
• Sales growth – as company sales increases, so too will
the inventory.
3. Accounts Payable
• Changes to new suppliers – switching to a new
supplier that requires short payment terms, the
company’s access to free credit from the suppliers will
be reduced, and if there are many new suppliers who
require rapid payment then source of funds will
significantly reduced.
• New terms with existing suppliers–if an
existingsupplier negotiates a shorter payment term from
the company, the amount of funds available through
accounts payable will be reduced.
• Usage of early payment discount terms–when
controller has decided to reduced expenses by taking
as many early payment discount as possible, the level
of expenses will drop but the amount of available funds
from suppliers will also decrease.
• Incorrect early payments–if accounts payable staff is
incorrectly managed, it is possible that some payments
to suppliers will be made earlier than necessary, which
will reduced the amount of funds available from
suppliers.
Creating a cash flow model for a capital investment
• When creating a cash flow model for a capital
investment, it is best to create a timeline of at least five
years over which cash flow projections of various kinds
can be trace.
• Once timeline is created, the next step is to itemize all
cash outflows. These tend to be group at the beginning
of a project, because this is when equipment is acquire
and install.
• Cash outflow is the need for working capital, such
expenditures like maintenance and equipment
upgrades at set intervals should be included.
• A final issue is that many of the cash flow in or out can
be traced to specific dates, such as during the first,
second or third quarter of the year.
• Once all of the cash flows have been itemized in the
cash flow model, the next step is to include the present
value factor for each line item that yields the net present
value of the cash flow.
• The present value of each line item is then calculated by
multiplying the present value factor by each cash inflow
or outflow, and this information is entered in the fifth
column in the model. The final column in the model is
useto keep a cumulative total of all cash flows, so that
 one can quickly determine in what year the net cash
flows from the project turn positive.
Creating and Evaluating a Cash Forecast
If there is no chief financial officer (CFO) or treasurer,
then the job of determining the projected flow of cash falls on the
Exhibit 5.2 Sample Cash Forecast
shoulders of the controller. This means that the controller must
maintain a worksheet that estimates the cash inflows and
outflows.
The basic concept on which the cash forecast is built is that
this is not accrual accounting.

Cash flow line item January February March

Section I - Assumptions

Sales dollars per period $2,000,000 $2,500,000 $3,000,000

Production cost as a percentage of sales 50% 55% 55%

Days needed to collect accounts receivable 45 45 45

Days needed to pay account payable 30 30 30

Days of inventory on hand 60 60 60

Sales tax percentage 6% 6% 6%

Sales per employee $100,000 $100,000 $100,000

Annual average pay per employee $40,000 $41,000 $41,500

Section II - Cash Inflows

Collection on accounts receivable $2,000,000 $2,000,000 $2,000,000

Collection on notes receivable 5,000 5,000 2,500

Collection from asset sales 0 15,000 0

Collection from equity sales 0 0 100,000

Total Cash Inflows $2,005,000 $2,020,000 $2,352,500

Section III - Cash Outflows

Payment for production cost $1,000,000 $1,100,000 $, 375,000

Payments for salaries and wages 66,667 85, 417 103,750

Payments for general and administrative costs 175,000 175,000 175,000

Payments for capital expenditures 0 150,000 0

Payments for notes payable 25,000 25,000 25,000

Payments for sales taxes 120,00 150,000 180,000

Payments for income taxes 0 0 75,000

Payments for dividends 0 0 200,000

Incremental inventory change 0 750,000 550,000

Total Cash Outflows $1,386,667 $2,435,417 $2,683,750

Net Cash Flows +518,333 -415,417 -331,250

Cumulative Net Cash Flows +$618,333 $202,916 -$128,334

In the first section of the budget as shown in exhibit 5.2 the
underlying data and assumptions needed to compile the
remainder of the report are listed. The key data and assumptions
are:
• Sales dollar per period. The key driver of the entire
cash forecast is the amount of sales volume to be
expected in each of the measurement periods.
• Production costs as a percentage of sales. The
amount of production costs needed in each period is
derived directly from the anticipated sales figure for
each reporting period.
• Days needed to collect accounts receivable. This
assumption interacts with the sales figure from
previous months to arrive at the amount of collections
from accounts receivable expected in the current
month.
• Days needed to pay account payable. When
determining cash outflows the primary determinant is
the average number of days during which a company
holds onto its account payable before using payments
to supplier.
• Days on inventory on hand. This item in particular is
deserving of careful attention to ensure that the correct
turnover figured us used.
• Sale tax percentage. This is percentage that the
company owes the government on sales that occurred
in the prior period.
• Sales per employee. A component of the cash
outflows section at the bottom of the cash forecast is
the payroll cost, which is partially derived by this line
item, which assumes a certain headcount based on the
sales volume.
• Average pay per employee. This measure multiplies
the total headcount by this average pay per person to
determine the actual outflow.
In the second section of the cash forecast shown in Exhibit 5.2,
all possible sources of cash inflows are included.
• Collection on accounts receivable. This is the
primary source of cash inflows, and the only one from
continuing operations.
• Collection on notes receivable. This is usually a
manual entry in the cash forecast
• Collection from assets sales. A company will sells
assets from time to time, which result in a cash inflow.
• Collection from equity sales. This is done at the
company's discretion and is usually timed to take
advantage of the highest possible market price of
company stock.
Final section in Exhibit 5.2, all possible sources of cash outflows
are included.
• Payments for production costs. These are the costs
for materials and associated production supplies that
are needed to create products.
• Payments for salaries and wages. This cash outflows
is derived with a formula that is based on the sales per
employee and the average pay per person.
• Payments for general and administrative costs.
These costs are associated with corporate overhead,
such as sales, audit, insurance, and rent.
• Payments for capital expenditures. Payments for
capital expenditures are highly predictable.
• Payments for notes payable. Debt payments can be
derived from a separate schedule of loan payments
dates and amounts.
• Payments for sales taxes. Sales taxes can be
predicted based on a percentage of the estimated
sales
• Payments for income tax. It is expected changes in
income, and record this expense in the cash forecasts
as a quarterly payment.
• Payments for dividends. Amount to be paid is
probably very consistent with previous payment
amounts.
• Incremental inventory change. This is the only line
item in the cash outflow section that can be show either
an inflow or an outflow, because inventory levels may
rise or fall.
Increments Cash Flow Analysis
A key issue to consider when constructing or reviewing any
of the preceding cash flow analysis is that the only cash flow that
matters from the perspective of making a decision is Incremental
cash flow. This is the increase or decrease in cash flow that are
specifically attributable to a management action. For example,
assume that a machine produces 1,000 can per hour, and an
upgrade to the machinery will result in an increase in the
theoretical capacity to 1,500 can per hour, for an Incremental,
change of 500 can per hour. The cost of the upgrade is
$100,000,and the profit from each can is $. 04. The machine
runs eight hours a day for five days per week; therefore, the
increase in capacity will result in an added cash inflow of
$41,600, which is calculated as follows:
(500 can per hour) x $. 04= $20 per hour Incremental cash
inflow =($20 per hour of cash inflow) x (40 hours per week) x (52
weeks per year) = $41, 600
Interpreting Variation in the Flow of Cash
In many cases, the reason for the change is a seasonal one.
For products such as these, management will usually begin
production some months in advance of the selling season, or
even keep the production facility open for the fully year, but at a
very low level of production. During these production months,
cash flows will be decide duly negative, because there will be no
sales. Then sales will explode during the peak selling season,
with collections in accounts receivable starting a month or so
later, resulting in an enormous cash inflow during the rest of the
year.
Another issue that gives rise to significant cash flow
variation is the impact of the business cycle on company
activities. A business cycle is a long-term change in business
that is due to external economic conditions