1 Introduction

WHAT YOU NEED TO KNOW

Why would anyone want to read a Statement of Financial Position (previously

called a balance sheet), and try to decipher all the figures and strange
expressions on it? For anyone who knows nothing about it, reading a Statement
of Financial Position is like trying to figure out hieroglyphics, but there is a
wealth of important and interesting information hidden behind all that
apparently incomprehensible material. That is where one will find all the
financial information about an organisation and what keeps it afloat.

Just as a doctor may use a thermometer as the first step in determining the state
of a patient’s health, financial managers, shareholders or prospective investors
use the Statement of Financial Position as their initial gauge in determining the
state of an organisation’s financial health. They then apply other investigatory
techniques, as doctors may do, before they are in a position to make an
assessment. We might therefore conclude that the Statement of Financial
Position plays an important role in attempting to assess an organisation’s degree
of financial success.

However, the Statement of Financial Position is not the only instrument used to
assess an organisation’s financial health. It is really only one component of a set
of documents, generally referred to collectively as an organisation’s financial
statements. These usually consist of the Statement of Comprehensive Income
(normally called the income statement) and the cash flow statement, each of
which complements the other two. This is especially true of the Statement of
Financial Position and the Statement of Comprehensive Income: the one is
seldom read without the other, therefore when we speak about reading a
Statement of Financial Position, we really mean that we are reading all three
documents because, on its own, the Statement of Financial Position will provide
only part of the story.
Financial statements from previous years provide a history of the organisation’s
affairs. When they are compared with those of the current year, we can judge
whether or not the organisation has progressed over the years.

What are financial statements?

Before going any further, we need to briefly define these three documents. After
this, it should begin to be clear why the Statement of Financial Position, for
example, does not provide all the information that may be required by the
reader.

The Statement of Financial Position

The Statement of Financial Position may be defined as a document which

reflects the state of an organisation’s financial and business affairs on a
particular day, usually the last day of the financial year. However, the directors
may wish to keep a closer watch on the organisation’s affairs and would
therefore require financial statements more often than once a year, say quarterly
or half-yearly. In each of these cases, the Statement of Financial Position would
reflect the state of affairs on the last day of each respective period.

Typically, the Statement of Financial Position reflects the organisation’s assets

and liabilities, both long and short term. Since the liabilities represent the total
funds used to finance the assets, the total asset value must equal the total of the
liabilities. This means that the one amount must balance with the other.

The Statement of Comprehensive Income

The Statement of Comprehensive Income may be defined as a document which

reflects the results of the organisation’s business and financial transactions
during an entire financial year or other shorter period. Typically, the Statement
of Comprehensive Income reflects the total income from sales, less all
operating, administration and marketing costs. Thereafter, it reflects how
rewards were dispensed in the form of interest, taxes and dividends to all parties
who had vested interests in the organisation during the year. Finally, the
Statement of Comprehensive Income reflects the amount of net income (if any)
that is to be retained in the organisation for major uses such as paying off long-
term loans and expanding its operations.

The cash flow statement

The cash flow statement may be defined as a document indicating how cash has
flowed into and out of the organisation during the year or other given period.
For example, it would show cash flowing in from total cash sales, but cash from
total credit sales would be reflected only when the asset trade receivables or
accounts receivable are reduced.

You will learn later that cash flows into the organisation when assets are reduced
(or sold) and when liabilities are increased, for example when shares are issued
or money is borrowed. Similarly, cash flows out when loans are repaid, or trade
and other payables are paid. Any transaction which is reflected in the cash flow
statement will also be recorded in the Statement of Financial Position and
Statement of Comprehensive Income in the appropriate place and manner.

Consequently, following on the remark made earlier concerning their

importance, we may assume that the Statement of Financial Position and the
Statement of Comprehensive Income are the two primary documents
comprising an organisation’s financial statements, while others, including the
cash flow statement, are secondary, and play only supporting roles.

The purpose of financial management

The purpose of reading financial statements is to observe how an organisation

has earned and spent income, and what its current financial position is. This is
accomplished by applying the principles of financial management. The financial
manager must know these principles in order to manage the organisation’s
financial affairs, to preserve its assets, and to maintain its liquidity and
solvency positions (these terms will all be defined later). Likewise, other
interested readers who wish to understand how the organisation operates must
become acquainted with the principles of financial management.

The purpose of this book

This book is therefore directed not only at all students of financial management,
but also at all individuals, from clerks to managers, who are engaged in
managing the financial affairs of the institution in which they are employed. It is
especially directed at individuals who have a limited knowledge of financial
management and wish to supplement it.

No financial tasks can be performed without at least a basic understanding of the

principles of financial management. The most elementary form of instruction in
this field would be to learn by working in tandem with someone else. However,
such opportunities are not always available. The authors trust that this book will
therefore provide a thorough grounding in the basics of financial management.

This book is also directed at prospective investors who have only limited
knowledge of the methods applied to assess the financial value of investment
projects prior to investing cash through loans or by purchasing shares. Other
potential readers would be individuals from other fields who are suddenly thrust
into the financial field. Imagine if a marketing manager with virtually no
knowledge of financial management were to be unexpectedly promoted to the
position of managing director. Having a set of financial statements thrust before
him for his comment may prove very embarrassing. The study of an
uncomplicated book such as this one could effectively prevent embarrassment in
similar situations.

And, finally, this book is directed at ordinary individuals who want to know how
to balance their own weekly, monthly or annual budgets. Although such people
might not use documents as formal as financial statements, the principles of
financial management would nonetheless be applied in some or other form, and
knowledge of these basic principles could be a valuable asset. After all,
knowledge is power!

Presentation of the subject

For the benefit of either ordinary individuals or students, the authors have
worked on the assumption that their knowledge of financial management and its
ramifications is relatively scanty or even non-existent. This book will therefore
begin at an appropriately basic level and proceed with adequate explanations to
the level required by a senior officer of an organisation.

As may be seen in the table of contents, this book is divided into chapters, the
first of which is this introductory one. In addition, the table of contents provides
a comprehensive list of all the headings and subheadings, which should help the
reader find a particular topic with comparative ease. The comprehensive index at
the end of the book should further aid in quickly tracking down other items not
presented in the table of contents.

Chapter 2 comprises a brief discussion of various terms which generally seem

to cause confusion.

Chapter 3 provides explanations of the application of some of the basic

mathematical principles required in financial management. Although some
readers might not require this information, others may find it useful.

In Chapter 4, the actual financial statements are studied. In the discussion of the
Statement of Comprehensive Income and the Statement of Financial
Position, the various items they contain are considered in some detail, not only
each in its own right, but also from a content and informational point of view.
For example, a discussion of the payment of dividends on the Statement of
Comprehensive Income includes an explanation of the different kinds of
shareholder and their respective rights. This is expanded upon in the discussion
on the Statement of Financial Position by means of a further explanation of
ordinary and preference share capital, and the integration of each of these items
into the organisation’s capital structure.

In Chapter 5, the cash flow statement is discussed.

Chapter 6 demonstrates what information may be obtained from the study of an

organisation’s financial statements. This information is obtained by means of
financial analysis, which should indicate the levels of liquidity, activity,
solvency and profitability in the affairs of the organisation.

Chapter 7 embraces a very important topic, namely the management of

working capital, also known as the management of net current assets. Financial
managers are spending more of their time and effort on the management of
current assets and liabilities than previously.

Chapter 8 discusses the principles of financial planning as well as the cash

budget.

The value of money, or cash, is influenced by time, and Chapter 9 deals with
the time value of money.

Chapter 10 covers the investment decision. This important area, in turn,

involves the use of capital budgeting techniques, which financial managers use
to determine whether or not to purchase fixed assets, and how such purchases
will affect the profitability of the organisation.

Chapter 11 deals with the concept of valuation, which involves the cost of
capital, which is also termed the required rate of return. The rate of return is a
focal point around which decisions are made in determining whether or not, for
example, to make certain capital purchases. The required rate of return is
important because the determination of the capital structure of the organisation
depends on it. Capital structure, in turn, will be influenced by financial leverage.
The capital structure, that is, determining what proportion of loan capital may be
included with shareholders’ funds in financing the organisation as an operating
entity, must be carefully planned. This concept is therefore also known as the
financing decision, a very important topic which is discussed in Chapter 12.

In Chapter 13, we shall discuss in some detail the concepts of operating risk,
financial risk and operating leverage (note that financial leverage is discussed
in Chapter 11). These facets play important roles in determining the
organisation’s capital structure.

Dividends are the rewards the organisation pays out to its shareholders or
owners, and Chapter 14 discusses the organisation’s dividend policy – that is,
the decisions required to be made and procedures to be adopted in the payment
of dividends.

As a sequel to cash management, Chapter 15 discusses the leasing of fixed

assets, a subject which involves both the management of cash as such, as well as
the procurement of fixed assets by leasing instead of purchasing them.

Chapter 16 is entitled simply Finale. It discusses a few basic ideas not covered
elsewhere in the book, and also closes off the subject of financial management
as contained in this book.

Notes about each chapter

Note that each chapter (except this introductory one) opens with a section called
Learning outcomes, which indicates what you may expect to learn in the
chapter and how to apply the principles discussed. Before the conclusion of each
chapter, there is a section called Significance of this chapter. In this section,
you are asked to imagine that you are the financial manager of an organisation
(or perhaps a manager of your own private affairs). The questions to consider
are: What in this chapter will I be able to apply to ensure the continuing
existence of the organisation?, or What in this chapter will be useful in the
management of my own financial affairs?

Four or five questions have been set at the end of each chapter. These are merely
attempts to provide a means to assess the reader’s understanding of the content
of the particular chapter, and are referred to as Self-test questions. They are
typical of examination questions and also of the kind students usually ask when
they are unsure of a certain concept and its use, or when they are unable to grasp
the difference between two related concepts.

Of course, many more than four or five such questions could have been set, but
this would have defeated the basic purpose, which is to show you the kind of
question you could draw up for yourself. As you might realise, you would be
unable to set such questions without knowing the relevant work. By setting your
own questions, you will improve your insight into the subject because you will
then be searching the work for problem areas which you might need to
investigate further.

Where questions involve calculations, the answers will be provided in brackets

beside them. However, it is essential that you attempt these questions before
comparing your answers with the ones given.
Note that no discrimination is intended where an individual in the book is
referred to as “he”, “his” or “him”. The aim is to simplify reading by doing
away with awkward terms such as “he/she” or “he or she”, etc.

At the end of the book

The financial tables required for discounting and compounding sums of money
are provided in Annexure A at the end of the book. These factors are calculated
to three decimal places.

Annexure B contains a glossary of acronyms used in the text, followed by a list

of items of additional literature. At the end of the appendix is an index for
quick reference to subject items in the book.

CONCLUSION

The principles mentioned earlier will be explained with greater insight and in
greater detail than is commonly encountered in many textbooks on financial
management. This insight was developed by the authors over many years, from
experience gained as lecturers. The same techniques they use in explaining the
apparent complexities of the subject to uninformed students have been applied
in this book.

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