Martin Quinn's management and financial accounting blog

A year or two ago I set a hypothetical assignment for some of my students on a comparison of CO2 emissions on road freight versus rail freight. I based on the assumption that a CO2 charge would have to be paid by firms, and they could in fact save money by using rail freight. Of course the problem with rail freight is that is does not go door-to-door, but it might still be an option for transporting between cities or depots – depending on volume.  At the time when I set the assignment, I did not find many examples (at least in the UK/Ireland), but I came across a Tesco press release in November last. According to the release, Tesco are expanding their use of rail services, which will mean 24,000 tons less CO2 and 72,000 less road journeys. Yes, this is a great thing for the environment, but the management accountant in me really wants to know the cost  savings generated by this.

 If you have studied management accounting, you’ll have heard the term balanced scorecard. A scorecard is a report of key performance indicators – both financial and non-financial – of an organisation.  Many organisations not only use some form of scorecard, but also publish it on their websites or display it in a public place within the organisation.

Take for example London’s Heathrow airport. As you can see on the graphic here, they produce a monthly report (see here) which looks at many areas of performance for each terminal.  Like many firms, they use a colour-coded system, where red usually means a target has not been achieved – for example, seat availability seems to be an issue in Terminal 3 on the example here.

This scorecard is a great example – if you click the link above you’ll see it has much more than I show here. I have only one negative thing to say about it – and this falls from a recent trip through Terminal 1. I discovered this wonderful colourful (and positive) scorecard on my way to the gents – on the corridor into the toilets to be specific. Surely there’s a better place to display results? Or maybe it does not matter as only us management accountants take any notice of such things.

In my former life as a management accountant in industry, I worked in a number of projects which automated either production itself, production planning, or both. A term I was use to at that time was Manufacturing Execution System or MES. So what is an MES and why should management accountants know about them?  Well, an advertisement in the November 2011 edition of Financial Management  (CIMA’s monthly magazine) prompted me to write about it. AN MES is a system which basically communicates from sales through to the actual making of a product or a the start of a process.  An MES may include a sales order module, which would gather customer orders and pass these on to planning modules or directly to process equipment. Typically, an MES will improve a production process as production is scheduled more efficiently and can be monitored for back-logs and jams.  Also, an MES will also typically integrate with an ERP system, which means that a businesses systems are fully integrated. According to the advert in the CIMA magazine, Carlsberg (yes the brewer) improved performance in several areas once it used an MES; sales increased bu 1.5%, gross margins up 1.2%, downtime decreased from 28% to 13%, material loss decreased by 1%. All of these translate into increased profitability, which of course is of interest to managers and management accountants. I would argue that understanding how an MES works in a business is a vital piece of kit for any management accountant, particularly if such performance improvements can be made. If you are interested in reading some more, here are two websites I am familiar with which offer MES systems; Kiwiplan and ATS.

When I teach management accounting to students, I am always looking for examples to relate what I say to a real life example.  So, a while back I was trying to think of an example which might convey the fact that management accountants are not (or should not be)  just bean-counters. The role of a management accountant/business analyst/business partner is much more than just accounting. My experience tells me that a good management accountant (and manager too) get’s their hand dirty i.e. knows a good deal about the business in terms of how things are made/delivered. If you don’t know the business, then how for example can you actually undertake a cost-saving exercise. So now for the example. I read a blog post on The Economist website a while back. The title caught my eye actually “Reducing the barnacle bill”. The article post mentions how barnacles attached to a ships hull below the waterline can increase drag so much that fuel costs increase 40%.  The post then mentions several chemical solutions currently available and some being worked on. The point from this example is that should a management accountant at a shipping company know such detail of operations. I’d like to suggest, yes they should.  Only such detailed knowledge of the operations would highlight the need to control the “barnacle cost”. I’m sure there are many more similar examples out there.

 Just a short post to say I wish you all a very happy and peaceful Christmas and let’s hope 2012 brings joy and happiness too.

To keep it festive and light-hearted, here’s a line to end the year on (which I found here) – “year-end is approaching – keep calm and carry on reconciling”.

(Picture is the Leipziger Weihnachtsmarkt)

As we have seen in an earlier post the ROCE may be useful to shareholders, but there are a number of other ratios which they may find particularly useful as investors. These are Earnings per Share (EPS) and Price Earnings (PE).

EPS represents the profit per individual share. It as calculated as follows:

EPS:                            Profit after tax, interest and preference dividends

Number of ordinary shares in issue

The top portion of the EPS ratio represents the profit that is available for payout as a dividend. This does not at all mean it will be paid out, but it is the profit available to ordinary shareholders. Given that the bottom portion of the EPS is the number of ordinary shares issued, the EPS is not very comparable between two companies. However, the trend of the EPS of a particular company is an important indicator of how well the company is performing and it is also an important variable in determining a shares price

The PE ratio shows a company’s current share price relative to its current earnings – which assumes the company is a public company and its shares are available for purchases through a stock market. It is calculated as follows:

P/E ratio:                                 Market price per share

Earning per share

It’s usually useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general, or against the company’s own P/E trend. It would not be useful for investors to compare the P/E of a technology company   (typically high P/E) to a utility company (typically low P/E) since each industry has very different growth prospects. Care should be taken with the P/E ratio because the bottom part of the ratio is the EPS, which as stated above may not be that comparable between companies. There are some crude yardsticks for the P/E ratio as follows:

• A P/E of less than 5-10 means that company is viewed as not performing so well;
• A ratio of 10-15 means a company is performing satisfactorily;
• A ratio above 15 means that future prospects for a company are extremely good.

Again, as with all such yardsticks, these will vary by industry and depend on other factors which drive share price e.g. bad publicity, the general economic outlook.

As in previous posts, let’s use the accounts of  Diageo plc from 2010 to calculate these ratios.

EPS = 1,762,ooo/2,754,000   = £0.64 per share (data from p. 107/150)

PE = 1060/64  = 16.6 times (share price from http://www.diageo.com/en-row/investor/shareprice/Pages/Shareprice-History.aspx. Based on the yardstick mentioned above, the PE for Diageo reflects sound future prospects.

In this post, I’ll detail some ratios which can helps a business manage its working capital (working capital is current assets less current liabilities). A business can calculate a ratio for each of inventory, trade receivables, and trade payables which help  interpret how well working capital is managed. In my previous post, I showed some ratios which help determine liquidity and solvency; with the ratios below, we have all elements of working capital covered (including cash) .

The first ratio is inventory turnover, which is calculated as follows:

Inventory turnover:                 Cost of sales

Average inventory

This ratio tells us how many times a year inventory is sold. You’ll notice the bottom line says “average inventory”, which might be a simple average of the inventory at the start of the year and the end of the year, or a rolling average. The reason for using an average is to try to remove seasonal variations.

The next ratio reflects how well trade receivables are managed:

Average period of credit given:          Trade receivables x 365

Credit sales

This ratio tells how many days credit, on average, is given to customers. The top line is multiplied by 365 to give the answer in days. If you want it in months, multiply by 12 instead. If the period of credit given is getting longer, this could be problematic,  as cash is not collected as fast by the business.

Now let’s see the average period of credit taken. This is very like the previous one, except it relates to suppliers. It is calculated as follows:

Average period of credit taken:                      Trade payables x 365

Credit purchases

One thing to note about this ratio is that it may not always be possible to obtain the credit purchases figure from published financial statements.  The period of credit taken should not be too long either. If it is getting longer, it may be a sign of cash flow problems.

As in my previous posts, I’ll now calculate the above ratios using the figures from the 2010 annual report of Diageo plc.

The inventory turnover is:  4099 (3281+3078)/2 =     (data from p.106/108) =1.2 times per annum.  This means the company sells its inventory just over once per year. This probably seem really low if you think about how quickly beer and other alcohol sells in a retail sense. However, if we look at the detailed notes on inventory in the annual report, we can see that about 2/3 of the inventory is deemed “maturing” inventory.

The average period of credit given is: 1495 x365/9780 = 56 days  (data from p.106/140). This seems a reasonable period of credit.

The average period of credit taken is: 843 X 365/4099 ) =75 days (data from p.106/148). Note that I am using the cost of sales figure as a substitute for the credit purchases figure – which is typically not available in  published accounts. Again this figure seems reasonable and is longer than the period of credit given, which makes logical sense.

In summary from the figures above,  the working capital of Diageo plc seems well managed.

Your have probably heard the terms liquidity and solvency. Liquidity refers to the ability to convert assets to cash. For example, inventories may be more liquid (i.e. can be sold for cash quicker) than a non-current asset like a building. Solvency refers to the ability of a business to pay debts as they fall due. Liquidity and solvency are closely related concepts. If assets cannot be converted to cash, debts like loan repayments or payments to suppliers may not be met. To be unable to pay debts as they fall due means a business is insolvent, which can mean business failure. There are two useful ratios to help us assess the state of a businesses’ liquidity – the current ratio and the quick (or acid-test) ratio. The current ratio is:

Current ratio:                           Current assets

Current liabilities

The basic idea the current ratio is that for a company to be able to pay its debts as they fall due, current assets should cover current liabilities by a multiple. Generally a current ratio of at least 2:1 is good. This means that current assets are twice current liabilities. So, even if some stock could not be sold or some trade receivables not paid, current liabilities would still be covered for payment. However, the 2:1 figure is only a guideline. If we  calculate the current ratio for Diageo  plc for 2010 (from the statement of financial position on p. 108), we get:

6,952/3,944 = 1.76 : 1.

Although not 2:1, it should not be a major problem. Think about the type of business and the inventory it has – can you imagine Diageo having difficulty selling it’s stock of Guinness for example.

The Liquid ratio, and it is calculated as follows:

Liquid ratio:                            Current assets – inventory

Current liabilities

This ratio is also called the Quick ratio or the Acid Test ratio. It is very similar to the Current ratio, except that inventory is deducted from current assets. This is because inventory is typically regarded as being the least liquid current asset. Often the yardstick for the Liquidity ratio is 1:1, but this depends on the type of business. For example, large retailers may have relatively low stock and almost no receivables, which will skew the figure well below zero if we assume suppliers give credit.

If we  calculate the current ratio for Diageo  plc for 2010 (from the statement of financial position on p. 108), we get:

6,952-3,281/3,944 = 1.12 : 1

The Current and Liquid ratios serve as useful indicators of the liquidity/solvency or a business. However, as with other ratios, the trend over time is important. Any business may face short-term liquidity problems which could skew either of the above ratios. Short-term liquidity problems may arise if, for example, customers are slow to pay or inventories can’t be sold. Such problems are normally overcome through the  management of inventory and receivables, which I’ll deal with in the next post.

(Image above from withfriendship.com)

Elsewhere on my blog, I have written a post of the basics of the double entry accounting system. I had a comment on this post asking for some more information on single entry accounting – so here it is.

The basic idea of the double entry accounting system is that information is recorded twice. The system allows any business or organisation to get a picture of its incomes, expenditures, assets, liabilities and capital at any point in time. The double entry system is encoded into all accounting software and is the basis of all financial reports of businesses.

In the double entry system, any transaction is recorded from its source all the way through to the financial statements. For example, if a supplier is paid the following happens:

• the cheque is recorded in a “day book” – normally a cash/cheque payments book
• the suppliers balance is updated – in a personal ledger account
• the bank balance is updated
• by virtue of the previous two items, the assets (bank) and liabilities (trade payables) are updated
• the financial statements (income statement and balance sheet) are updated.

In a single entry system, some of the above is not done. The best way to explain this is by an example. When I worked in small accounting firm some years ago, most sole traders kept what were single entry records. At that time (the early 1990′s) most small sole traders kept records in a manual form –  most had no computer anyway. The records would typically comprise  a book where all purchases/expenses were recorded, a book where all payment in and out of the bank were recorded and a book where all sales were recorded. Records of things like assets – how much was owed by customers or records of vehicles for example – and liabilities – how much was owed to suppliers for example – were not kept. Using these books, it is only possible to prepare an income statement. Thus, as the double entry system is not applied in full, i.e. transactions are not recorded through ledgers in this example, then the single entry system applies.

It is not possible to say that the single entry system means that only certain specific records are kept. It’s probably better to think of the single entry system of accounting as one which does not fully use the principles of double entry, but does allow profit to be calculated. In the example above, what we did was to build up a list of the assets and liabilities, as well as the capital of the business, to allow us to prepare an income statement (profit and loss account) and statement of financial position (balance sheet).

When a business or manager refers to their cost structure, they are talking about the composition of the costs of the business. Typically, costs are either fixed or variable. Fixed costs stay the same regardless of what happens e.g. how much is sold. Variable costs increase or decrease in line with business activity e.g. the more product sold, the higher the purchase or manufacturing costs. It goes without say that a business manager needs to have a full knowledge of how their business responds to changes in output and how the business itself actually operates.  I read a great example of this back in June this year in the Guardian.  The article mentioned how Ryanair had started talks with a Chinese aircraft manufacturer (Commercial Aircraft Corporation of China) in an effort to build a cheaper alternative to its current aircraft, the Boeing 737. What struck me was not the cheaper cost of the aircraft, but attempts by Ryanair to design the aircraft with exactly 200 seats – about 15 more than the Boeing. Why 200 seats? Simple answer actually, anything above 200 seats and one additional crew member is needed.  Keeping the seats at 200 means that each extra seat could yield anaverage profit of about €40 per seat.  Now that’s knowing your cost structure and operations in detail

Here is a really good article from Forbes on what other businesses could learn from the legacy of Steve Jobs – and to the man’s testament this is posted from an iPhone at my kitchen table. Read the piece here

I remember some meetings in my past life, when I had to justify expenditure on information to my boss – a chartered accountant with not too much in-depth knowledge of IT. This was in the late 1990′s. Of course, technology has moved on dramatically since then, but I’d be fairly sure that any accountants today would still be questioning the costs if IT/IS infrastructure and software.  And today, it is not only the cost of the equipment that needs to be considered, it is the cost of the information held by companies. This is a very difficult thing to cost, but the problems at Sony in recent months gives some idea. In May 2011, the Los Angeles Times wrote about the cost of the first hacker attack on Sony (there was another one in June 2011). The article reports a cost of  $171 million, which is believe it or not is nearly as much as the impact of the Japanese earthquake/tsunami earlier that year on the companies profit ($208m). I’m not sure what the hackers did to break in to Sony’s systems, but I bet it would have cost a lot less than $171 million to make their systems hacker-proof. And I’d also bet the hacker’s would be happy to repair the damage for a lot less than $171 million too!

A small delve into economics, sorry. I read this article on the Wall Street Journal about my homeland (well, my dear home too!) and it make me think, well, we not total gobshites! Of course, we’re not, no matter what Fr. Jack (left says!). But in all seriousness, I can’t help but compare what the articles says to my own experience of talking to and helping small Irish businesses.  I don’t know anyone who is not worried about the future of their business, but yet they all pulled-up their socks and did what any management accountant would advise – look at your costs, your processes, what you do and so on. I know two businesses who realised  they needed to work 3-days weeks for almost a year, but they are now fine again. Others dropped price, or just worked smarter. I also can think of others who just would not adjust their cost structure, prices, staff or anything. Where do you think these guys are? Well nowhere simply. Of those businesses that adapted to survive, they have learned a hard lesson on cost structures, doing things well, adjusting price and looking after customers. Those, like the WSJ article say about Ireland, will be the stronger firms in the future ( I hope ).

One of the first few things that I would typically teach students that are new to accounting is that all most organisations need to control what they do in some way.  Control can be of a financial nature, i.e. preparing financial statements, and this is something we typically associate with “for-profit” organisations.

However, many not-for-profit organisations also need to keep accounting records and have intricate financial/accounting based control systems. For example, a charity might like to know its sources of funding and keep a detailed trace on all expenditures. Similarly, any sovereign  state needs to keep track of its income (usually taxes) and its outgoings e.g. expenditure on schools, roads and social welfare. A few months ago, a number of articles on the annual financial report of the Vatican State caught my eye (see here and here). In brief,  the Vatican State had a surplus of about €10 million for 2010. The Vatican is a peculiar organisation in that it is somewhere between a Church and a State.  I can’t find the annual report on-line, but  as far as know one main source of income for the Vatican is the traditional “Peter’s Pence” collection held annually at all catholic churches across the world. The press releases surrounding the 2010 Vatican financial report seems to suggest that deliberate efforts were made compared to previous years to control costs and keep within budget. So, even the Vatican has a use for accounting information – both financial statements of some kind, and management accounting. By the way, if you do find the annual reports of the Vatican on-line, do get in touch

Okay, so I have no much interest in football, but this recent piece in The Economist makes for great reading if you’re into the footie – or like me trying to paint peformance management issues in a lighter way!  You can read the articles for yourself, but the basic theme is that while both banks and football clubs pay high salaries to retain/attract the best talent, the question is does this make economic sense. Arguably, the more successful banks and football clubs get to keep more of their revenues as they make more money by having the best traders/players.  So it seems to make sense that pay and performance are linked in banks and football clubs.  However, if bankers/players pay is capped, they can move elsewhere, which may have an effect on the performance of the bank/club they leave.  So, according to the article, unless a cartel scenario exists in banks it is unlikely that any cap on pay  will be useful in an economic sense. It may be what politicians want, but it’s unlikely to make economic sense.