Accrual Accounting and Cashflow


Before the end of World War 1 most managers kept track of cash out and cash in. many senior citizen owner-managers still do today. There is an inherent problem in keeping the records that way, however, if the business offers and receives much credit. Doing business on credit displaces the time of the exchange of cash from the exchange of goods and services. Sometimes very little cash comes in during a particular month and very much cash comes in during other months. The same is true of cash out.

Keeping in track of what you pay or get paid for credit transactions causes the monthly reports describing the operations to fluctuate from month to month even though the goods and services flowing in and out of the business may be very much the same. About 1920 the accounting profession began placing emphasis on the accrual method of accounting to overcome this difficulty.

The accrual method portrays the smoothed-out profit as if all the transactions had been for cash and as if the business had purchased only exactly what was needed to make the sale. It is not an accurate portrayal of everything going on in the business, but it is a good approximation of the net effect of those things that affect profit. The problem is that so much emphasis has been placed on the accrual method income statement and balance sheet that the importance of cash has been regulated to virtual obscurity.

Even this result is satisfactory when the reports are describing large businesses with access to external financing through the stock market, commercial paper, and bank loans at the prime interest rate. But companies that do not have access to these external sources of financing have a different problem. For them, the flow of cash through the business means life or death, whether the accrual based profit is great or terrible. When new or small businesses need cash they must turn to the bank, the banker will look to the personal savings and assets of the owner-manager for collateral.

Accountants have not forgotten nor overlooked the importance of cash. They recognize the need for cash in sufficient quantity to keep the business operating. For their purposes, however, they often infer the cash available to the business from the income statements and describe future cash availability with the balance sheets. They, and others, frequently describe it as: cash flow equals net profit after taxes plus depreciation and other noncash expenses, such as amortization.

This statement is incorrect except under some very stringent preconditions that rarely exist in practice for a small business. This statement is an approximation that is valid for large and stable businesses in which changes from year to year are small and the statements from which the cash flow is inferred are annual reports. For a small and new business looking at monthly financial reports this approximation is inadequate. In a small, growing business the net cash flow to the firm’s bank account does not equal the net profit plus depreciation. Profit is not cash nor is it cash flow.

Although this pronouncement may be unconventional, entrepreneurs are realistic. Successful entrepreneurs ask how it really works and then get on with building their business. In the conventional approach the analysts, having inferred cash flow from profit, depreciation, and amortization, stop there, allowing their readers to assume that the resulting cash is in the bank wiating to be spent.

My Consultancy–Asif J. Mir – Management Consultant–transforms organizations where people have the freedom to be creative, a place that brings out the best in everybody–an open, fair place where people have a sense that what they do matters. For details please visit www.asifjmir.com, Line of Sight

Closed-loop Teams


For years, banks have taken several days, and even weeks and sometimes months to get a decision to a personal loan applicant. The application would be passed around the various departments, traveling at its own pace. A series of supervisors, clerks, and internal mailpeople handled it. Today, aggressive banks take the application directly into a focused, coordinated group—a credit analyst, a collateral appraiser, and a senior personal banker—who decide and respond to the customer sometimes in thirty minutes and always inside a day. This is a small closed-loop team.

 

A closed-loop team includes everyone who is necessary to make the deliverable flow. The team includes all the needed functional people and decision-makers and is self-scheduling. Everyone the team is working for the same objective—to provide the deliverable on time. The team is empowered to make decisions and to act. It has all functions inside it with short lines of communication. Its leader is responsible for its overall performance and for seeing that it gets all the capability, both technicall and human, it needs. All of these are essential to flexibility.

 

The old bank loan approval process was open loop. There was no continuity in the process, no visible standard, little learning between the principles, only occasional feedback on the process, and no one responsible for making it better.

 

In order for the loop to close on a process it must be tightly organized around the deliverable; the same core group must be involved in the process every day; and there must be a working leader on the team.

 

Small teams work better than large ones because large groups create communication problems of their own. It’s best to include only essential functions and to exclude people whose job is peripheral to the deliverable. For example, the bank loan team excludes accounting and records people. Teams have to be self-managing and empowered to act because referring decisions back up the line wastes time and often leads to poor decisions. So the team ioncludes a bank officer because if the officer were not on the team, he or she would be prone to second-guess the group’s decisions. Its better if all the questions are asked and answers are exchanged just once.

 

Closd-loop teams handle variety better than open-loop teams because they can create new information and flexibility.

 

My Consultancy–Asif J. Mir – Management Consultant–transforms organizations where people have the freedom to be creative, a place that brings out the best in everybody–an open, fair place where people have a sense that what they do matters. For details please visit www.asifjmir.com, Line of Sight

Project Financing


Project Financing (PF) has emerged as an innovative and timely financing technique and is being used in many high-profile infrastructure projects. Employing a carefully engineered financing mix, it is used to fund large-scale projects, from communications, to telecommunications, and power to energy projects. It is a preferred alternative today. It will be foremost option of future.

PF holds great promise, which is just beginning to be realized as a means of financing projects designed to help meet the enormous infrastructure needs that exist in a developing countries.

Most infrastructure projects in developing countries are being funded by exchequer and thus in nearly all cases the construction of much desired projects are delayed due to lacking funds and deficient resources. Particularly when local governments are functioning full swing developing countries need to consider PF as a preferred choice.

PF can be arranged when a particular facility or a related set of assets is capable of functioning profitably as an independent economic unit. City governments (sponsors) of such a unit may find it advantageous to form a new legal entity to construct, own, and operate the project. If sufficient profit is predicted, the project organization can finance construction of the project on a project basis, which involves the issuance of equity securities (generally to the sponsors of the project) and of debt securities that are designed to be spell-liquidating from the revenues derived from project operations.

The intricacies of PF are formidable, and can easily be misunderstood and consequently, misused. While PF structures share certain common features, by necessity, they require tailoring the package to the particular circumstances of the project. That is where both the benefits and the challenges lie.

What distinguishes PF from conventional direct financing is that in PF, the project is a “distinct legal entity” and the financing is tailored to the cash flow characteristics of the project assets. Such a structure can yield a more efficient allocation of risks and returns than conventional financing, but careful financial engineering is critical.

It is a form of asset-based financial engineering. It is asset-based because each financing is tailored around a specific asset or related pool of assets. It involves financial engineering because, in so many cases, the financing structure cannot simply be copied from some other project. Rather, it must be crafted specifically for the project at hand.

PF is the raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project at the source of funds to service their loans and provide the return and a return on their equity invested in the project. The terms of the debt and equity securities are tailored to the cash flow characteristics of the project. For their security, the project debt securities depend, at least partly, on the profitability of the project and on the collateral value of the project’s assets.

PF is not a means of raising funds to finance a project that is so weak economically that it may not be able to service its debt or provide an acceptable rate of return to equity investors. In other words, it is not a means of financing a project that cannot be financed on a conventional basis.

At the center is a discrete asset, a separate facility, or a related set of assets that has a specific purpose. This can include trash collecting trucks, toll roads, water supply and sewer projects, or some other item of infrastructure. This facility or group of assets must be capable of standing alone as an independent economic unit. The operations, supported by a variety of contractual agreements, must be organized so that the project has the unquestioned ability to generate sufficient cash flow to repay its debts.

PF can be advantageous to Pakistan when it has a valuable resource deposit, other responsible parties would like to develop the deposit, and it lacks the financial resources to proceed with the project on its own.

Commercial banks and life insurance companies have traditionally been the principal sources of debt for large projects. In the typical financing structure, commercial banks would provide construction financing on a floating rate basis, and life insurance companies would then provide “permanent financing” on a fixed rate basis by refinancing the bank loans following project completion. For infrastructure projects have become a high priority, commercial banks, having adjusted to the tighter capital standards, have expanded their role in PF. They advise as well as lend.

Multilateral agencies, such as the World Bank and IDB, and various agencies, such as Eximbank and OPIC, have also stepped up their funding of private infrastructure projects. Developing countries’ capital markets can also be a useful source of funds. Raising funds locally can reduce a project’s political risk exposure.

Most recently, through the financing of hundreds of independent power projects, it has become evident that PF is suitable for relatively low-risk projects that involve standardized nonproprietary technology.

PF has attracted growing interest as a means of obtaining capital. Its potential is perhaps greatest for the many large infrastructure capital investment projects that are on the drawing boards of many local governments. The projects are large and expensive, and the risks are great. But the potential benefits are enormous. Project financing could be the answer to the financial needs of such local governments.

My Consultancy–Asif J. Mir – Management Consultant–transforms organizations where people have the freedom to be creative, a place that brings out the best in everybody–an open, fair place where people have a sense that what they do matters. For details please contact www.asifjmir.com, Line of Sight