Financial tools in management of small and medium

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Peter Krištofík Marzanna Lament Hussam Musa Anna Wolak-Tuzimek

Financial tools in management of small and medium-sized enterprises

London 2015

Financial tools in management of small and medium enterprises Reviewers: Assoc. prof. Wojciech Sońta, Ph.D. – University of Technology and Humanities in Radom Assoc. prof. Bogusław Ślusarczyk, Ph.D. – University of Rzeszów Authors: Assoc. prof. Peter Krištofík, Ph.D. – Matej Bel University in Banská Bystrica, Faculty of Economics Marzanna Lament, Ph.D. – University of Technology and Humanities in Radom, Faculty of Economics Assoc. prof. Hussam Musa, Ph.D. – Matej Bel University in Banska Bystrica, Faculty of Economics Anna Wolak-Tuzimek, Ph.D. – University of Technology and Humanities in Radom, Faculty of Economics Copyright © 2015 by Peter Krištofík, Marzanna Lament, Hussam Musa, Anna Wolak-Tuzimek ALL RIGHTS RESERVED Published by Sciemcee Publishing. LP22772, 20-22 Wenlock Road London, United Kingdom N1 7GU Sciemcee Publishing is part of SCIEMCEE. It furthers the SCIEMCEE's mission by disseminating knowledge in the pursuit of education, learning and research at the highest international levels of excellence. No part of this publication may be reproduced in any manner without the express written consent of the publisher, except in the case of brief excerpts in critical reviews or articles. All inquiries be address to Sciemcee Publishing, LP22772, 20-22 Wenlock Road, London, N1 7GU or [email protected]. First Edition: 2015 A catalogue record for this publication is available from British Library. Sciemcee Publishing has no responsibility for the persistence or accuracy of URLs for external or third-party internet referred in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Every effort has been made in preparing this book to provide accurate and up-to-date information which is in accord with accepted standards and practice at the time of publication. Nevertheless, the authors, editors and publishers can make no warranties that the information contained herein is totally free from error. The authors, editors and publishers therefore disclaim all liability for direct or consequential damages resulting from the use of material contained in this book. Readers are strongly advised to pay careful attention to information provided by the book. Sciemcee Publishing also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Sciemcee Publishing books may be purchased for educational, business, or sales promotional use. For information, please e-mail the Sciemcee Publishing at [email protected]. ISBN 978-0-9928772-7-9 Includes bibliographical references and index.

Contents Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 5 Chapter 1 Selected aspects of enterprise finance management . . . . . . . . 9

1.1. The notion and nature of enterprise finance. . . . . . . . . . 9 1.2. Making of financial decisions in an enterprise . . . . . . . . . 13 1.3. Internal conditions of financial decisions . . . . . . . . . . 21 1.4. External conditions of decision-making. . . . . . . . . . . 24 1.5. Nature and significance of capital in an enterprise . . . . . . . 31 1.6. Principal sources of external capital. . . . . . . . . . . . 38 1.7. Capital structure of small and medium-sized enterprises in the European Union. . . . . . . . . . . . . . . . 51 1.8. Conclusion. . . . . . . . . . . . . . . . . . . . 59 References . . . . . . . . . . . . . . . . . . . . . 60

Chapter 2 Accounting information system of SME sector enterprises. . . . 69

2.1. Classification of enterprises by international accounting regulations. . 69 2.2. Information generated in the accounting system and its characteristics. 77 2.3. Information requirements of small and medium-sized enterprises. . . 86 2.4. Criteria of selecting forms of business accounts . . . . . . . . 90 2.5. Accounting policies and their determining factors. . . . . . . . 95 2.6. Reporting duties of SME enterprises. . . . . . . . . . . 107 2.7. Information generated in the accounting system and information requirements of enterprises. . . . . . . . . . . . . . 115 2.8. Conclusion. . . . . . . . . . . . . . . . . . . 120 References . . . . . . . . . . . . . . . . . . . . . 122

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Chapter 3 Tools for evaluation of financial condition of enterprises . . . . . 133

3.1. Financial analysis as a financial management tool. . . . . . . 3.2. Financial analysis and risk management in SMEs. . . . . . . 3.3. Ratio analysis. . . . . . . . . . . . . . . . . . . 3.4. Simplified methods of evaluating financial standing of an enterprise. 3.5. SWOT analysis of small and medium-sized enterprises. . . . . 3.6. Conclusion. . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . .

133 153 156 167 179 181 183

Chapter 4 Finanical planning and budgeting. Control and internal audit . . 191

4.1. Definition of key concepts. . . . . . . . . . . . . . . 191 4.2. Limitations of traditional budgeting and factors influencing quality of budgeting, forecasting and financial planning . . . . . . . . . . . . . . . . . . . . 200 4.3. Factors influencing quality of budgeting, forecasting and financial planning processes . . . . . . . . . . . . . . . . . 206 4.4. Value-adding budgeting, forecasting and financial planning process . 212 4.5. Role of the finance department . . . . . . . . . . . . . 216 4.6. Link between financial planning information and strategic decision-making . . . . . . . . . . . . . . . . . 221 4.7. Control and its types. . . . . . . . . . . . . . . . 225 4.8. Internal audit in enterprises. . . . . . . . . . . . . . 227 4.9. Conclusion. . . . . . . . . . . . . . . . . . . 237 References . . . . . . . . . . . . . . . . . . . . . 238

Introduction Effective management of contemporary enterprises is directly connected to an uninterrupted process of making difficult decisions of exceptional importance to an enterprise. This is due to the continuously intensifying competition that causes all entities to struggle for optimum, strongest positions in the market. Such goals and actions require maximum effectiveness of enterprise management that gives rise to the need for ongoing analysis of performance and achievements. Outcomes of this analysis may affirm decisions made are correct or signal that changes to management are needed. They also assist owners with evaluation of management board and current standing of a business and management with monitoring of conditions in a firm. Contemporary enterprise theory claims all and any decisions made within an enterprise have the objective of maximising its market value. Thus, management of business finances is one of principal ways of attaining this objective. This scientific monograph is a product of international cooperation of researchers from two universities in Poland and Slovakia. The book addresses various aspects of applying financial instruments to management of small and medium-sized enterprises. The chapters include extensive discussion of subjects associated with: making of financial decisions, financing of enterprise operations, accounting information system, tools for assessing financial standing of enterprises, planning, budgeting and controlling in enterprises. The monograph is divided into four chapters dealing with both theoretical issues and practical elements employed by enterprise managers. Chapter one addresses making of optimum financial decisions in an enterprise and the role of external capital in financing of enterprise development. A decision made is associated with making choices, solving of problems, setting goals and directions of operation, as well as determining methods and ways of realising the above. All actions pursued by enterprise managers should serve its objectives. From the viewpoint of finance management theory, max-

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imising value of a business and benefits to owners of capital invested in assets are the fundamental objectives of firms. For this reason, financial decisions of managers are aimed at facing competition in the market and appropriate development of a firm while maintaining an adequate financial standing. Achievement of financial goals requires adequate financing. Sources of the financing encompass capitals generated by an enterprise (own capitals) and external capitals from e.g. bank crediting or leasing. Own capital gives its owner a title in an enterprise which is expressed as involvement in distribution of profits or covering of losses and voting rights at meetings of shareholders appropriate to the capital contributed. Third-party capital, on the other hand, is an additional source of financing for enterprise operations and development. In the case of firms with modest accumulation capacities, however, it can become a source of financing for investment and development projects. Determination of mutual proportions between own and external capitals in order to obtain an optimum structure of capital commitments is of paramount importance to proper functioning of an enterprise. Firm owners can then take optimum advantage of rising profitability of their capitals and minimise chances of bankruptcy. Statistics were employed to evaluate and analyse capital structures in small and medium-sized enterprises active in the European Union countries. The second chapter discusses accounting information systems of SME enterprises. Information is a major resource of any enterprise that supports decision-making processes. It must fulfil certain qualitative characteristics to meet stakeholder expectations while being commensurate with capabilities of enterprises and meeting their information requirements. Financial information used for the purposes of enterprise management is basically generated by accounting, therefore IAS/IFRS have laid down its qualitative characteristics that make it useful in making of decisions. In order to assure this information usefulness, accounting should realise a range of principles to be applied by all businesses, though in consideration of their specific nature and information requirements. This is addressed by regulations of Directive 2013/34/EU and IFRS for SMEs, which govern rules of drafting financial statements for SME enterprises. The initial section of chapter two addresses in particular: principles of classifying businesses in light of international accounting regulations, qualitative characteristics of information created by accounting systems, which are also pre-requisite to the systems' usefulness, and criteria deciding selection of a format for recording economic transactions. The second part of the chapter

Introduction

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is dedicated to information requirements of small and medium-sized enterprises and their implementation in light of applicable regulations, especially accounting policies and their determining factors. Research undertaken indicates information requirements of small and medium-sized businesses for the purposes of short- and long-term management and relates them to information generated by accounting as dependent on business size. The most common tools for evaluation of enterprises' financial standing are discussed in chapter three. In the context of a turbulent macroeconomic environment, financial position of an enterprise must be monitored on a continuous basis. Multidimensional instruments which serve a variety of assessment and analytical tools are employed to this end. Assessments of enterprises as a whole, based on synthetic value measurements of their property and financial resources, examination of processes and results, that is, financial analysis, play an important role. Analysis of five ratio groups: profitability, liquidity, debt, efficiency and solvency, is a specific instance. Profitability is regarded as the crucial criterion of enterprise evaluation, of interest to both owners and managers. Disclosure of profits offers an opportunity for return on invested capitals by way of dividend and is a major source of investment financing, which fosters development and market standing of an enterprise. Development of an enterprise requires systematic evaluations of its financial standing, particularly in the ever-shifting reality. Simplified methods (discriminant analysis, EVA, MVA), kinds of early warning systems against adverse changes in direct and remote environments of an enterprise, are principal ways of examining, exploring and assessing financial position in small and medium-sized enterprises. SWOT analysis of an entity's strengths and weaknesses against the background of opportunities and threats from the environment is employed to estimate competitive standing of enterprises. Chapter four addresses issues of financial planning and budgeting as well as internal control and audit as instruments verifying assumptions and plans in place. Financial planning and budgeting are responses facing enterprises in connection with the changeable economic environment. Decisions related to planning in general, and types of plans, their scopes, levels of detail and periods covered in particular, are made as required by an enterprise itself, external conditions and resources in place. Size and scale of operations of an enterprise play major roles as well. Internal control and audit are forms of verifying assumptions made, assessment of business performance and its

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comparison to plans, as well as key tools of organisation management that improve its functional efficiency. The fourth chapter covers in particular: the concept of financial planning and budgeting and their importance in the system of enterprise finance management, rules of financial planning and budgeting, factors determining their quality, as well as benefits to enterprises from realisation of the planning and budgeting processes and mutual relations between plans and financial decisions made. A final section of this chapter is devoted to internal control and audit as verification and evaluation instruments. Use of internal auditing in enterprises of different sizes in Poland and globally is discussed on the basis of statistics. Finances of an enterprise are key elements of a number of major aspects of its operations, beginning with assessment of performance and ending with project financing. To be successful, therefore, managers must conduct skilful evaluations in order to make effective contributions to making of appropriate financial decisions. Instruments for assessing financial standing of a business are exercised to this end. We are convinced this publication will be of interest to both scientists and practitioners as a source of knowledge and inspiration for a continuing discussion of financial instruments and their application to adequate management of small and medium-sized enterprises Authors

Chapter 1 Selected aspects of enterprise finance management 1.1. The notion and nature of enterprise finance

Enterprise finances are a specific area of finance addressing financial decisions made by enterprises, tools and analysis supporting these decisions. The area can be analysed from a variety of perspectives: •• Functional – as a process of collecting and expending monies. It encompasses real cash flows and provides conditions for its future flows, •• Subjective – finances as seen from the viewpoint of subjective and organisational structure of managing processes of cash collection and expenditure. •• Objective – finance in a range of selected areas of enterprise operations. •• Enterprise finances are economic phenomena associated with collection and expenditure of monies for purposes of business operation. Enterprise management should undertake appropriate organisational, decision-making and control actions in the field of finance to manage economic development for a business to generate optimum performance [Bień 2011, p. 14]. Managing enterprise finance is undoubtedly the prime goal of management. It involves acquiring sources of business financing (capitals) and investing the same in assets in order to attain the strategic objective of maximising profits of shareholders in (owners of ) an enterprise, that is, individuals who have permanently invested their capitals in an enterprise [Griffin 2004, p. 117]. Finance management involves financial resources of an enterprise. Managers of a finance organisation are commonly the managing subjects.

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An individual heading a finance organisation is normally referred to as the finance director. Shareholder profits come in the following forms [Fudaliński 2002]: •• Dividends paid, i.e. part of profits earned by a business, •• Long-term growth of company shares over and above rate of inflation. Finding sources of financing Investing capital in assets to Maximise shareholder benefit by

Maximising profitability of equity capital

Optimisation of financial surplus

In consideration of reasonable financial risk

Fig. 1.1. Management of enterprise finance Source: [Bień 2008, p. 14].

Finance plays passive and active functions in enterprise management. The passive function relates to expressing consequences of business decisions by means of money indicators which allow for aggregation of expenses and results of decisions and for evaluation of business activities. The active function of finance relates to the fact that financial resources determine development potential of an enterprise. Lines and rate of business development depend on cash resources which are held and can be acquired. Deficits of financial resources not only prevents implementation of long-term development plans but may also cause a bankruptcy [Głodek 2004, p. 139]. Knowledge of an enterprise finance manager must be suited to the nature and scale of a business. In small enterprises, finances are commonly managed by owners or appointed managers. In case of more complicated decisions, assistance of third-party consultants is used as well. Finances of large enter-

Chapter 1: Selected aspects of enterprise finance ...

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prises are managed by specialists and supervising directors are usually board members [Bień 2011, p. 17]. There are three principal objectives of finance management: •• Financial planning (budgeting), •• Realisation of financial plans (provision of financing), •• Control (controlling of financial plan realisation). Finance management of a profit-oriented enterprise is aimed at enhancing wealth of its owners [Michalski 2011, p. 175]. Formulation of the central objective does not exclude a multitude of partial goals connected to various areas of enterprise finance. Aims connected to management of working capital, of capital volume and structure, to finance planning, or goals of analysis can be set [Czekaj, Dresler 2011, p. 14]. Other objectives of finance management include [Davies 1993, p. 87]: •• Assurance of regular and adequate funding, •• Assurance of optimum use of funding, •• Assurance of investment security. It is reasonable to set partial goals as it often facilitates awareness and implementation of the central objective in the management process. Finance management cannot be viewed as consisting solely in searching for and choice of enterprise financing under existing market conditions. It is also a factor of improving competitiveness of an enterprise [Berley, Westhead 1990, pp. 535-557]. Functions of finance management or, more accurately, of a team responsible for financial decisions of an enterprise, can be more fully stated to comprise: •• Determination of costs and benefits expected from various forms of both long- and short-term allocations of enterprise financing; •• Allocation of resources and determination of its costs (choice of an investment); •• Choice of sources of financing and methods of execution; •• Estimation of revenue and of the associated risk of an enterprise. Basic functions of finance management [Głodek 2004, p. 122]: •• Management of asset levels and structure as appropriate to operational requirements and effectiveness criteria; •• Determination of investment lines and forms, evaluation and choice of investment projects to implement; •• Optimisation of capital structure considering costs of capital acquisition and alternative sources of financing (leasing);

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•• Estimation and evaluation of revenue and of the associated risk of an

enterprise;

•• Current analysis (evaluation) of an enterprise's asset and financial position

to assess feasibility of operations, investments and financing on assumptions providing the starting point for development decisions; •• Analysis of an enterprise's market standing and evaluation of impact of external conditions on investment and financial decisions; •• Formulating conclusions for profit distribution policies in consideration of strategic objectives. Finance management process employs detailed techniques to supply relevant information for purposes of business management. Accounting is a key instrument, recording transactions and helping to evaluate financial performance of an enterprise and its links to the outside world on the basis of figures. Management accounting is a qualitatively superior stage of providing appropriate information to the right people at the right time. Accounting and financial reporting play a significant role in decision-making [Trostel, Nichols 1982, pp. 47-62]. Finance management has a supporting function at every stage of business development. When an enterprise is organised, a future finance manager analyses profitability of planned investments and selects optimum sources of financing. At the stage of managing a developed and organised business, finance management will serve to [Machała 2011, p. 20]: •• In the field of operations: –– manage production, –– manage logistics. •• In the field of investments: –– analyse and select investment projects. •• In the field of finance: –– assure financing for operations, –– assure financing for investments. Finance management is present wherever decisions are made that affect financial standing of an enterprise, that is, a majority of day-to-day and strategic management decisions.

Chapter 1: Selected aspects of enterprise finance ...

1.2. Making of financial decisions in an enterprise

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One of the key factors affecting the success of an enterprise in the market is its sound financial management, which consists of a number of areas. High quality and detailed input information which creates the form of accepted decisions are the basis for successful management and decision-making [Marková et al. 2014, p. 123]. Management of enterprise finances requires knowledge appropriate to nature and scale of a business. In small enterprises, such functions may be carried out by owners or managers with possible assistance of specialist consultants in case of complicated decisions. Finances of larger enterprises, on the other hand, are managed by specialists headed by a board member referred to as a finance manager. A finance manager is responsible for correct and effective financial operations of a company, with key responsibilities including [Bień 2011, p. 19]: 1. Organisation and supervision of internal information flows - internal information enables control of financial operations, signals possible threats and irregularities requiring intervention and facilitates evaluation of an enterprise's financial standing; 2. Reporting to management on a company's financial position, its anticipated developments and consequences for continuing business; 3. Decisions to acquire external capital to minimise financial costs and maintain liquidity; 4. Contacts with external partners – creditors, debtors, tax authorities. Contemporary finance managers must be highly qualified and cannot rely on routine and experience in their decision-making. This relates to growing importance of finance management due to the following causes: •• Intensifying competition, •• Increasingly complex and costly technological solutions that require financing to be acquired, •• Rates of inflation, •• Unstable fiscal systems which directly affect financial results of an enterprise, •• Rising importance of the capital market, •• Expanding scale of enterprise operations. The main function of a finance manager is to obtain funding and control its spending so as to maximise corporate value. As part of this function, a range

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of goals are implemented which can be divided into five groups [Gajdka, Walińska 2000, pp. 24-25]: 1. Financial planning and forecasting. A manager must work with other board members to determine financial plans in order to realise concepts of future enterprise operations. 2. Planning and evaluation of investment effectiveness and acquisition of funding to implement investments. According to adopted plans, a manager is responsible for amassing adequate capitals to finance these plans. 3. Coordination and control A manager must work with other members of management as financial decisions s/he makes directly affect operations of the company. 4. Liquidity management. As part of short-term financial management, a manager monitors policies of customer crediting (accounts receivable), payments for supplies (accounts payable) and reasonable levels of inventories. 5. Activities in the financial markets, particularly in the capital market. A manager must know rules of operating in the financial markets, particularly in the capital market, the source of funding by means of share or bond issues as well as the place to invest disposable funds. A manager's financial decisions involve continuous choices from among available possibilities (alternatives) on application of specific criteria to facilitate a most satisfactory choice under the circumstances. Success or failure of an enterprise is largely dependent on their overall quality [Dean, Sharfman 1996, pp. 368-396]. In line with the approach prevailing in management theory, all decisions should be made so as to maximise benefit to enterprise owners [Brealey, Myers 1991, p. 3]. These decisions can be divided into day-to-day and strategic decisions.

Day-to-day decisions

Day-to-day decisions are made over a time frame of one year or shorter. They aim to maximise performance given the existing business profile and essentially constant capital resources of an enterprise. Day-to-day decisions generally concern recurrent issues and problems, e.g. refinancing and repayment of short-term crediting. Well-known procedures limiting the scale of risk and providing for optimum, tried and tested solutions can be taken advantage of to arrive at such decisions. Therefore, detailed day-to-day decisions (e.g. vindication of receivables, payment of due wages) are delegated to

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lower levels of management. A range of day-to-day decision, especially those requiring choice among variant solutions, should be reserved for a finance manager (e.g. short-term borrowing from banks, investment of temporarily disposable funds). Maximisation of corporate value is the overarching objective of shortterm (day-to-day) decisions. Whereas appropriate investment projects are selected by means of long-term decisions, short-term decisions focus on assuring operation of an enterprise. This means provision of adequate cash flows to service long-term debt, meeting of current liabilities and unexpected expenditure. In this connection, corporate value is maximised where return on equity exceeds its cost. Short-term decisions concern chiefly management of working capital [Berley, Westhead 1990, pp. 535-557]. Working capital finances working assets of an enterprise. Selection of sources of financing for working assets depends on an enterprise's working asset requirements and a strategy of their financing adopted by an enterprise. Working capital varies substantially over time. It is often defined as a capital which is instantly available to an enterprise. Adequate levels of net working capital help to avoid: •• High cost of obtaining capital to finance daily activities, •• Losses on necessarily quick sale of assets (even below their value) to acquire capital for day-to-day activities. Decisions concerning management of working capital are not made on the same grounds as long-term decisions. The main criteria determining the former are liquidity and profitability. Provision of financial liquidity to an enterprise requires maintenance of certain cash levels which not only give access to discounts offered by suppliers of procured goods or preserve good credit standing with banks and suppliers, but above all offer opportunities for flexible response to imminent loss of liquidity or for purchasing products at bargain prices [Sierpińska, Wędzki 2010, p. 222]. Cash conversion cycle is the most popular measure of cash flows and liquidity. It denotes the period from the time of cash outgoing to buy production factors (repayment of liabilities) till the time of cash incoming against accounts receivable. Diagnosis of liquidity requires a highly detailed analysis of the life cycle, in particular, its duration and dates of receivable collections and payment of liabilities. It becomes reasonable, therefore, to examine working capital levels and compare them to asset levels and sources of short-term financing affecting that capital.

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Return on invested capital is the most common measure of profitability used to make short-term decisions, indicating a percentage rate of profit to invested capital in a given period of time (usually a year). Return on equity is another indicator in use. They both should be maximised. Day-to-day decisions concerning management of working capital are intended to strike a balance between security (liquidity) and profitability of an enterprise. Four fundamental elements of working capital management can be distinguished: 1. Cash management – enough cash should be held to meet liabilities on time, though too much cash needs not to be held and should be invested, for instance, 2. Inventory management – stocks of inventories should provide for smooth production and for product requirements while minimising costs of ordering, shipment or storage, 3. Management of receivables – adjustment of an enterprise's crediting policies. Customers must be encouraged to buy, on the one hand, while impact of extended terms of payment should be minimised, on the other hand, 4. Management of short-term debt – a structure of short-term sources of financing (including credit facilities, merchant crediting, factoring) should be selected to minimise costs of debt servicing and safely assure liquidity.

Strategic decisions

Strategic decisions are investment decisions with long-term financial effects and often costly research. Such decisions commonly involve substantial costs and considerable risk of uncertainty of initial assumptions, e.g. concerning acceptance of new products by the market, which increases over time. For these reasons, strategic decisions are normally made at top levels of management, that is, by the management board, although finance managers should play a major role in preparation of such decisions and then in their implementation. Strategic decisions relate to capital investments [Bojorquez Zapata et al. 2014, p. 50] and are made in consideration of three basic conditions: •• Finance management is characterised by attempts at maximising enterprise value via investments in projects generating specific profits subject to specific risks, •• Projects must be properly financed, •• If such projects cannot be carried out, surplus cash should be repaid to shareholders as dividend.

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Strategic decisions involve choices enabling operation of an enterprise in the long term. Thus, long-term decisions comprise: 1. Investment decisions, 2. Decisions to finance projects, 3. Dividend decisions (policies). Investment decisions – relate to lines of development and serve to realise market strategies [Łukasik 2009, p. 14]. Managers are expected to assign an enterprise's resources to a range of investment projects. Each investment decision requires evaluation of the particular alternatives (projects), determination of investment scale, time of project implementation and anticipated associated cash flows. Investment decisions fall into certain parts: 1. Evaluation of investment projects – each project should be assessed using the method of discounted cash flows and a project providing maximum value ought to be selected. Methods of evaluating investment projects: a) Method of net present value (NPV ) – all future incoming cash with reference to the present value and reduced with the initial outlay, b) Internal rate of return (IRR) – a rate of discount at which the current value of incoming cash for a given investment project is equal to the initial outlay, c) Payback period (PP) – the time a business needs to receive enough incoming cash from an investment to recover the initial outlay, The above methods are isolated, that is, they answer the question whether realisation of a given investment project will generate incoming cash flows over and above spending on operation of an investment item and investment spending, whereas they do not take into account the effect of a given investment project on financial results of an enterprise as a whole [Perridon, Steiner 1986, p. 30]. 2. Flexibility assessment – a project can frequently offer a variety of possibilities for managers to choose from, which prevents a full evaluation by means of the NPV method – this is true of many research and development projects, inter alia. In case of complex projects with a variety of scenarios, two methods are commonly applied: a) Decision tree analysis (DTA) – a graphic tool supporting the decisionmaking process, used in quality management and known to the theory of decision-making. The decision tree algorithm is also employed in machine learning for purposes of knowledge acquisition from examples, b) Real options valuation (ROV)

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3. Evaluation of uncertainty – each project is liable to uncertainty, therefore, diverse scenarios of project realisation should be assessed. Manipulating an assumed value of a factor while others remain constant is a typical method. Forecasting of various NPV scenarios envisages variations of such factors as demand for a product, rates of interest, material prices and production costs. Three scenarios are commonly drafted: worst-case, probable, and best-case. Financing decisions – objectives of enterprise finance management can be attained given adequate financing. Sources of financing encompass capitals generated by an enterprise (equity) and external capital obtained from crediting, loans and stock issues (third-party capitals). Managers must consider two aspects of their project financing decisions: 1. An appropriate structure of capitals must be determined to maximise the total corporate value. Project financing from external sources gives rise to obligations which must be honoured regardless of the project's success or failure. Financing with equity is safer, though its cost is normally higher. Net profits belong to owners, therefore, profits of a project net of interest are payable to shareholders as consideration for their capital. As long as profitability of enterprise capital is greater than the rate of debt interest, financing with third-party capital is a worthwhile undertaking. An excessive share of third-party capitals in capital structure may become problematic as it may cause liquidity issues. Third-party capital: a) Produces financial leverage – additional profits, on repayment of thirdparty capital, improve profitability of an investment. However, interest on third-party capital increases any losses, b) Is a cheaper source of financing, c) Allows for effects of the tax shield by reducing of effective capital cost, though only if interest on third-party capital can be charged to cost of income. 2. A closest possible relation must be maintained between assets financed and their financing capitals in respect of both time of financing and appropriate cash flows This applies to dependencies associated with long-term financing – in the short run, assets are financed by means of appropriate working capital management. Dividend policies – dividend denotes payment of profits to shareholders or retention of the same for re-investment in a business. Payment of dividend is conditioned by a variety of factors, including: liquidity position and access to sources of financing, investment requirements

Chapter 1: Selected aspects of enterprise finance ...

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and potential, transactional costs, shareholder preferences as to current and future share income, capital owners' need to maintain control over a business, taxation of dividend and capital gains. Impact of the different factors has been examined both theoretically and empirically [Wrońska 2011, p. 260]. Taxation of payments to owners is a major factor affecting dividend policies. This is confirmed by fiscal theories. These assume investors require higher returns on shares in companies paying dividend; dividend income taxation requires higher dividend payments in order to gain the same rates of return [Miller, Scholes 1978, Miller 1986]. Dividend policy decisions may have either positive or adverse effect on share prices. This relates to two fundamental questions: •• What portion of profits should be paid at a specific time? •• Should a business maintain a steady, stable rate of dividend growth? Decisions concerning dividend policies must be made considering the fact that monies paid (or to be paid) into a company are in fact owned by shareholders. Therefore, management should not retain profits if they cannot be reinvested to produce returns expected by shareholders [Brigham 2005, p. 202]. The overall formula of optimum profit distribution should state profits ought to be reinvested if income from such reinvestment is greater than income from investing such profits out of a business [Głodek 2004, p. 139]. Day-to-day and strategic decisions are interrelated. It is only once they are harmonised that economic effects can be optimised, e.g. if a strategic investment is partly financed with a long-term loan, current decisions concerning cash outlays should provide for timely repayment of loan instalments including interest. Should realisation of strategic decisions be impeded, dayto-day decisions should help to eliminate or remedy the consequences [Bień 2000, p. 20].

Principles of decision-making

Financial decisions concern choice of sources of financing for day-to-day (operational) and development (investment) activities of an enterprise, that is, acquisition of capitals. They include: •• Decisions to raise additional equity, •• Decisions to take advantage of profits earned by a business, •• Decisions to take loans and credits, •• Decisions building the so-called optimum capital structure.

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Capital costs and degree of financial leverage are basic measures evaluating effectiveness of financial decisions. Effective finance management decisions are guided by the following principles: 1. 'Time is money' – value of money varies in time as earlier resources are of greater value since they can generate additional income from investment, cut risk and enhance purchasing power. 2. Behavioural principle – experience of other, successful enterprises should be taken into account in the decision-making process. Tried and tested solutions can be applied to one's own business. 3. Principle of choice – a greater choice of future actions and flexibility come at a price (e.g. option transactions, fees for early credit repayments, etc.). 4. Value of ideas – mediocre profits arise from ordinary ideas, exceptional profits come from implementation of new ideas subject to more-thanaverage risk. 5. Dependence 'risk – rate of return' – choices between risk and profit are made as part of financial decisions depending on individual investor preferences. Management should be aware of these preferences (tendencies to risk) as this will help to formulate optimum development plans. 6. Effective market – the capital market is assumed to be effective, which means its players have equal access to all essential information and respond promptly. 7. Principle of signalling – business is associated with a variety of information, variously received by market participants. Not all entities have identical access to information or exhibit the same tendencies or aversions to risk, etc, 8. Accrual of profits – calculations of effectiveness do not include all costs and benefits of a given project, considering only those offering growth. Accounting of costs should ignore those an investor has no control over, the so-called irrelevant or 'sunk' costs, constant and independent. In parallel, benefits generated regardless of whether a project has been accepted or rejected should not be taken into account where effectiveness is evaluated. 9. Principle of bipartite transactions - expectations of two parties to each financial transaction, buyer and seller, who must negotiate a price, should be remembered as a minimum. The parties commonly have diverse bargaining powers at their disposal and may evaluate financial decisions differently. 10. Principle of diversification – the foundation of an investment portfolio, where returns are to be maximised and risks minimised. Diversification is effected by appropriate combinations of stock with varying rates of return and risks.

Chapter 1: Selected aspects of enterprise finance ...

21

11. Principle of risk aversion - investors prefer undertakings with higher rates of return and lower risk. A balance of returns and risk depends on individual investor preferences. Given a known tendency to risk, specific financial decisions may be anticipated. 12. Principal of egoism – investors are motivated in their decisions by their particular financial interests, considering lost profits that could be earned as part of other projects (alternative costs). Lost profits are valued as the difference between actual and theoretical benefits. These costs are not accounted for in the books, yet they should be taken into consideration when financial decisions are made.

1.3. Internal conditions of financial decisions

Internal limitations (conditions) apply to a particular enterprise and must encompass, inter alia, its fixed and working assets, labour resources and staff qualifications. These limitations may be altered to some extent, e.g. by improving qualifications by means of additional training. It might also prove necessary to hire workers with better qualifications required by an enterprise. An enterprise can be provided with more fixed and working assets, for instance, to change the existing production technology. Modifications require difficult, economically viable financial decisions. Too little emphasis is placed in Poland on intellectual capital of an enterprise, which dramatically improves effectiveness of a production potential in place. This is corroborated by analyses conducted in developed countries of the West [Dębska, Ślusarczyk 2010, pp. 41-43]. Assets of an enterprise should enable its business activities. Therefore, owners (shareholders) bring adequate capitals as cash or material contributions. These may be supplemented with third-party funding, that is, bank or merchant (trade) crediting and loans taken directly in the financial or capital markets by issues of short-term stock or bonds. As a business develops, its capitals must grow by means of not only raising shares, loans or credits but also retaining all or part of net profits. An enterprise uses equity and third-party capital to finance purchases of necessary long-term assets (real estate, plant and machinery, means of transport, equipment, etc.), production materials and goods to be resold. These capitals also finance wages, third-party services, taxes, etc. As products and commodities are sold, accounts become receivable and profits ought to be earned. Cash collected from customers can be reused to finance another cycle of business operations.

22

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Synthetically outlined economic operations have their cash representations. As such, they can be reduced to a common value denominator in spite of their diversity. On the other hand, economic operations require money to be carried out – accumulated from different sources and expended on various goals. Management of enterprise finance has the strategic objective of maximising profit to owners and thus improving corporate value. The goodwill, most commonly considered by potential buyers, consists of three principal components : •• Current and future cash flows generated by an enterprise [Rinne, Wood, Hill 1986, pp. 44-50], •• Cost of capital financing the enterprise, •• Variability of current and future cash flows [Tarczyński, Mojsiewicz 2001, p. 145], likelihood of irregular repayment of liabilities and of the consequent bankruptcy [Smithson, Smith, Wilford 2000, p. 135]. Goodwill is to a large extent affected by anticipated profits, which should be realised with continuing operation and development of a business in mind [Sońta 2002, pp. 14-18]. For instance, higher costs of advertising and quality improvement in a given period may reduce current profits but are often inevitable to maintain existing and boost future sales, a pre-requisite for profits and continuing operation in future. There is a distinct need, therefore, of properly linking long-term and shortterm decisions as part of finance management in order to maximise profits in the long run. This maximisation should be reflected as adequate profitability of equity available to an enterprise. Business profitability may be represented as profits and their dynamics, margins of sales profits, relations of profits to value of assets and in other ways, however, the relationship of net profit to equity made available by owners should play a fundamental role in the financial strategy of an enterprise. It is only this presentation of business profitability which allows for evaluation of profitability of capitals invested in a business compared to other, variant investments. Returns on equity also largely determine value of owners' shares and current (market) goodwill, to a significant degree dependent on a business's capacity for profit generation. Relationships between profits and depreciation, that is, gradual inclusion of wear and tear of fixed assets among costs, plays a major part in determining a desirable profitability of equity. A quicker depreciation does cut profits in the short term yet also allows for early withdrawal of invested capital and its spending on other projects. Depreciation over a longer period improves prof-

Chapter 1: Selected aspects of enterprise finance ...

23

its as early as the initial stages but delays withdrawal of invested capital and triggers an earlier taxation of profits (this will be explained in detail below). Total surplus finance generated in a given period of time, including not only profit but also depreciation write-offs, frequently termed cash flow, is of paramount importance to effectiveness of capital invested in an enterprise [Harmgardt, Tiedtke 1992]. SURPLUS FINANCE = NET PROFIT + DEPRECIATION (cash flow) Depreciation write-offs are gradually charged as costs, yet they do not need to be balanced with equivalent cash outlays. They should be treated, together with net profits, as the starting point for calculation of return on invested capital, therefore. Investments in business activities are aimed at discounting possible future benefits. Scale of anticipated benefits is usually connected to risk of a given undertaking [Bień 2011, p. 17]. Risk means the actual financial benefits from a given project may prove lower than expected or even give rise to losses. A dependence is common: the greater the anticipated profits on committed capital, the higher the risk or uncertainty of expected benefits. And vice versa – if anticipated benefits are more likely to come true, and thus the risk is lower, one must remain satisfied with lower benefits as they are associated with a lower 'cost of risk'. Unspecified shifts of future external conditions of a business (see below) as well as imperfect management (e.g. neglect of state-of-the-art management techniques, wrong HR or purchasing policies) are sources of the risk. Business and financial risks can be distinguished [Szczepański, Szyszko 1998, p. 29]: •• Business risk involves, for instance, declining sales, heavier competition, poorer than expected performance or unexpected losses, assuming all assets are financed only with equity. •• Financial risk arises where part of assets is funded with third-party capitals and a company is dependent on its creditors. The risk of losing liquidity, i.e. ability of timely repayment of liabilities, is a particularly clear and dangerous case of financial risk. Scale of financial risk rises as debts mount. Reasonable use of third-party capitals, on the other hand, fosters profitability of equity and compels taking of financial risk. A contradiction arises, therefore, between attempts at

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Financial tools in management of small ...

maximising profits on equity and threat to continuing business operations in effect of excessive debt. The risk of losing liquidity results from dissociated due dates of incoming cash and accounts payable to creditors. This risk also denotes inability to secure loans or crediting and is not always present in the case of losses. It may also affect enterprises generating even high profits if the equilibrium of incoming cash and necessary outlays is disturbed (e.g. due to excessive commitment to new investments without securing sources of their financing) [Ostaszewski 2002, p. 53]. The drive for maximising profits should therefore be accompanied with an awareness of the associated financial risk and determination of profit realisation limits by decision-makers. It must be feasible to incur risks without causing bankruptcy of a business. Depending on a degree of risk an enterprise is prepared to incur, greater or lower benefits can be expected with a greater or lesser degree of certainty. Harmonised day-to-day and strategic decisions provide for optimum economic effects. For example, if a strategic decision involves an investment to be partly financed with a long-term loan, current decisions regarding cash spending must ensure timely payment of the loan and its interest. Also, if realisation of strategic decisions encounters obstacles, day-to-day decisions should help eliminate or remedy adverse effects of such obstacles.

1.4. External conditions of decision-making

Accuracy of financial decisions depends on a range of internal conditions (like staff qualifications) over which an enterprise has some control, as well as external conditions associated with business activities, over which an enterprise not only has no control but should adjust to. A finance manager (owner), especially when making strategic decisions, should not ignore external conditions that will accompany a business in future. Ignorance of macroeconomic conditions which can interfere with operation and development of a company is unacceptable as well. Both presence and any major shift of such external conditions require sufficiently early correction to financial policies of an enterprise. Absence of management response to occurrence or changes of external conditions or delayed adaptive behaviour may lead to decline of potential profits, losses and occasionally severe risk of insolvency. Not only an adequate knowledge of the present but also accurate forecasting of future conditions are necessary, therefore.

25

Chapter 1: Selected aspects of enterprise finance ...

External conditions of financial decisions

Economic situation

Inflation

State fiscal policies

Monetary policies

Exchange rate policies

Fig. 1.2. External conditions of an enterprise's financial decisions Source: The authors’ own compilation on the basis of: [Bień 2011, p. 22].

Economic situation

Situation of capitalist economies is subject to cyclical fluctuations, with irregular duration of cycles and severity of the fluctuations. A cycle consists of an economic boom and flourishing, followed by symptoms of decline, crisis and sometimes prolonged depression which must be overcome in order to introduce another period of prosperity. Causes of instability of the contemporary financial system have been analysed by H. Minsky [Minsky 2008]. Several can be determined [Bąk 2014, p. 50]: •• Changes in the financing structure of enterprises and households leading to significant exposure of businesses and individuals to the risk associated with the financial market and producing substantial dependence of the financial standing of firms and private investors on current circumstances in the financial markets. •• Changes in the structure of corporate liabilities: repayment of long-term financing is replaced with short-term financing. •• Dependence of liabilities repayment on the ability to refinance with funds from new crediting. •• Dynamic development of financial engineering. •• Restricted legislative impact of state institutions on economic processes including financial market mechanisms and attitudes of market players. •• Growing tendency to risk among financial institutions, chiefly banks. At times of prosperity, most businesses can expect substantial boost of sales revenue and profits. This justifies and even requires more expansive financial policies, including bolder use of working and investment crediting. Conditions become more conducive to increasing equity with external funding (e.g. by way of new share issues in the capital market or increasing hold-

26

Financial tools in management of small ...

ings in a limited company). Capital owners (investors) are tempted by profits higher than interest on bank deposits or loan securities (e.g. bonds) at times of economic booms. This is accompanied by lower financial risks and far fewer bankruptcies while enterprises find it easier to overcome their financial difficulties [Bień 2011, p. 24]. More prudent financial policies in view of possible declines of profit and revenue are called for at the peak of economic growth if signs of a bust are expected or already apparent. Development investments need to be postponed until better times and steps must be taken to avoid freezing of cash in excess stocks of goods and products. Solvency of customers buying at delayed terms of payment, that is, taking advantage of merchant crediting, should be verified more cautiously for fear of bankruptcy of even normally reliable payers. Short-term crediting should be resorted to more carefully if refinancing is not sufficiently assured. Economic fluctuations have varying impact on diverse industries. It is less severe on businesses selling everyday commodities (e.g. basic food) and more pronounced on manufacturers and sellers of durable and investment goods, e.g. machine, electronic or motoring industries, particularly as compensatory demand is intensely limited at times of crisis [Ślusarczyk 2014, pp. 189-192]. To limit the possible risks of subsequent slumps of economic cycles, a longterm financial strategy should provide for financial liquidity, that is, the ability to meet liabilities on time in periods of both boom and bust. This primarily applies to financial planning which should anticipate scenarios of a continuing current cycle as well as its shifts for better or worse [Bień 2011, p. 26].

Inflation

Inflation denotes growth of the overall price level over a specific period of time [Mankiw, Taylor 2009, p. 215]. It is difficult to explain its causes in a given country as it is triggered by a variety of developments. Economic and other than economic causes can be distinguished, the latter connected to behaviour of businesses in the event of inflation and their expectations as to its further course. Inflation may generate significant profits to an enterprise, though basically on paper as assets shrink and resources accumulated against depreciation may not be sufficient to purchase new machinery in future. The time gap between payment and receipt of a performance may also adversely affect a given enterprise as it transfers income between enterprises. At a time of inflation, each

Chapter 1: Selected aspects of enterprise finance ...

27

delay in payment brings benefits to those who do not pay and losses to those expecting payments [Marciniak 2001, p. 415]. Inflation causes purchasing power of money to fall. A high inflation increases nominal interest on loans and credits, threatens depreciation of real value of equity, accounts receivable and monies of a business. Financial policies and their realisation in a way that would prevent decline of real goodwill and value of capitals while providing for a real growth of profits and financial surplus in spite of the reducing purchasing power of money are of paramount importance. A temporary demand for products of an enterprise may arise at a time of high inflation, caused by customers escaping from depreciating money, especially if interest on bank deposits fails to compensate for declining purchasing power of cash resources. Management of enterprise finance becomes far more complicated at times of stagnation, where signs of recession or crisis go hand in hand with high inflation. Recipients of considerable bank crediting risk forfeiting their liquidity in the circumstances. The risk transfers to other partners, leading to insolvency. Adequate financial decisions in the case of high inflation are conditional upon sufficiently reliable forecasts of future price changes, during the next dozen months as a minimum.

State fiscal policies

State fiscal policies are normally understood as the process of managing public expenditure and taxation to alleviate economic fluctuations and maintain growth trends in an economy of high employment, free from high and variable inflation [Samuelson, Nordhaus 2012, p. 279]. They have an overwhelming effect on financial standing of an enterprise, mainly by means of a tax system that absorbs the bulk of an enterprise's revenue as a rule. Knowledge of a tax system and trends of its change is therefore of great importance to making of financial decisions. This applies in particular to indirect taxes, such as the value added tax or excise duty, which considerably reduce net sales revenue, and income tax, determining net profit levels. Consequences of extension or hikes of indirect taxes on sales cannot always be compensated with adequate increases of prices paid by customers. A kind of pricing barrier is commonly present which, once exceeded, causes a falling demand for certain products, decreasing sales revenue and profit as a result. On the other hand, exemption of some products from indirect taxa-

28

Financial tools in management of small ...

tion or reducing rates of the same occasionally does not require corresponding price reductions, thus potentially improving profits [Bień 2011, p. 27] Changes of income tax rates also immediately affect profits disposable on meeting of fiscal liabilities. Therefore, decisions to lower these rates are welcome by businesses as they are expected to drive development trends of enterprises. Falling tax receipts are frequently balanced by rising burdens of indirect taxation, though. This may cut net profits in spite of income tax decreases if rising indirect taxes cannot be fully compensated with price increases. Instability of a tax system gives rise to a specific economic risk, since it restricts possibilities of appropriate financial decisions, particularly long-term decisions. Awareness of government and parliament plans and intentions in respect of the tax system is highly important as it allows for early preparations. Custom duties, particularly on imported products, are a weighty fiscal burden. A significant source of budget revenue, they are also an instrument of foreign trade management considering trading balance and protection of domestic manufacturers from foreign competitors. Ranges of products subject to customs duties, as well as the great variation and shifts of their rates are all reflected in pricing of imported goods and products. A reduction of customs duties, boosting competitiveness of foreign products, forces domestic manufacturers to cut their prices and suffer falling profits or discontinue manufacturing of unprofitable products. Raising duties, on the other hand, offers profit opportunities to domestic manufacturers while hiking costs of companies using imported products and commodities. Awareness of state budget assumptions, especially with regard to balance of revenue and spending, is of great importance. Tax increases are imminent in case of high budget deficits. Escalating demand of State Treasury for money is expressed in issues of bonds and bills at attractive rates of interest. This restricts money supply for other uses and thus the possibility of securing loans and credits. It also commonly raises general interest rates and thus financial costs of an enterprise. It should be noted that state budget spending triggers substantial demand in diverse areas of consumption. Its growth above inflation raises demand for goods and services purchased by the state budget (e.g. construction and refurbishing of schools, hospitals, administrative buildings). Restriction of state outlays, on the other hand, spells declining sales revenue for enterprises servicing the public sphere. The danger of insolvency is singular if public bodies are unable to pay their contractors and providers on time due to finance restrictions. In effect, businesses are in default towards their trade partners,

Chapter 1: Selected aspects of enterprise finance ...

29

including tax authorities which charge high default interest. Realistic evaluation of public sector customers' solvency cannot be neglected and, if in doubt, deliveries should be subject to additional guarantees or advance payments. The foregoing analysis implies taxation is a special element of state economic policies. The state can use it to influence operations and financial results of enterprises. Some taxes, e.g. VAT, are not connected to solvency of businesses and thereby impede the tendency to take business risks. Financial result is a measure of an enterprise's assessment. It summarily represents effects and costs of operations. Restrictive fiscal policies of a state reduce global demand, which adversely affects GNP and hampers economic growth [Nyk 2011, p. 117].

Monetary policies

States pursue monetary and rate of exchange policies. Monetary policies involve application of money supply as an instrument of general economic policy [Friedman 1969, p. 277]. A central (issuing) bank is the institution whereby the state realises these policies. Monetary policies of the central bank consist in management of money supply. They have some impact on both such monetary magnitudes as interest rates and rates of exchange and real magnitudes: gross national product, investments and consumption [Dmowski et al. 2008, p. 76]. Monetary policies commonly attempt combinations of contradictory objectives. Trying to overcome a recession, the central bank takes actions to provide more access to and cut pricing of credit money. Interest rates determine pricing of basic banking products, which substantially affects levels of enterprise investments. A central bank leading expansive policies reduces underlying rates of interest. Cheaper access to the central bank's funds improves liquidity of commercial banks and cuts interbank rates. As a result, more corporate crediting is supplied at lower rates of interest, interest in crediting increases given the falling costs of financing, and finally investments grow. These actions may boost inflation, though, and the central bank will introduce restrictive policies, i.e. raise the underlying rates of interest to contain and reduce the inflation. High interest rates discourage corporate investment, lift the cost of money and enforce use of own funds (investment out of retained profit). Given the high rates of interest, own funds have high return requirements, which means enterprises invest in highly profitable undertakings.

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Financial tools in management of small ...

When taking bank credits, a finance manager must consider the risk of rising interest rates and mounting difficulties of securing new credits in the place of those already repaid (that is, problems with refinancing) [Bień 2011, p. 30].

Exchange rate policies

Specialist literature offers a number of definitions of exchange rate policies. They commonly mean evolution of an exchange rate and its use by monetary authorities of a given state to attain certain economic goals [Dmowski et al. 2008, p. 87]. Rate of exchange is the proportion at which a quantity of a given currency is exchanged for a unit of another currency. This is the price of legal tender of one country expressed in the money of another. Rate of exchange is one of the essential prices in the global economy [Bartov, Bodnar 1994, p. 1758]. The currency market is determined by demand for and supply of foreign currencies. It has the following functions in the market economy [Misztal 2004, p. 17]: •• It enables a comparison between domestic prices of goods, services and financial instruments and prices in other countries, •• It ensures international comparability of prices, •• It contributes to development of foreign trade, •• Rates of exchange set by the currency market are key prices in each open market economy, •• It allows for transfer of purchasing power between countries, •• It links a domestic and the international financial markets, •• It is one of the most important tools for governments to implement economic policy goals. Rate of exchange is a strategic price as it influences prices of imported raw materials, components and products, determining the price structure across the entire economy. It also decides economic effectiveness of export and import transactions. In the contemporary economy, the state normally pursues active exchange rate policies as part of both fixed and managed floating exchange rate systems. The former involves occasional nominal devaluation or revaluation of a domestic currency or a systematic, gradual change of the parity rate of interest. The real exchange rate may vary even if the central rate remains steady or fixed. This is the case of different rates of inflation or deflation between

Chapter 1: Selected aspects of enterprise finance ...

31

countries whose currencies are compared. State of economy impacts the real exchange rate in stabilised economies with systems of pure floating rates of exchange. A domestic currency appreciates in real terms at times of high growth dynamics. This is due to rising inflation domestically and growing interest rates which attract capital. Real-term depreciation is typical for stages of decline [Chadha, Prasad 1997, p. 333]. Variations of real-terms exchange rates, regardless of their determining factors, have significant impact on structure and dynamics of trade turnover. Values of exports and imports are assumed to depend on real rather than nominal rates of exchange [Hermann 1996, p. 473]. Exchange rate policies have considerable effect on enterprises which carry out export and import operations. A currency rising in relation to another is a boost to a domestic importer and a loss to an exporter, a weakening national currency has the opposite consequences.

1.5. Nature and significance of capital in an enterprise

Capital is an ambiguous notion, variously defined and interpreted in the particular fields (disciplines) of economics, i.e. economics of finance, accounting, etc. Generally, capital is defined as accumulated wealth serving to develop production and monies required for production. Capital is an economic category denoting a value capable of growth. The difference in value arising from the growth is referred to as added value, profit or interest. Capital is a desirable good as its possession allows for activities that (if reasonable) raise its value (it is increased) or fulfil a function that provides returns on committed wealth (capital). If it is used inappropriately, though, it will be lost [Lichtarski 2007, p. 163]. Specialist literature proposes a variety of capital definitions. Capital is most often described as: •• Wealth previously amassed by an enterprise in order to continue production, •• All sources of financing for property (assets) of an enterprise, •• Resources serving to multiply economic values and coming in three forms: monies, means of production and intellectual resources, •• All internal, external, tangible, intangible, own, third-party, term and nonterm resources committed to an enterprise. Capital is a factor of shifting composition, liquidity, sources, etc. The range of capital definitions is a function of the variety of its applications. Some of

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Financial tools in management of small ...

these definitions help to clarify mechanisms affecting economic processes, others to estimate e.g. goodwill or dividend, still others are employed in business practice, in the nomenclature common in financial documents such as the balance sheet or profit and loss account. Structural changes of the economic system, the changing environment and economic expansion in recent years have contributed to a dynamic rise of small and medium-sized enterprises. As they grew, they showed higher requirements for external funds which facilitate operation of any enterprise. They enable business owners to meet day-to-day and investment financial needs as part of the business. In effect, enterprises tend to take increasing advantage of external capital, ultimately cheaper than owner capital. Businesses are ready to accept credit risk in return for future benefits. Table 1.1. Sources of enterprise financing Sources of financing External Owner

Third-party

Initial capital

Long-term Investment Reserve capital crediting

Short-term Bank crediting

Share issue

Loan

Loan

Public aid

Leasing

Issue of debt securities

Bond issue Securitisation Venture capital Factoring Securitisation Trade credit Buyer credit Source: [Dębski 2005, p. 386].

Internal

Property transformations Regular receipts Depreciation fund Sales of redundant assets Faster turnover of working assets

Capital transformations Retained profit

Dedicated funds Reserves

Enterprises use capital from a variety of sources. From the viewpoint of capital's origin, internal and external financing can be distinguished. Internal financing occurs in a functional organisation and is also called self-financing. External financing, on the other hand, denotes influx of funds from outside a company. It is primarily employed as part of development processes when substantial capitals are required.

Chapter 1: Selected aspects of enterprise finance ...

33

Division of capital according to the criterion of ownership

Diverse criteria are applied to characterise capital of an enterprise, yet the division into equity and external capital, based on the criterion of ownership, is the most widespread. The former is owner capital and the latter is capital of enterprise creditors [Łuczka 2001, p. 38].

Equity in an enterprise

As an enterprise is founded, its owners contribute the initial capital, the primary source of asset financing [Bojar, Żminda 2007, p. 91], the startingpoint for creation of the enterprise's equity. Equity can be defined as the difference between the sum total of assets held by an enterprise and external capital used. Equity is available to a company in perpetuity. This means that shareholders, or owners, can only be refunded once their capitals have been liquidated. This permanent provision of capital gives rise to ownership, which generates the right to sharing in possible profits or occasional covering of losses on operations of an enterprise. This capital is of huge importance to an enterprise: •• It is a stable source of enterprise financing, •• It improves financial liquidity of an enterprise, •• It is a sure-fire guarantee for creditors. Equity is rarely payable, long-term liabilities of an enterprise to its owners [Gmytrasiewicz, Karmańska 2011, p. 52]. It is a valuable equivalent of assets owned by an enterprise [Sawicki 2001, p. 277]. Equity can be contributed as external payments, its acquisition depends on legal and organisational status of an enterprise. It should provide for adequate financial liquidity and constitute a pledge of an enterprise to its potential creditors. Equity can be divided into: •• Entrusted capital, that is, capital contributions of owners brought as shares, share subscriptions, and the like, •• Generated or self-financed capital, profits available for an enterprise to incur future risk and improve overall financial standing. Entrusted capital is perpetual yet its value may fluctuate by new share issues or acceptance of new business partners. The capital can only be repaid when a company is liquidated. Entrusted funds represent financial and/or material contributions of owners, co-owners or shareholders in a company. They are virtually permanently associated with a business entity. They are long-term but their value may vary as a result of different factors, e.g. a new

34

Financial tools in management of small ...

share issue, acceptance of new business partners, acquisition of additional fixed or working assets, etc. Profit, depreciation and transformations of assets and capitals are among the internal sources of equity. Generated net profit is the source of self-financing [Spišáková 2009, p. 53]. An enterprise uses its part to finance its property. Scale of the self-financing is determined by profitability of an enterprise and its profit redistribution policies [Ostaszewski 2001, p. 56]. Enterprises write off depreciation of their own fixed assets or fixed assets in paid use provided the assets are part of their user's property [Suhányiová 2009, p. 192]. Depreciation write-offs are business costs and thus reduce taxable income [Farys 2002, pp. 101-102]. Depreciation write-offs make up a depreciation fund, an internal source of financing for investments to reproduce assets of an enterprise. The write-offs are deducted in the entire term of depreciation at a fixed (straight-line) or declining-balance rate. The declining-balance method is accelerated depreciation where the write-offs are higher initially and decline over time. Tax liabilities can thus be spread over time so as to improve financial liquidity of an enterprise. Greater depreciation write-offs reduce taxable income and the resultant tax payments. Equity may be changed by decisions of enterprise owners, for instance, to make surcharges, to reduce the capital or to retain profits. Increasing of equity improves financial liquidity of an enterprise. (Cash and other) contributions constitute capital in private partnerships. The capital can be raised with retained profits, acceptance of new partners or by increasing of partner contributions. Capital of limited partnerships can be raised with retained profits, by increasing the number of limited partners or issue of securities. In companies limited by shares, on the other hand, capital comes from contributions of partners and of shareholders. Capitals can be increased by retaining profits, raising partner contributions or share issues. Capital of limited liability companies can be raised by additional contributions (surcharges), profit retention, new shareholdings or share issues. Capital in joint-stock companies is raised through share issue or capitalisation of reserves (payment for the higher capital with reserve funds of a company).

External capital in an enterprise

Capital requirements of an enterprise are a function of its day-to-day operations and realisation of planned investment projects. Capital determines potential of a business and makes for its effectiveness.

Chapter 1: Selected aspects of enterprise finance ...

35

Capital can be classified according to ownership criteria, distinguishing owner and third-party capitals. Thus, capital is own and external resources needed to boost value and generate profits of an enterprise [Wójcicki 2001, pp. 98-99]. Equity is frequently insufficient to finance activities, especially at the stage of enterprise development. Financial requirements of planned investments are greater than equity obtained by a business. Therefore, external capital is of paramount importance in financing of an enterprise [Sieradzka, WolakTuzimek 2012]. It is available for a specific period of time and must be repaid by an appropriate, prearranged date. Taking advantage of external capital involves certain costs which have been agreed on before and cannot often be assigned to any purpose, but only to goals negotiated with a creditor, which diversifies the risk of failure [Matejun, Szymańska 2012, p. 210]. Suppliers of funds expect consideration in the form of interest, commissions, instalments, and the like. This means constant expenditure of an enterprise which may hamper its cash flows and pose a risk to its liquidity. Financial liquidity is the ability of an organisation to pay on time its current liabilities associated with its operations. Repayments are secured with enterprise assets and financed with its equity. Failure to pay on time or at all causes a range of adverse consequences, for example, bankruptcy of an enterprise. Additional costs may arise at moments of financial difficulties which considerably reduce goodwill of a business. Businesses with sufficient financial liquidity and credit rating have no major problems obtaining external capital financing. Cost is the fundamental criterion of selecting external capital as the source of financing. This is a rate of return expected by a business as dependent on a risk incurred. This is most often perceived in the context of planned investments, with particular attention paid to the question of whether it will bring sufficient benefits to compensate for costs of the financing. External capital helps to realise investments that would normally be out of the financial reach of an enterprise. It reduces tax liabilities by lowering taxable income. The cost of external capital is lower than that of equity not only because of interest but primarily owing to the risk which is more restricted in the case of investing creditors than of the owners. Therefore, the former expect lower risk premium and return on investment into external capital of an enterprise than its owners [Duliniec 2011, p. 83].

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Financial tools in management of small ...

An enterprise deciding to contract interest-bearing liabilities experiences effects of financial leverage. This entails a faster rate of growth of profit on capitals of a business owing to considerable commitment of external capitals. This effect is explained by the moment external capital boosts profitability of equity in specific circumstances. If the cost of external capital is lower than of equity, the positive leverage effect obtains and will obtain until a permanent growth in share of external capital in financing of an enterprise will improve profitability of equity. When the trend reverses, using external sources of capital will decrease economic effectiveness of the enterprise. Obtaining, administration and application of capital properly requires knowledge of and respect for its basic characteristics and functions, which will not disturb the financial balance [Łuczka 2001, p. 38]. External capital entails certain rights, obligations and risks. It cannot be assigned to financing of any purposes chosen by an enterprise, only those agreed upon with a capital provider. This necessitates allowing a creditor the right to monitor the enterprise, that is, inspect its documentation and assess its current and future financial capabilities. This helps to establish the business situation and the extent of risk associated with financing of an enterprise, as well as terms and conditions on which the capital provider is willing to supply its capital. Characteristically, the price of external capital rises as debts of an enterprise mount. This increases the risk, since the higher a debt ratio of an enterprise, the greater the business risk, which directly affects costs of capital. An excessive share of external capital in financing of an enterprise may give a creditor certain entitlements towards the enterprise. In extreme cases, this can lead to a creditor appointing third parties to manage or monitor an enterprise. In case of liquidation or bankruptcy of an enterprise, claims of capital providers are first to be satisfied, before owner claims. External capital fulfils a range of functions. They are important, although more limited than those of equity. It guarantees repayment of an enterprise's liabilities to creditors after equity has been consumed, and sets limits of business activities of an enterprise (the so-called working function). With regard to the first function (of a guarantee), external capital is taken advantage of only if equity of an enterprise has been wholly consumed to repay debts. This principle of a hierarchy of responsibility for financial losses sets a clear boundary between external and owner capitals [Łuczka 2001, p. 50]. The second function defines the extent of business operations of an enterprise. This refers to projects which can be pursued by an enterprise and

Chapter 1: Selected aspects of enterprise finance ...

37

defines their scope by providing specific quantities of means of production and rights needed to initiate certain processes. Knowledge of functions and characteristics of external capital is a condition for an enterprise to reach goals of its financial policies. The moment equity is not sufficient to deliver basic objectives of an enterprise, its functions are taken by external capital. The latter improves profitability of an enterprise's financial administration. Decisions to increase the share of debt in capitals of an enterprise (e.g. issue of debt securities or taking of credit) are normally treated as a good signal by capital market investors and share prices of such quoted companies tend to rise. External investors see more debt as anticipating stable future cash flows at levels which will service debts without jeopardising financial liquidity [Duliniec 2011, p. 83]. There is a whole gamut of external capital classifications. In general, external third-party sources of financing are categorised according to their duration. Therefore, external capitals can be divided into long- and short-term. Table 1.2. Sources of external capitals in an enterprise External capitals Long-term capitals Short-term capitals Long-term bank credits Short-term bank credits Credit guarantees Renewable liabilities Leasing Supplier credits Franchising Buyer credits Aid resources Factoring Bonds Non-banking loans Non-banking loans Short-term securities Source: The authors’ own compilation.

An appropriate analysis of all criteria helps to determine which source of external capital is best from the viewpoint of an enterprise's development. A phase in the life-cycle of an enterprise is a factor restricting the choice of sources and types of capital. Availability of various sources of financing depends on phases of a cycle which an enterprise is undergoing. In the phase of foundation and initial growth, equity from non-public market or internal sources is the key source of financing. The range of available types and sources

38

Financial tools in management of small ...

expands at the stages of growth and maturity to include external capitals, which play an important role in an enterprise. Optimisation of the capital structure requires decisions concerning the types of capital needed by an enterprise. External capital is then needed to provide for adequate liquidity, both short and long-term.

1.6. Principal sources of external capital

Selection of a source of financing for a business depends on a number of factors. Firms commonly elect to finance operations with their own capital, though not every enterprise has this option [Vaceková, Svidroňová 2014, pp. 120-130]. As own funding for modernisation or day-to-day requirements is not available, a firm decides to secure capital from external sources. Crediting is the most frequently selected form of such financing [Duda, WolakTuzimek 2014, p. 347].

Bank credit

Providing credit to businesses and private individuals is the core activity of all banks. Bank credit is specified and reserved to banks in banking laws, which means that other organisations or individuals cannot supply credit [Wolak-Tuzimek 2006, p. 110]. To this end, banks temporarily amass disposable funds from the population, enterprises and other institutions. The sum total of accumulated resources determines the sum of credits awarded. A credit is obtained for a definite term after which it must be repaid. The term is expressed in days, or months and years in the case of longer agreements. Bank credit is an economic relation where one party makes available to another party specified monies or goods, whose equivalent and a possible consideration must be repaid by a fixed date. Credit is provided by banks at a specific interest, which is its price and the starting point for calculating bank revenue. Bank revenue from credits awarded is the credit interest dependent on the amount of credit, its term and rate of interest. Interest is paid by a borrower, to whom it is a cost. Interest constitutes the principal revenue of banks [Doll et al. 2002, p. 89]. Bank is the most common source of financing for most enterprises. It is a lawfully incorporated entity licensed to carry out banking operations which impose a risk on funds entrusted under any title of repayment.

Chapter 1: Selected aspects of enterprise finance ...

39

Business legislation forces an enterprise to have a current bank account. This, as well as the nature of banking activities, gives rise to most of the banking services. The privileged status of banks in contacts with enterprises diminishes the role of other sources of financing, often available to few organisations that meet a variety of criteria. Beside financing investments, banks are basic mechanisms of business operation (current account) and investments (e.g. term deposits). The word 'credit' comes from the Latin 'credere', to believe or trust. As part of a credit operation, a bank makes certain monies available to a borrower, bound to repay them, plus interest, by an agreed-upon date. General principles of crediting are set out in banking laws, with detailed procedures laid down in crediting by-laws [Bogacka-Kisiel 2000, p. 32]. Credit is supply of capital (mostly money) by a creditor (lender) to a debtor (borrower) on specified terms. Receiving a credit means emergence of a liability for a debtor. The debtor must normally pay interest in return for the credit. There are two basic forms of credit: trade and bank credit. Current account credit is usually short-term and awarded without banking commissions or guarantors. Interest is normally deducted from the account by the bank. Credit is an unusual commodity, sold by a bank to a customer on specific terms. Each commodity, including credit, has its price. The price of credit comprises interest (fixed or variable), commissions (initial handling, commitment) or other costs (e.g. early repayment commission, charges for establishment of guarantees, insurance premium). Credit is a key product of each bank; it exerts considerable influence on development of production and consumption in present-day market economy. Investment and development processes cannot be implemented without appropriate capital, which can be obtained as credit. An appropriate application of credit to business activities can provide for material income [Wolak-Tuzimek 2005, p. 365]. Credit means an economic relation arising from one party providing specified goods or monies to another party on condition of repayment of their equivalent at a later date [Gigol 2000, p. 60]. As part of crediting, a specific sum of money is made available to a customer, guarantees or pledges are made on behalf of the customer to third parties, in return for which the customer agrees to repay a money loan or meet a liability including interest [Dobosiewicz 2010, p. 114]. Credit is most frequently awarded for purposes of enterprise development [Beka, Črskyá 2006, pp. 5-7].

40

Financial tools in management of small ...

Credit activities are one of the most central operations of a bank. Banks act as financial intermediaries in the mechanism of distributing surplus money across the economy, primarily via crediting. The crediting function prevails in bank activities, therefore the quality of credit portfolio has a decisive effect on profitability and security of a bank. Appropriate risk management of the overall credit commitment of a bank is of a fundamental importance to a bank's security and its adequate profitability. Unpaid credits remaining in bank portfolios, are the main reason for their financial difficulties and can lead to insolvency as a consequence [ Jaworski, Zawadzka 2011, p. 721]. Credits are important sources of financing for business activities in today's economy. In a stable market economy with an efficient system of assessing risk inherent in planned undertakings of a business, borrowers can rely on receiving about a half of the funds needed to realise their projects. Principal characteristics of credit include [Doll et al. 2002, p. 91]: •• Goal-orientation – a bank credit serves to finance a specific undertaking and the bank reserves the right to audit its utilisation. If a credit is used contrary to the credit agreement, the lender may terminate the agreement, •• Repayability – a borrower is bound to repay the amount of credit and interest by a date set down in a credit agreement. Any changes must be executed in writing. Default on any credit instalment causes the bank to charge a higher interest, •• Interest – bank's consideration for lending capital to a borrower, also the latter's cost (commissions, interest). A credit agreement should specify the rate of interest and its possible changes, specifying reasons for its increase or reduction, as well as methods of interest payment. Aside from the interest, banks charge credit commissions, •• Guarantee – associated with the risk arising when a credit is awarded. The banking law stipulates that, to ensure credit repayment, a bank may require guarantees provided for by civil and promissory note laws as well as in customary cooperation with foreign banks. This refers in particular to regulations concerning deposits, pledges and guarantees, as well as material title in real estate, called the mortgage, •• Timeline – a date of credit repayment fixed in a credit agreement. This is crucial for two reasons. A bank awards credits from its accumulated deposits and the correlation must be therefore observed between credit due dates and dates set for deposit holders. Untimely repayment of credit can complicate a bank's liquidity. It also triggers sanctions, namely, charging of a higher interest by the bank.

Chapter 1: Selected aspects of enterprise finance ...

41

Each credit offered by banks fulfils definite functions. Four basic functions of credit are distinguished [Pruchnicka-Grabias, A. Szelągowska 2006, p. 23]: •• Issue – money is introduced via the credit mechanism of money issue. This function is implemented by each bank credit as every credit award launches new money and each credit repayment withdraws money from the market, •• Stimulation – instruments of credit policies are employed to affect economic development and utilisation of production factors (land, labour and capital), •• Profit – material (financial and economic) benefits are derived from increased purchasing power of a business. The profit function of credit cannot supplement demand in a national economy, though, which arises from money savings of various business organisations. The distributive function of credit denotes its use to create additional demand for money, •• Restructuring – mainly consists in affecting structural and ownership transformations in an economy. Banks carry out a variety of credit operations suited to requirements of potential customers. Award, repayment or utilisation of credit are closely linked to credit types. The particular solutions may slightly differ across banks, as expressed in credit by-laws. Some credit groups are subject to dedicated bylaws or the so-called general terms and conditions of crediting in respect of specific operations, e.g. currency credits. Banks occasionally issue credit instructions to set procedures for staff to follow when assessing credit applications, for operation of credit commissions, negotiating conditions and applicable terms of agreements. A variety of credit divisions are used by the Polish banking system depending on criteria. It should be noted that the nomenclature in this area varies. The same type of credit may be named differently in diverse banks, which is legal and understandable. Banking supervision and Ministry of Finance have not regulated banking nomenclature as yet. The possibility of credit repayment often depends on a selected type [Dobosiewicz 2010, p. 270]. The following fundamental criteria can be applied to divisions of credits:

Period of crediting

Repayability by a definite date is a characteristic feature of credits, with dates of credit award and repayment negotiable and laid down in credit agreements. Polish banks adopt this criterion and their by-laws distinguish: •• Short-term credits, provided for up to 1 year,

42

Financial tools in management of small ...

•• Medium-term credits, to be repaid for between 1 year and 3 years, •• Long-term credits, to be repaid for above 3 years.

The time element, beside the amount and interest rate of a credit, determine the economic content of a crediting operation. Selection of a credit term is essential to a borrower, as the cost of credit is very high and each day adding to that cost counts. Rate of interest, rising dramatically over time, is another factor influencing selection of a crediting period. Waiting times for a credit are long, therefore an entrepreneur can never be confident about being awarded another credit and always faces the risk of remaining without funds. Regardless of estimated inflation, credit rate of interest always grows along with the term of crediting. Long-term credits are typically investment credits and short-term credits – operational credits [Wąsowski 2004, p. 74].

Forms of credit (methods of awarding)

Form of crediting is important from the viewpoint of operational techniques. Credits can be awarded [Sołoma 2013, pp. 107-128]: •• In the current account – a debt appears as overdraft balance in the borrower's current account. It results from their payment orders charged to that account. Funds incoming in the current account reduce the debt, on the other hand. This group can include open (blank credit – a bank authorises a borrower to trigger an overdraft balance in their account and agrees to honour payment documents where the bank is designated as the domicile (a party where the document is to be paid) even despite lack of funds in the borrower's account. Open credit is a short-term credit. Its amount, or a limit up to which a borrower can contract debts, is normally determined on the basis of current receipts and receipts in the account anticipated over the term of crediting. Open credit is a renewable or cash credit (taken due to temporary lack of cash). Cash credit is short-term and should be repaid over several days. It is in the borrower's interest for this credit to be awarded at a very short notice, almost instantly. This is only possible, however, if the borrower is a regular customer, i.e. has had a current account with the bank for a year as a minimum, is of solid financial standing known to the bank), •• In the credit account – it is awarded by means of a dedicated, 'credit' account, which serves to record utilisation and repayment of the credit. This may be a purpose-oriented credit (needed to finance a specific transaction. It is not renewable as a rule and repaid with receipts from a planned

Chapter 1: Selected aspects of enterprise finance ...

43

investment), a credit for due liabilities (normally short-term and not renewable. It helps to meet liabilities causing payment difficulties), seasonal (associated with a seasonal nature of requirements of some enterprises, e.g. seed purchases by farmers in spring. It is not renewable as a rule), line of credit (renewable). An enterprise can take advantage of a credit a number of times till a moment set out in the agreement. Term of the agreement is typically below a year and can be prolonged as another agreement without the need to repay the earlier crediting. This credit is convenient to enterprises yet awarded only to a limited group of customers of well-tested reliability). A discount credit involves deduction of discount interest in case of early repayments.

Object (purpose) of credit

Depending on their object (purpose), the following credits can be distinguished [Skowronek-Mielczarek 2007, p. 67]: •• Working – normally short-term, for day-to-day business requirements. These can be provided both in current and credit accounts, •• Investment – supplied for longer terms in order to finance expenditure to create or increase fixed asset resources. Investment credits are usually supplied via credit accounts, •• Export, •• Agricultural procurement – for farmers. Demand for investment, typically long-term crediting, rises when inflation is a single-digit quantity. The process of fixed asset recapitalisation certainly pushes demand for such crediting. Investments – in contradistinction to working asset requirements – are rarely financed with equity of businesses. Shares of investor's own assets reduce risk, on the other hand. Working and investment credits are corporate credits, that is, other than crediting for private individuals who use credits for household requirements [Wąsowski 2004, p. 75].

Methods of securing credit repayment

With regard to credit guarantees, the following credits can be listed:

•• Lombard, pledged against objects, securities, goods, etc., •• Mortgage, secured with mortgages established on real estate owned by

a borrower or another party, e.g. guarantor.

44

Financial tools in management of small ...

Business classification

Credits can be classified as per the simplified nomenclature of the European Business Classification EKD: •• Industrial, •• Commerce and servicing, •• Agriculture, •• Construction, then subdivided into sections. The industry comprises: mining and extraction, production, supply of electricity, gas, water. The role and quality of credits provided to businesses are analysed per sections. The Polish Business Classification (PKD) is also employed to categorise credits according to their sectoral structure.

Credit types:

•• Export credit – to finance exports, that is, export contracts for supply of

goods or services to domestic suppliers or credits issued to foreign buyers to finance export agreements. This also comprises crediting a domestic supplier to refinance its credit to a foreign customer. •• Operational credit – to finance regular business activities, namely, core transactions of a company, it helps to finance payments to suppliers at due dates, wages, routine costs, interest and capital instalments on term loans, i.e. any payments that must be effected in order to run a business. These credits chiefly finance inventories and accounts payable. •• Investment credits – to finance new or enhance the existing manufacturing capacities of a borrower as well as other associated joint investments, issued to finance undertakings intended to reproduce, modernise and multiply fixed assets. This financing produces fixed assets. Investment credits play a key role in building credit portfolio of any bank, these receipts have an essential economic function, therefore. Investment credits fund tangible fixed assets. They are mostly long-term credits, though there are credits awarded for several months (often to purchase new machinery). This type of crediting is highly varied and can be divided into three groups with regard to its purpose. Thus, there are credits to construct new plants, credits for investments boosting production capacities of existing plants and credits for associated investments, not undertaken with a view to direct financial benefits. Large, long-term credits are the most profitable, and at the same time the riskiest, to banks. After an initial high labour expenditure, a bank derives great, and less labour-consuming benefits from interest

Chapter 1: Selected aspects of enterprise finance ...

45

over many years. Supply of substantial credit guarantees high profits. This also entails considerable risk associated with difficult market situations and long-term position of an enterprise.

Leasing

Leasing is a contract whereby a financing party agrees, as part of its business, to purchase an item from a designated seller on terms laid down in a contract and to provide the same item to a user for use and deriving benefits for a fixed term, whereas the user agrees to pay the financing party a money consideration distributed over agreed-upon instalments which is at least equal to the price or consideration paid by the financing party for acquisition of the item. It can be said in general that leasing involves a lessor providing an object or a property right (e.g. machinery, equipment, means of transport, real estate, etc.) to a lessee who will use it in return for periodic payments. Leasing allows for use of fixed (or other tangible) assets without paying a full purchase price. It is therefore a peculiar type of crediting where an investor receives not funds but assets. Leasing can also be treated as a specific form of investment financing [Majková 2008, p. 40] where investment goods are used not by purchasing but by hiring them in return for lease payments. This means that, as part of this financing, a lessee is not an owner but a user. Its development is a consequence of certain contradictory trends in the market. On the one hand, technical progress forces manufacturers to constantly replace rapidly ageing equipment, which implies substantial investment expenditure, on the other hand, equipment manufacturers find it difficult to sell their products. In the circumstances, rental of manufactured equipment is beneficial to both parties [Piasecki 2001, p. 478]. By force of a leasing agreement, the financing party agrees, as part of its business, to purchase an item from a designated seller on terms laid down in the agreement and to provide the same item to a user for use or use and usufruct for a fixed term, whereas the user agrees to pay the financing party a money consideration distributed over agreed-upon instalments which is at least equal to the price or consideration paid by the financing party for acquisition of the item. Virtually any object or property right (e.g. cars, machinery, computer equipment, buildings, offices, rooms) may be leased.

46 •• •• •• •• ••

Financial tools in management of small ...

Leasing is characterised as follows [Ostaszewski 2000, pp. 162-163]: A lessee defines equipment and selects a supplier without relying only on a lessor's knowledge and opinion, A lessor acquires an item to be rented according to and in connection with an agreement about which a supplier knows that it has been or will be executed by the lessor and lessee, Depreciation of the entire or a substantial portion of a leased item must be taken into account when calculating lease fees, A leased item can only be used for business purposes, not for private, family or household needs, A lessee assumes the entire risk inherent in usage and possession of an item.

Types of leasing

Leasing is a highly flexible source of financing with regard to drafting terms and conditions of lease agreements. A broad range of its types and varieties are therefore distinguished in market practice. Nevertheless, two types of leasing are the most common [Wolak-Tuzimek et al. 2015, p. 169-176]: •• Operating lease, •• Finance lease. Finance lease involves provision of an investment good for use and possible usufruct for a specific term, normally close to its useful life, i.e. the period during which the good is very likely to be in good working order and useful to profitable business. In practice, this means that the user's payments in the term of the agreement will cover the lessor's entire cost and bring some profit [Skowronek-Mielczarek 2007, p. 77]. Another important characteristic of the finance lease is the fact that the user incurs the full risk associated with an item made available, pays for its maintenance, insurance, any taxes and other charges. User of a finance lease cannot withdraw from the agreement before its term unless an appropriate compensation is paid to a leasing company. Value of leased fixed items may vary enormously, which necessitates application of diverse methods and techniques of financing lease transactions. Financing for goods of a relatively low value can be provided by a leasing operator, whereas transactions involving high-value items (ships, complete production lines, aircraft, etc.) typically require refinancing. A refinancing entity, commonly a bank that supplies a monetary credit to the lessor to cover all or part of the purchase price of a leased item, becomes another party then,

47

Chapter 1: Selected aspects of enterprise finance ...

beside the lessor and lessee. The credit is normally secured with material rights to leased items (e.g. a pledge). The lessor also assigns a substantial part of accounts receivable under the lease agreement to the bank, which provides an additional collateral of the bank credit. Financial lease characterised above can be described as direct lease. Another variety, referred to as leaseback, is applied in practice. A lessor purchases a commodity from and proceeds to lease it back to a lessee as per a lease agreement. This type of lease transaction is in fact a special way of improving the lessee's financial liquidity. By selling certain material goods to a leasing operator and then entering into a lease agreement, the lessee generates a cash flow which can be assigned to other purposes while keeping the right to use the object of transaction [Gabrysz, Koślicki 2011, p 106]. Table 1.3. Principal differences between operating and finance lease Operating lease

Term of agreement is shorter than useful life of leased item

Finance lease

Term of agreement is close to the useful economic life of leased item

Cost of depreciation, maintenance and Cost of depreciation, maintenance and repairs of leased item is incurred by lessor repairs of leased item is incurred by lessee, or lessor for additional payment Lease payments, including the capital and The capital part of lease payment is paid interest portions, are fully added to the for with the lessee's net profit while the interest portion is charged to the lessee's lessee's operating cost operating cost Lease payments do not cover the full value Lease payments cover the full value of of a leased item a leased item A leased item is not the lessee's asset

A leased item is the lessee's asset

Early withdrawal from the agreement is possible

Early withdrawal from the agreement is subject to compensation payable to the lessor

VAT is charged on each lease payment

VAT is charged once, on the full value of a leased item

Source: [Skowronek-Mielczarek 2007, p. 83].

Current (or operating) lease is the other principal type, characterised by far shorter terms of agreements (normally below three years). It is thus a method of meeting manufacturers' temporarily greater demand for certain produc-

48

Financial tools in management of small ...

tion goods, as a result of e.g. seasonal nature of their production. The term of a lease agreement is nearly always shorter than technical and economic useful life of an item, therefore, lease payments cannot fully cover the purchase price, possible crediting and profits of a lease company. For the lease operator to fully recover its costs, it is therefore necessary to enter into another contract with the existing or another user, or to sell the commodity. A supplier of operating lease normally incurs the full cost of maintenance, repair and insurance of a leased item and pays applicable taxes. In practice, a lessee may withdraw from an agreement before its term. This is particularly important as it allows a user to discontinue using an item that becomes obsolete with technical progress or is underused as demand for its products declines. This feature of operating lease transfers nearly the entire risk of a leased item to the lessor.

Advantages and disadvantages of leasing

Leasing is a good form of business financing. It is more accessible than many other channels of capital. Operation of more than 800 lease companies in the EU countries and the steady growth in value of fixed assets acquired to be leased are proof of its benefits. The rapid development of this type of financing confirms that benefits of leasing considerably outweigh its shortcomings. Leasing fulfils a range of functions in economic practice which can be treated as its advantages [Skowronek-Mielczarek 2007, p. 81]: •• It is an instrument of financing for business investment requirements, •• It drives investment processes at a minimum initial commitment of own resources, •• It facilitates access to means of production in the absence of own capital resources, •• It helps to reduce the investment risk, accruing mostly to the owner of the means of production and, to a lesser extent, to their user, •• Leasing offers can be adapted to individual needs and requirements, with due regard to the user's business realities, •• It improves flexibility, innovation and competitiveness of a lessee, •• It allows for free determination and time distribution of lease payments in consideration of paying capabilities of a business, •• It provides capital at a constant interest, •• It does not increase the lessee's debt and thus does not prevent access to other forms of crediting,

49

Chapter 1: Selected aspects of enterprise finance ... •• It fosters financial liquidity of a business, •• It provides balance sheet and fiscal benefits to the lessee.

Table 1.4. Advantages of leasing to users and providers Advantages to users

Up to 100% of an investment value can be financed – a bulk of, or even a whole, of the user's investment can be financed from external sources Flexible financing of investments – terms and conditions of a transaction can be adapted to individual needs and preferences

Advantages to providers

An additional method of financing and crediting of investments – leasing broadens opportunities of traditional financial institutions and offers business to organisations only providing leases

Source of high profits – sometimes far higher than those earned on other crediting operations

Avoidance of initial investment expendi- Tax benefits – the financing party effects ture - the financing party, as owner of investment and depreciation write-offs a leased item, can resign from the user's advance towards lease payments, except when a user exhibits a low credit rating or is after greater tax benefits Expansion of credit opportunities - leasing does not exclude other forms of borrowing and increases the overall sum of crediting available to the user

Reduced overall cost of investment – the sum total of costs incurred by the user as part of a leasing transaction may occasionally prove lower than the purchase price of the same commodity Tax benefits – most accrue to the financing party, yet in some countries users are entitled to deduct lease payments from their taxable income

Access to state of the art technologies – responding to technical progress by replacement of rapidly obsolescing investment goods that are leased

Source: The authors’ own compilation.

Reduced risk - the financing party can recover a leased item if users default on their obligations

Involvement of a supplier in the transaction - the financing party must buy a leased item from a supplier as per the leasing agreement. They begin regular cooperation based on sharing of customers. This boosts turnover and profits of the financing party

50

Financial tools in management of small ...

Key drawbacks of leasing [Ickiewicz 2004, p. 178]: •• A certain ambiguity and conceptual vagueness of leasing can be a problem to both its parties, its different notions and diverse tax treatments across countries obstruct determination of economic and legal consequences of such an agreement, unclear tax legislation and its resultant random interpretations often lead to failures, •• Depending on the type of lease, the risk is incurred by one party, lessees are at a disadvantage here, particularly in the case of finance leasing, mostly, lessees must make lease payments even if a leased item has been lost or damaged, in case of damage, a lessee must restore an investment commodity to its pre-existing condition, defaults on lease obligations also have more serious consequences for lessees than for lessors, •• High cost of acquiring tangible assets is the key drawback of leasing from the lessee's perspective, acquisition of fixed assets as part of a lease transaction is typically more costly than acquisition financed with bank credits or loans, •• A lessee formally has no claim over the lessor's profits from sale of an item at the end of a lease agreement, even though the lessee has partly or sometimes fully refunded the purchase price paid by the lessor with lease payments [Szyszko, Szczepański 2003, p. 83]. Business decisions concerning leases, just like any other decisions, must fulfil the criteria of effectiveness. Appropriate calculations must therefore precede any lease transaction. Diverse and usually complex nature of lease agreements obstructs assessments of their economic effectiveness. Without going into those complex details, it can be noted that leasing is basically a peculiar form of enterprise financing, it is an alternative to financing with equity or traditionally defined debt (e.g. bank credit). Alternative cost of financing purchase of leased items with debt is normally both the theoretical and practical reference point in evaluations of effectiveness of leasing. Such an assessment of economic effectiveness of leasing involves a comparison between the current cost incurred by users of equipment purchased with credit and leasing. Leasing is better if the current net value of leasing costs is lower than the current net value of a purchase financed by crediting. Procedures and results of evaluations of the economic effectiveness also depend on applicable fiscal and accounting laws.

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Chapter 1: Selected aspects of enterprise finance ...

1.7. Capital structure of small and medium-sized enterprises in the European Union

Choice of appropriate sources of financing is an extremely important aspect of the finance management process in each enterprise and its effectiveness can potentially determine long-term standing in the market. Each industry or sector functions as part of a variety of legal systems and has unique business characteristics that are also reflected in types and sources of financing. The considerable role of financing in the Community-wide SME sector is demonstrated by the fact that it is ranked the second most important factor in business operations following on customer acquisition. Small and medium-sized enterprises primarily take advantage of external sources of financing. In 2013, more than a half (54%) of such enterprises looked for support to external financing. 22% of SMEs resorted to both internal and external sources, with merely 4% using solely internal sources of financing. The remaining 20% resorted to none of these sources. 100% 90% 80% 70% 60% 50% 40% 30% 20%

LI ME AL. IS RS NO IL MK TR

0%

AT HU SK CY ES EE PL LU DE FI BG EU IE CZ IT NL BE SE HR RO FR UK SI EL LV LT DK MT PT

10%

Used only internal funds

Used only external financing

Used both internal funds and external financing

Did not use any source of financing

Fig. 1.3. Financing structure: use of internal funds and external financing in 2013 Source: [SMEs’ Access to Finance survey, Analytical Report, 2013, p. 20].

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Financial tools in management of small ...

Enterprises in all European Union states employed external capital as the chief source of financing. Their proportion was maximum in Denmark (67%) and the lowest in Romania, Croatia and Hungary (41% each). Businesses in Austria and Hungary relied on their own capitals to the greatest extent (9%). Enterprises which did not take advantage of any form of financing in 2013 operated in Romania, Latvia and Portugal (42%, 40%, 36%, respectively). Internal financing is a form of equity financing, albeit not obtained from outside financiers. In 2014, only 14% of the EU enterprises financed their operations with their retained profits or by selling their assets. Most businesses active in Malta and Ireland were able to fund their activities and investments with internal financing (27% each). SMEs utilising internal financing were fewest in Portugal (2%) and Greece (6%), on the other hand. 30%

25%

20%

15%

10%

0%

PT EL DK LV PL BE NL HU RO ES SK EU-28 DE IT FI SI BG AT CZ SE HR CY LU UK FR LT EE IE MT

5%

Fig. 1.4. Financing with equity – retained earnings or sales of assets in 2014 (%) Source: The authors’ own compilation based on: [SMEs’ Access to Finance survey, Analytical Report. 2014, p. 63].

53

Chapter 1: Selected aspects of enterprise finance ...

Enterprises with more than 250 employees (33%) and industrial businesses (19%) most commonly tended to employ their own capitals. 14% of SMEs utilised their equity, with medium-sized enterprises doing so to the maximum degree (22%). Innovative enterprises used internal capitals more frequently than noninnovative businesses (16% and 13%, respectively). This may be related to the risky nature of their activities, uncertainty and financial performance which is difficult to determine. Total Non- innovative firms Innovative firms 250- employees SME 50-249 employees 10-49 employees 1-9 employees Services Trade Construction Industry 0%

5%

10%

15%

20%

25%

30%

35%

Fig. 1.5. Financing with equity according to selected criteria (%) Source: [SMEs’ Access to Finance survey, Analytical Report. 2014, p. 64].

In 2009-2014, more than a half of small and medium-sized enterprises expected no changes of availability of internal capitals. More entities expected improvements (23% on average) than deterioration (14% on average) in this respect. Trade and service SMEs expecting improved availability of internal capital were the most numerous (29% in each sector), followed by industrial (28%) and construction businesses (26%). These were predominantly enterprises employing between 50 and 249 (33%) and considered innovative (31%).

54

Financial tools in management of small ... 60%

50%

40%

30%

20%

10%

0%

2014

2013 Improve

Remained unchanged

2012 Deteriorate

2011 na/dk

Fig. 1.6. Expectations of enterprises regarding availability of internal financing in 20092014 (%) Source: [SMEs’ Access to Finance survey, Analytical Report. 2014, p. 120]. 100% 90% 80% 70% 60% 50% 40% 30% 20%

0%

IE MT UK LT ES SE HU DK NL RO DE PL SK BG EU CZ EE HR SI LU IT BE AT LV FI PT FR EL CY

10%

Improve

Remained unchanged

Deteriorate

na/dk

Fig. 1.7. Expectations of the EU enterprises regarding availability of internal financing in 2014 (%) Source: [SMEs’Access to Finance survey, Analytical Report. 2014, p. 121].

55

Chapter 1: Selected aspects of enterprise finance ...

In 2014, enterprises expecting improved availability of equity operated in Ireland, Malta and the UK (59%, 45%, 44%, respectively), whereas 54% of the EU enterprises did not expect any changes and treated that availability as satisfactory. Market enterprises obtain capital from external sources in a majority of cases. In 2014, they most commonly financed their operations with bank overdraft or credit line (37%). Leasing was another popular source, utilised by as many as 29% businesses. Own capital, that is, retained earnings organisations could use to finance their activities, were below 14%. Financing with debt securities was the least common (1%). debt securities equity other sources factoring other loan trade credit grants or subsidised bank loan bank loan retained earnings or sales of assets (internal funds) leasing or hire-purchase bank overdraft or credit line 0%

5%

10%

15%

20%

25%

30%

35%

40%

Fig. 1.8. Sources of finance used by SMEs in the EU-28 in 2014 (%) Source: [SMEs’Access to Finance survey, Analytical Report.2014, p. 62].

Most enterprises utilising external capitals were active in Sweden (68%) and Estonia (65%), with the proportion reaching its minimum in Hungary (39%) and Greece (28%). 54% businesses resorted to third-party funding across the European Union on average. The diversity of these figures may be caused by business attractiveness of enterprises in a given country and economic situation.

56

Financial tools in management of small ... 72% 71% 71% 70% 70% 69% 69% 68% 68% 67% 67%

2009

2011

2013

2014

Fig. 1.9. Use of banking products by the SME sector in 2009-2014 (%) Source: [SMEs’Access to Finance survey, Analytical Report. 2014, p. 74]. 100% 90% 80% 70% 60% 50% 40% 30% 20%

0%

MT IT IE LU BE CY PT FR DK RO BG AT NL ES SI EU PL UK HR CZ HU DE SK EL FI LV EE LT SE

10%

Fig. 1.10. Use of banking products to finance enterprises in the EU-28 in 2014 (%) Source: [SMEs’Access to Finance survey, Analytical Report. 2014, p. 75].

57

Chapter 1: Selected aspects of enterprise finance ...

Banking products are the key sources of business financing. Although they bear high interest, enterprises use them to continue expanding their operations. In addition, investments funded with bank crediting generate profits that are substantially greater than financing charges. In 2009, as many as 71% SMEs took advantage of banking products. The figure declined by 3 percentage points to reach 68% in the subsequent years. Banking products were the principal sources of financing for enterprises in Malta (88%), Italy (85%) and Ireland (82%). Barely 32% of Swedish entities resorted to banking products, since requirements of borrowers are highly stringent in that country. Swedish lenders avoid the risk of structural lending of the kind that precipitated the credit crunch. It can be noted that trust in banks has not been restored since the crisis which led to bankruptcy of Lehman Brothers (2008) and other institutions globally several years ago. Construction and trade enterprises (71% each) resorted to banking products to the maximum extent. As far as employment is concerned, microenterprises used such financing to the maximum (70%) and large employers of more than 250 to the minimum degree (66%). Innovative activities did not affect decisions to use banking products. Total Non- innovative firms Innovative firms 250- employees SME 50-249 employees 10-49 employees 1-9 employees Services Trade Construction Industry 62%

63%

64%

65%

66%

67%

68%

69%

70%

71%

Fig. 1.11. Use of banking products according to selected criteria in 2014 (%) Source: [SMEs’Access to Finance survey, Analytical Report. 2014, p. 76].

72%

58

Financial tools in management of small ...

Table 1.5. Expectations of external financing in 2009-2014 (%) Remained Improve Deteriorate unchanged Bank loans 2014 21 55 17 2013 16 56 13 2011 14 52 17 2009 12 59 14 Bank overdraft or credit line 2014 21 59 15 2013 15 62 12 2011 14 61 16 Equity 2014 18 51 8 2013 8 38 5 2011 11 38 6 2009 4 42 4 Trade credit 2014 21 60 12 2013 13 62 9 2011 11 58 14 2009 7 49 9 Debt securities 2014 18 46 12 2013 6 39 5 2011 5 39 10 2009 2 30 3 Debt other 2014 14 60 8 2013 10 46 5 2011 8 40 6 2009 5 49 4

na/dk ? 7 15 17 15 5 11 9 23 49 45 50 7 16 17 35 24 50 46 65 18 39 46 42

Source: The authors’ own compilation based on: [SMEs’Access to Finance survey, Analytical Report.2014, p. 120].

Chapter 1: Selected aspects of enterprise finance ...

1.8. Conclusion

59

Finance plays a major role in the process of enterprise management since no single decision cannot be evaluated in the perspective of its impact on financial results. All actions by enterprise managers should serve its fundamental objective. From the viewpoint of finance management theory, maximisation of goodwill and benefits to owners who have committed capital assets are the strategic goals of business operations. Finance management consists in making decisions to achieve the best relation between performance and the overall expenditure on the one hand and to secure resources in order to attain that performance, on the other hand. Effects of finance management are reflected in financial standing of an enterprise, its capacity for timely repayment of liabilities and financing of its development. Finance of micro and small enterprises is normally managed by owners. They may employ assistance of external consultants in case of complicated decisions. Specialists supervised by directors make financial decisions in large organisations, on the other hand. An enterprise desiring to expand requires influx of equity or third-party capitals. Capital owners expect certain benefits that will not only preserve value of the capital but also generate adequate compensation for the risk incurred. Employment of financial resources gives rise to a unique capital structure that may affect both current financial standing and value of an enterprise. Thus, investment capacity of a business depends on value and cost of the capital in place. Therefore, deterioration of a potential source of investment capital is of paramount importance. Analysis of capital use by small and medium-sized enterprises in the European Union implies bank overdraft or credit line were the most common sources of corporate financing in 2014 (37%). The highest proportions of enterprises resorting to external funding in 2014 operated in Sweden (68%) and Estonia (65%), whereas their share was minimum in Greece (28%) and Hungary (39%). Enterprises also attempted to take advantage of equity, that is, reinvest profits retained from sales of assets, to develop their operations. In 2014, their percentage was maximum (27%) in Ireland and Malta and minimum

60

Financial tools in management of small ...

in Greece (6%) and Portugal (2%). Only 8% of Polish and 12% of Slovak enterprises resorted to self-financing. Enterprises also used banking products to finance their activities. Most businesses of this type operated in Malta (88%) and Italy (85%) in 2014. The same indicator was lowest for Sweden and Lithuania (32% and 42%, respectively). It ranged around 68% in Poland and reached 54% in Slovakia. It can be concluded that the stage of enterprise development is associated with varied sources of financing. A number of factors also depend on economic potential of a country, phase of the economic cycle or conditions a given country provides for development of SMEs. Countries leading or lagging in respect of financing with a given source varied in the period analysed. This points to some economic developments which either fostered or halted expansion of businesses.

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WÓJCICKI Z. (2001). Finansowanie działalności przedsiębiorstw. Olsztyn: Wyższa Szkoła Informatyki i Ekonomii Towarzystwa Wiedzy Powszechnej w Olsztynie, 2001. ISBN 978–83–87867–69–0. WROŃSKA E. (2011). Wybrane czynniki determinujące wypłatę dywidend w spółkach osobowych − aspekty podatkowe. In A. Jackiewicz (ed.), Finanse i rachunkowość w zarządzaniu współczesnym przedsiębiorstwem − Teoria i praktyka, Przedsiębiorczość i zarządzanie. Łódź: Społeczna Wyższa Szkoła Przedsiębiorczości i Zarządzania Tom XII, Zeszyt 13, 2011. ISSN 1733-2486.

Chapter 2

Accounting information system of SME sector enterprises 2.1. Classification of enterprises by international accounting regulations

Depending on size, SME sector is divided into medium-sized, small and micro-entities. This classification is also adopted by the European Union, chiefly for appropriate management of the Community programmes. The clear definition of entity groups makes EU actions for development of small businesses more effective as they are addressed to a specific set of entities and eliminate organisations with greater economic power from the support programmes. The notion of a small and medium-sized enterprise has been in force since 1 January 2005 according to the Commission Regulation (EC) No. 70/2001 of 12 January 2001 on the application of Articles 87 and 88 of the EC Treaty on state aid to small and medium-sized enterprises, amended by the Commission Regulation (EC) No. 364/2004 of 25 February 2004 amending Regulation (EC) No. 70/2001 as regards the extension of its scope to include aid for research and development. The Commission Regulation (EC) No. 800/2008 of 6 August 2008 declaring certain categories of aid compatible with the common market in application of Articles 87 and 88 of the Treaty (General Block Exemption Regulation) applies to public aid provided to SMEs. The definition of SME is applicable to all policies, programmes and actions the Commission implements in relation to small and medium-sized enterprises (SMEs).

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Fundamental classification criteria of SME organisations are presented in the Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises (2003/361/EC), as well as the Commission Regulation (EC) No. 800/2008 of 6 August 2008 declaring certain categories of aid compatible with the common market in application of Articles 87 and 88 of the Treaty (General Block Exemption Regulation). They are based on three fundamental elements: •• Number of employees, •• Balance sheet total, •• Annual turnover. Two criteria, i.e. number of employees and balance sheet total or the annual turnover, must be fulfilled in order to qualify to a given enterprise grouping. Detailed classification criteria of SMEs in light of the EU regulations are set out in Table 2.1. Table 2.1. Classification of SME entities in line with the Commission Recommendation of 6 May 2003 (2003/361/EC) Type of business

Number of employees

Balance sheet total

Annual turnover

Micro-enterprise

Up to 10

Up to € 2 000 0000 Up to € 2 000 0000

Small enterprise

Up to 50

Up to € 10 000 000 Up to € 10 000 000

Medium-sized enterprise

Up to 250

Up to € 43 000 000 Up to € 50 000 000

Source: Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises (notified under document number C (2003) 1422) (2003/361/EC), Commission Regulation (EC) No. 800/2008 of 6 August 2008 declaring certain categories of aid compatible with the common market in application of Articles 87 and 88 of the Treaty (General Block Exemption Regulation) - Article 1 Annex I.

Classification criteria of enterprises are governed by applicable laws of the EU member states that comply with EU regulations as they are directly binding and applicable in all the European Union member states. Characteristics of small and medium-sized entities, as well as rules of drafting financial statements by the SME sector are regulated by a dedicated International Financial Reporting Standard for Small and Medium-Sized Entities (IFRS for SMEs). It applies to enterprises other than public trust

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71

entities1 which are obliged to compile and publish general statements in order to satisfy information requirements of a wide range of users who are not in a position to demand statements suited to their specific information requirements [IFRS for SMEs, p. 7, p. 8]. Therefore, IFRS for SMEs covers businesses which compile a full range of financial statements, i.e. including balance sheets (statement of their financial position), profit and loss accounts (statement of total income), cash flow statements (statement of incoming and outgoing cash), summary of equity changes (statement of equity changes), additional notes and explanations. This means it applies to entities that draft full financial statements whose securities are not in the public market, that is, essentially large and mediumsized enterprises. Micro-entities and small enterprises are not subject to these regulations in view of the recording and reporting formats they use, suited to tax settlements and a partial scope of financial statements. Financial statements drafted solely for their own management, fiscal or other authorities are not necessarily general financial statements – the latter serve needs of a wide variety of users, for instance, shareholders/ stakeholders, lenders, employees or the broadly-defined public. The aim of financial statements is to supply information on financial standing, performance and cash flows of an entity which assists users with making business decisions [IFRS for SMEs, p. 7] and to satisfy information requirements of users who are not in a position to demand statements suited to their specific information requirements. General financial statements are presented separately or as parts of other, publicly available documents, such as annual reports or issue prospectuses [IFRS for SMEs, p. 8]. •• The scope of the standard comprises the following issues: •• The notion of a small and medium-sized business entity, •• Statement of financial position, •• Statement of total income and statement of income, •• Statement of equity changes, •• Statement of retained income and profit, •• Cash flow statement, A public trust entity files its financial statements with the Securities and Exchange Commission or another supervisory authority competent for issue of any instruments in the public market or holds assets entrusted by a broad range of stakeholders. Thus, public trust entities encompass:

1

–– Issuers of debt or capital securities in the public market, –– financial institutions or entities which, according to their statutes, manage financial assets entrusted to them (banks, trust funds, investment funds, insurance companies).

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Notes to financial statements, Consolidated financial statement, Rules of accounting, estimations and errors, Financial instruments, Investments, Leasing, Transition of SME to ISFR, Sectoral activities. In comparison to the full IFRS, certain issues are excluded from the standard's regulation, e.g. interim financial reporting and segment reporting, or simplified solutions are adopted, e.g. concerning presentation and valuation of goodwill, income tax, financial instruments, costs of R&D work. Decisions regarding compulsory or possible application of the standards developed by IASB (International Accounting Standards Board) are made by legislative or regulatory bodies and entities responsible for setting standards in the particular legal systems. This applies to both full IFRS and IFRS for SMEs. Table 2.2 lists countries applying IRFS. Defining entities to which IFRS for SMEs is addressed – as discussed in Chapter 1 – is key to: a) IASB's ability to specify book-keeping requirements and scope of disclosures appropriate to a given group, b) Notifying legislative and regulatory bodies, standard-setting and reporting organisations and their expert auditors about the intended scope of application of IFRS for SMEs. A clear definition is also essential to preventing entities other than small and medium-sized organisations that are, not qualifying for application of IFRS for SMEs, from claiming they have followed the standard [IFRS for SMEs, p. 13]. Adoption of International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs) is a positive development, though it fails to cover a considerable group of SME sector enterprises, since it improves compatibility of financial information, prepares enterprises for and thus facilitates their entry into capital market [more information: Final Report of the expert group - Accounting Systems for Small Enterprises – Recommendations and Good Practices 2008, Haller, Eierle 2009, Deaconu, Popa, Buiga, Fulop 2010, Ikaheimo, Ojala, Stenin, Riistama 2010, Gockowska 2010, MartyniukKwiatkowska 2011, Kędzior 2011].

•• •• •• •• •• •• •• ••

73

Chapter 2: Accounting information system  ... Table 2.2. Global application of IRFS Country

Since when applicable

Subjects affected

Saudi Arabia

2005

Compulsory for banks and insurance companies. Implementation of IRFS is in progress.

Argentina

2012

Compulsory for entities beginning their fiscal year on 1 January 2012.

Australia

2005

Quoted companies. Private companies.

Brazil

2011

Compulsory for consolidated financial statements of banks and quoted companies. Gradually implemented in private enterprises since 2008.

China

-

Implementation of IRFS is in progress.

India

-

Implementation of IRFS is in progress.

Indonesia

-

Implementation of IRFS is in progress.

Japan

2010

Allowed to transnational corporations. Compulsory for quoted companies since 2016.

Canada

2011

Quoted companies. Other private entities, including non-profit organisations, may use voluntarily.

South Korea

2011

Quoted companies.

Mexico

2012

Quoted companies.

Republic of South Africa

2005

Quoted companies.

Russia

2012

Quoted companies.

Turkey

2005

Quoted companies.

USA European Union

2005

Allowed to foreign companies. Quoted companies.

Source: The authors’ own compilation on the basis of: http://www. irfs.org [accessed: 15.06.2015].

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Directive 2013/34/EU of The European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/ EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC (Official Journal of the European Union of 26 June 2013 No. L 182/19), constitutes the law governing accounting rules for small and medium-sized enterprises in the European Union. It is designed to harmonise requirements of small entities across the European Union and to prevent disproportional administrative burden. The Directive formulates the notion of a small, medium-sized and large entity in the perspective of its reporting duties. Classification criteria are based on: balance sheet total, net sales revenue and average employment in a business year, with fulfilment of at least two at the closing balance date qualifying for a given type of entity. Table 2.3 illustrates classification criteria in accordance with the EU Directive. Table 2.3. Classification criteria of entities in accordance with the Directive 2013/34/EU Type of business entity

Micro-entity Small entity

Medium-sized entity Large entity

Average employment in a business year

Balance sheet total

Net sales revenue

Up to 10

Up to € 350 000

Up to € 7 000 000

Up to 250

Up to € 20 000 000

Up to € 40 000 000

Up to 50

Above 250

Up to € 4 000 000

Up to € 8 000 000

Above € 20 000 000 Above € 40 000 000

Source: Article 3 Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC (Official Journal of the European Union of 26 June 2013 No. L 182/19).

A specific grouping of an entity evidently implies certain reporting requirements and possible application of some accounting simplifications, e.g. micro-, small and medium-sized entities may draft abridged balance sheets and profit and loss accounts. By force of Article 36 of the Directive 2013/34/ EU, micro-entities can be additionally free from the following duties: •• Disclosure of accruals and deferred income in the balance sheet,

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•• Compilation of additional notes and information to financial statements,

provided the information required is disclosed in notes to the balance sheet,

•• Compilation of reports of operations provided the information required

is disclosed in notes and information to financial statements or in notes to the balance sheet, •• Publication of annual financial statements, provided the balance sheet information included in such statements is properly submitted in accordance with national law to a minimum of one competent authority designated by a given member state (a central register, commercial register, register of companies). The Directive specifies the extent of additional information to be disclosed by micro-entities. Pursuant to Article 16 item 3 of the Directive, small and micro-entities should disclose the following information: 1. Accounting policies adopted, 2. Changes of revaluation capital where fixed assets are disclosed at current values, 3. Assumptions for and changes in value of financial instruments or assets other than financial instruments which are disclosed at fair value2, 4. Total financial liabilities, pledges and guarantees or contingent liabilities not disclosed in the balance sheet, 5. Advance payments and loans to administrative, management and supervisory bodies, indicating rate of interest, key terms and conditions and all sums repaid, written-off or redeemed, as well as liabilities contracted on behalf of such bodies as pledges and guarantees of any type, 6. Amounts and nature of cost or revenue items of exceptional volume or nature, 7. Financial liabilities of an entity which will fall due after more than five years and accounts payable with material collateral instituted by the entity, 8. Average employment in a business year. It should be pointed out the Directive only sets principal guidelines for the member states to lay down balance sheet legislation, leaving plenty of room for national regulations. Rules for classifying entities according to international regulations are shown in Table 2.4. By force of Article 36 item 3 of the Directive, micro-entities should not apply the categories of fair value or adjusted acquisition price to value their assets, equity and liabilities.

2

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Table 2.4. Classification criteria of entities according to international regulations Directive 2013/34/EU

Employment – up to 10 No definition Balance sheet total – up to € 2 000 0000 Annual turnover – up to € 2 000 0000

Employment – up to 10 Balance sheet total – up to € 350 000 Net sales revenue – up to 7 000 000

Employment – up to 50 These entities: a) are not public trust entities Balance sheet total – and up to € 10 000 0000 b) publish general financial Annual turnover – statements for external up to € 10 000 0000 users, including owners not involved in management, present and potential lenders and credit rating agencies.

Employment – up to 50 Balance sheet total – up to € 4 000 000 Net sales revenue – up to € 8 000 000

Medium-sized entity

Micro-entity

IFRS for SMEs

Small entities

Type Commission Recomof business mendation of 6 May entity 2003 (2003/361/EC)

Employment – up to 250 Balance sheet total – up to € 43 000 0000 Annual turnover – up to € 50 000 0000

These entities: a) are not public trust entities and b) publish general financial statements for external users, including owners not involved in management, present and potential lenders and credit rating agencies.

Employment – up to 250 Balance sheet total – up to € 20 000 000 Net sales revenue – up to 40 000 000

Source: Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises (notified under document number C (2003) 1422) (2003/361/EC), Commission Regulation (EC) No. 800/2008 of 6 August 2008 declaring certain categories of aid compatible with the common market in application of Articles 87 and 88 of the Treaty (General Block Exemption Regulation) - Article 1 Annex I, International Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs). article 3 Directive 2013/34/EU of The European Parliament and of the Council of 26 June 2013 on the annual financial statements, consolidated financial statements and related reports of certain types of undertakings, amending Directive 2006/43/EC of the European Parliament and of the Council and repealing Council Directives 78/660/EEC and 83/349/EEC (Official Journal of the European Union of 26 June 2013 No. L 182/19).

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2.2. Information generated in the accounting system and its characteristics

Information is a fundamental concept in the contemporary world, yet its definition is not easy as it has a variety of meanings. Therefore, scientists commonly avoid defining it, either relying on intuitive, everyday understanding or providing some supplementary descriptions [Malara, Rzęchowski 2011, p. 16]. Information is often identified with: •• Data – facts and figures collected for use in the decision-making process, •• Knowledge – information set against contexts and experience, •• Message – a sequence of signals with a specific meaning for the sender and recipient. One can say, therefore, that data are part of information, appropriately processed and suited to specific purposes. Knowledge is a systematised message containing not only information but also experience of an individual, whereas a message is a set of information which helps to define or systematise knowledge of an item. Thus, data is the most general concept, knowledge of an area is the most particular, and messages are effects of data processing and systematising, that is, a kind of link between data and knowledge. Table 2.5. Systematisation of different approaches to the concept of information Author The concept of information Year H. Greniewski In common-sensical terms, information is a message 1995 about something which can only be acquired by observation or mental activity and can be transmitted to another human. N. Wiener Content received from the outside world. Some con1996 tent transmitted by a sender. K. Laudon, A stream of data with specific meaning. 1996 W. Starbuck J. Penc Knowledge needed to define and realise tasks serving 2000 achievement of an organisation's goals. Information is a catalyst of management. G. K. Świderska An ordered and analysed message, signal transmitted 2003 in an appropriate (comprehensible) form to a recipient, required in connection with achievement of certain goals.

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Table 2.5. Continued. Author G. K. Świderska

Year 2003

D. T. Dziuba

2004

L. Kiełtyka

2010

S. Wrycza

2010

L. Floridi

2011

M. Mastalerz

2013

The concept of information An ordered and analysed message, signal transmitted in an appropriate (comprehensible) form to a recipient, required in connection with achievement of certain goals. Meaning ascribed to data, given a convention employed to represent the information. Each piece of information is data, but not every piece of data is information. A recipient is able to use information if they can receive signals transmitted and provide appropriate meaning to the signals. All that can be utilised for more efficient choice of actions leading to realisation of a certain objective. Potential of information is only implemented if properly used information can help realise an action. A key resource of every enterprise, a foundation of the decision-making function. Information support for decision-making processes. Set of data which is properly developed, i.e. gathered in line with rules of a system, and has a specific meaning. A data set ordered as appropriate to a given system and meaningful both to its creator and recipient.

Source: The authors’ own compilation on the basis of: [Greniewski 1995, p. 48, Wiener 1996, p. 54, Laudon, Starbuck 1996, p. 33, Penc 2000, p. 94, Świderska 2003, p. 52, Dziuba 2004, p. 20, Kiełtyka 2010, p. 83, Wrycza 2010, p. 62, Floridi 2011, p. 128, Mastalerz 2013, p. 33].

In summary, information is a set of adequately processed, analysed and selected data which describe an area or a situation for the purposes of making decisions or objective presentation of an area or situation under consideration. For information to fulfil its functions and goals, therefore, it should have certain characteristics which could ensure its objectivity to a substantial extent and determine its utility. This is the essential condition of information in the decision-making process, without which information is virtually useless. The many functions realised by information and stressing the necessity of its usefulness include [Mendel, Przeniczka 2002, p. 63]: 1. Gaining of competitive advantage, 2. Determination of customer attitude,

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79

3. Monitoring of the environment, 4. Coordination of strategy, 5. Measurement of task execution, 6. Support of decision-making, 7. Improved effectiveness of actions, 8. Enhanced reliability. Specialist literature provides a range of criteria for division of information and its consequent types. They are summarised in Table 2.6 Table 2.6. Criteria for division of information and types of information Division criteria of Types of information information –– Retrospective information – relating to the past, Time

–– Current information – relating to the present situation, –– Prospective information – relating to future occurrences, planning of changes in an enterprise, own forecasts or forecasts generally available in the market environment. –– Technical information, Scope and area –– Economic information, –– Macroeconomic information, –– Microeconomic information, –– Factographic information. –– Economic and financial information – describing developments in Functions an enterprise's economic environment, inter alia related to economof information ics, finance, planning, control, market, reporting, –– Non-financial information – concerning: operations of a business, safety, natural environment, ecology, marketing, etc. Types of information –– Comforting information – relating to the current situation, designed to monitor progress on goals, after T. Mendel, –– Development information – related to assessment of the condition J. Przeniczka or course of a development or process and possible difficulties with its realisation, –– Warning information – demonstrating actual or possible risks, –– Planning information – relating to level or condition of a future development or processes, –– Operational information – determining actions of own organisation compared to activities of others, –– Opinion-making information – helping to evaluate elements and environment of a system, –– Controlled information – addressed to market players, building image of an organisation.

Source: The authors’ own compilation on the basis of: [Malara, Rzęchowski 2011, p. 23, Oleński 2001, p. 181, Mendel, Przeniczka 2002, p. 64].

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For the purposes of this publication, financial information generated by the accounting system and presented in financial statements of a business addressed to both internal and external users is clearly of paramount importance. The concept of financial information is associated with the notion of accounting, most commonly defined as information system of an enterprise, a communication tool between sources and users of information. Satisfaction of users' information requirements is one of the most important objectives of accounting, considered one of its key (strategic information) paradigms, beside the valuation and fiduciary management paradigms. Thus, financial information is substantially generated by accounting, therefore its scope, types and characteristics, particularly those related to its utility, are defined and described by accounting. The theory of financial information generated by the accounting information system is presented in Table 2.7. Requirements of financial information users and types of information they are interested in are illustrated in Table 2.8. Table 2.7. Theory of financial information generated by the accounting information system Author H.A. Simon

Year 1954

H.J.M. van der Veeken, M. J.F. Wouters M.JF. Wouters, P. Verdaasdonk

2002

Ch.T. Horngren, W.T. Harrison Jr., L.S. Bamber M.Hall

2005

A.D. Socea

2012

2002

2010

Concept of financial information Information allowing for independent verification of ongoing or completed operations and for diagnosing operational issues. It represents the net effect of actions and irregularities in an enterprise. Information from the accounting system which forms the shared language for members of a given organisation to communicate in. Information about resources appropriate to organisational structure of an entity and needs of its users Means to developing knowledge about the environment in which a decision-maker operates. Supplied mainly by the accounting information system. It creates and propagates knowledge about what happened in the past. Serves to determine financial standing and its changes, enterprise's performance, risk levels, and effectiveness of actions.

Source: The authors’ own compilation on the basis of: [Simon 1954, p. 28, Van der Veeken, Wouters 2002, p. 364, Wouters, Verdaasdonk 2002, p. 82, Horngren, Harrison, Bamber 2005, p. 281, Hall 2010, p. 303, Socea 2012, p. 51].

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81

Table 2.8. Users and scope of financial information Users of financial Scope (types) of financial information information Shareholders, –– Risk associated with invested capital, potential investors –– Profits generated by a business (profitability), –– Ability to generate cash flows, –– Meeting of liabilities, –– Solvency of enterprise, –– Return on invested capital, Lenders –– Financial liquidity and solvency, and other creditors –– Ability to pay, –– Financial standing, –– Risk levels, –– Resources (assets) of entity, –– Development prospects. Buyers of products –– Financial standing, and services (customers) –– Prospects of going concern, –– Solvency, Financial liquidity, –– Profitability, –– Financial capacity to produce orders already placed. The state, fiscal –– Tax settlements, or local authorities –– Global financial policies, –– Forecast information, –– Statistical information. Competition –– Levels and structure of costs, –– Profitability, Financial position, –– Plans and capacity for market expansion – market share. Staff –– Profitability, –– Solvency. Management –– All financials serving to evaluate effectiveness of business decisions and for the purposes of planning and control of a business. Society –– Scope of operations, –– Prospects of going concern, –– Financial position. Source: The authors’ own compilation.

It can be concluded that each business creates a variety of information, both financial and other, as part of its activities which provides foundations for a range of business decisions. It is essential, therefore, that the information created be liable to minimum risk, that is, fulfil appropriate requirements and have certain qualitative characteristics, i.e. the ability to fulfil its function.

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Qualitative characteristics of information

Quality of information created by the accounting should be interpreted as a set of characteristics which determine the ability to meet requirements arising from functions of the accounting. Key accounting characteristics of information which determine its correctness (quality) encompass [Micherda 2006, p. 10, Micherda 2014, p. 18]: •• Reality, that is, conformity of its content with the reality, though not only in respect of quantity (conformity with the reality as far as size and volume of categories and business developments described are concerned), but also in qualitative terms (interpretation of the essence of the categories and business developments), •• Cognitive value, dependent on structure of an information set which is adequately detailed and presented, •• Operability, that is, timely frequency of information supply, •• Economicality in the process of information creation and effectiveness of its use. According to E. Nowak [1995, p. 14], book-keeping information should only be generated if benefits of its possession exceed costs of its collection. B. Stefanowicz [2007, p. 72] states quality of information should be its core characteristic and should meet the following partial features: accuracy, currency, timeliness, specificity, unequivocality, comprehensibility, completeness, selectiveness, significance – practicable importance, weight, reliability. J. Markowski [1984, p. 65] describes quality of information as a complex characteristic, a generalised degree of satisfaction with regard to an item under analysis. It comprises the following partial features: utility, correctness, usefulness, profitability (economicality, effectiveness). Qualitative characteristics of information have been defined conceptually by Financial Accounting Standards Board (FASB) and International Accounting Standards Committee/ International Accounting Standards Board (IASC/IASB), with scopes of preferred qualitative characteristics varying in time and across countries3. Contemporary conceptual frameworks in the Anglo-Saxon area have been developed in the US, Australia, Canada, New Zealand, the UK, South Africa, MSR (IASC) Committee. They can be divided into first and second generation conceptual frameworks. IASB and FASB are jointly drafting a third generation regulatory framework including eight major issues: objectives and qualitative characteristics of financial statements, elements, recognition and measurement of financial statements, reporting entity, presentation and disclosures, objective and status of the conceptual frameworks, application to non-profit entities, other issues, IASB Work Plan – Projected timetable as at 25 January 2009, www.isab.org, Staff Draft of Exposure Draft IRFS X Financial Statement Presentation, ISAB London, 1 July 2010.

3

83

Chapter 2: Accounting information system  ...

The regulations of the conceptual frameworks are designed to generate information useful in the process of making decisions (the decision usefulness approach), which is treated as the overarching objective of financial reporting [ISAB 2010, §10]. Information generated by financial reporting should be useful, that is, have certain qualitative characteristics which are variously defined by the particular conceptual frameworks (Table 2.9). It will have become evident the scope of qualitative characteristics has evolved, largely owing to the objective of financial reporting. Utility of information and qualitative characteristics of financial statements depend on information recipients, that is, the purpose of financial reporting. Within the third generation conceptual framework, financial reporting is designed to supply financial information of a reporting entity to current and potential capital investors, lenders and other creditors who make decisions in their capacity of capital providers [see more: Moehrle et al. 2010, p. 149-158, Zuchewicz 2010, p. 498]. Table 2.9. Qualitative characteristics of information generated by financial reporting as per conceptual framework regulations. Conceptual Year framework

Regulation

US FASB

1980

IASC/ IASB

1989 / 2001 Framework of the preparation and presentation of f inancial statements, IASC, July 1989, IASB, April 2001.

Qualitative characteristics

Declaration 2 On Con- Relevance, reliability, neutrality / imparcepts and Idea of Financial tiality, comparability, weight / materiality Accounting: Qualitative Characteristics of Accounting Information, US FASB SFAC 2, May 1980.

Understandability, appropriateness / congruity / usefulness, weight / materiality, reliability, accuracy of representation, content above form, neutrality / impartiality, prudence, completeness / fullness / integrality, comparability, barriers to appropriate / useful and reliable information, timeliness, balance of costs and benefits, balance of qualitative characteristics. Principles of accrual and going concern and postulates of true and fair view and fair presentation are adopted as foundations of the conceptual frameworks.

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Table 2.9. Continued. Conceptual framework Canadian conceptual framework

Year 1991

New Zealand conceptual framework

1993

Second generation New Zealand conceptual framework

2005

British conceptual framework

1999

Australian intergenerational conceptual framework

1990

Regulation

Qualitative characteristics

Financial Statement Con- Congruity, appropriateness – prediction cept, The Canadian Institute and feedback usefulness, timeliness, reliof Chartered Accountants, ability – accurate representation, verifiMarch 1991 ability, neutrality, conservatism, comparability, compromise among qualitative characteristics Statement of Concept for Gen- Congruity / appropriateness / usefulness, eral Purpose Financial Re- understandability, reliability, comparaporting, New Zealand Soci- bility Assumptions underlying preparaety of Accountants, 1993. tion of financial reports are also adopted – principle of going concern and accrual basis – and factors influencing qualitative characteristics are defined – balance of qualitative characteristics, between costs and benefits, weight / materiality, prudence / conservatism New Zealand Equivalent to Understandability, congruity / approprithe IASB Framework for the ateness – materiality, reliability – accuPreparation and Presenta- rate representation, content above form, tion of Financial Statements, neutrality, prudence, completeness, comNew Zealand Institute of parability, limitations of relevant and reChartered Accountants, June liable information – timeliness, balance 2005. of costs and benefits, among qualitative characteristics, true and reliable presentation. The accrual basis and the rule of going concern are adopted as the basic for drafting financial statements Statement of Principles for Congruity / appropriateness / usefulness, Financial Reporting, UK Ac- reliability – accurate representation, neucounting Standards Board, trality / impartiality, integrality, fullness, October 1999. completeness and lack of material errors, prudence, understandability, weight / materiality. Limitations of qualitative characteristics are also defined – appropriateness / usefulness versus reliability, neutrality / impartiality versus prudence, understandability Statement of Accounting Congruity / appropriateness / usefulness, reConcept SAC 3 – Qualita- liability, qualitative characteristics of prestive characteristics of financial entation of financial statements – compainformation, Australian Ac- rability, understandability, limitations of counting Research Founda- congruent and reliable financial information – AARF, August 1990. tion – timeliness, costs versus benefits

85

Chapter 2: Accounting information system  ... Table 2.9. Continued. Conceptual framework Second generation Australian conceptual framework

Year

Regulation

Qualitative characteristics

2004

Framework for the preparation and presentation of f inancial statements, Australian Accounting Standards Board, July 2004.

South African conceptual framework

2006

Framework for the preparation and presentation of f inancial statements, Accounting Standards Board, Lynnwood Ridge, Pretoria, Republic of South Africa, 2006.

Third generation conceptual framework

2010

Understandability, congruity / appropriateness – materiality, reliability – accurate representation, content before form, neutrality, prudence, completeness, comparability, limitations of relevant (congruent) and reliable information – timeliness, balance of costs and benefits, balance of qualitative characteristics, true and reliable presentation. Assumptions underlying preparation of financial reports are also specified – the accrual basis and the rule of going concern Understandability, congruity / appropriateness – materiality, reliability – accurate representation, content above form, neutrality, prudence, completeness, comparability, limitations of relevant and reliable information – timeliness, balance of costs and benefits, balance of qualitative characteristics, true and reliable presentation. The accrual basis and the rule of going concern are adopted as the basic for drafting financial statements. Significance, accurate representation of reality – completeness, neutrality, lack of material errors, compliance with economic content, additional qualitative characteristics – comparability, verifiability, timeliness, understandability.

ISAB

2009

Exposure D raft an Improved Conceptual Framework for Financial Reporting, IASB&FASB, ISAB, Preliminary Views on an approved Conceptual Framework for Financial Reporting, The Reporting Entity Discussion Paper, London 2008, IASB Work Plan – Projected timetable as at 25 January 2009, www.isab. org, Staff Draft of Exposure Draft IRFS X Financial Statement Presentation, ISAB London, 1 July 2010. The International Financial Significance, completeness, comparabilReporting Standard for Small ity, reliability, understandability, suitabiland Medium-sized Entities ity, prudence, timeliness. (IFRS for SMEs).

Source: The authors’ own compilation.

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Information supplied by financial reporting is doubly useful in the process of decision-making: •• Information helps to estimate future ability to generate cash, •• Information helps to evaluate the fiduciary function of the management [Kabalski 2009, p. 75]. This decision-making usefulness clearly determines certain qualitative characteristics of information supplied by financial reporting. It can be concluded that some qualitative characteristics are universal, e.g. reliability, true and fair view, comparability. Thus, they will remain constant regardless of financial reporting objectives and functions realised by accounting. It must also be pointed out quality of information supplied by accountancy is a major criterion for optimisation of an accounting system.

2.3. Information requirements of small and mediumsized enterprises

Information requirement is connected with realisation of the decisionmaking process that involves collection, processing and assessment of information about a future action. It is divided in three stages: •• Preparatory, which consists in gathering of information, •• Proper choice, which consists in evaluation of available variants, their analysis and making a choice, •• Realisation of a selected variant and control of outcomes [Koźmiński 2005, p. 6]. Obtaining of proper information, i.e. information of an appropriately broad scope concerning a decision-making problem and of appropriate quality, i.e. usefulness to the decision-making process, appears a pre-requisite for reasonable action and achievement of objectives by an enterprise. Information requirements of decision-makers depend on a range of factors, including: •• Size of enterprise – the larger an enterprise, the more complicated the decision-making process. Larger enterprises have more extensive structures with a number of processes and dependencies that complicate a the decision-making process, •• Type of operations – scope and type of information requirements vary depending on the nature and type of business activities,

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•• Phase of an enterprise's lifecycle – information requirements evolve across

stages of development and financial standing of an enterprise. Small and medium-sized enterprises have characteristics that affect management and thus the decision-making processes and information requirements. Bolton's Report [1971, p. 19] distinguished three groups of characteristics that differentiate small and other enterprises: •• Economic – small enterprises have relatively small shares in the market, •• Managerial – a small enterprise is administered by its owner or owners in a highly personalised manner, not via a formalised management structure, •• Other – an enterprise is independent as it is not part of a larger entity and its owners-managers are free from external supervision when making fundamental decisions. Thus, key managerial functions of owners as well as combining the ownership and managerial functions, which simplify the decision-making process while heightening the business risk, are the core elements affecting management of small and medium-sized enterprises. SME sector enterprises chiefly finance their investments with their own capital, which commonly restricts application of analysis of investment profitability and thereby increases risk and limits interest in information from the accounting system. Both the merging of managerial and ownership functions and the limited use of external sources of financing substantially affect information requirements of SMEs, which are therefore not interested in the financial accounting information system and normally employ simplified forms of recording business transactions. They may be motivated to generate full financial information by: Use of external sources of business financing, especially bank crediting – banks examining credit rating expect information about liquidity, financial performance, capital structure. Absence of full financial information is a major reason for considering a credit risky, •• Use of EU funding – SME sector enterprises using simplified records of business transactions are forced to open books of accounts or keep additional records to supplement data from simplified recording. Information generated by the financial accounting system is required at the stage of both applying and accounting for financing. The following most typical scope of information is most commonly employed in the decision-making processes of SME enterprises [Wysłocka 2010, p. 327]:

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Monitoring and evaluation of an enterprise's current financial standing, Liquidity management, Management of investment processes, Management of capital structure, Cost management, Tax management. This scope of information is very extensive, it is therefore reasonable to divide it into information used in long and short-term decision-making processes (Tables 2.10, 2.11).

•• •• •• •• •• ••

Table 2.10. Financial information useful in short-term management of a small business entity Object of information

Scope of information

Scope of data

Description of enterprise's cur- Value of revenue Current and planned revenue rent activities and development Forecast of short-term revenue potential Current and planned costs

Description of enterprise's current activities

Value of costs Forecast of short-term costs

Profitability of enterprise

Ability of enterprise to gener- Value of current and forecast ate profits financial performance Current and forecast assets Current and forecast capitals

Efficiency

Description of effective asset turnover helps to assess use of inventories

Current and forecast costs Value of current and forecast revenue Current and forecast assets Current and forecast capitals and their resources

Financial liquidity

Description of a firm's ability to meet its liabilities

Current and forecast working assets Current and forecast current liabilities

Cash requirements

Estimate of future solvency Short-term forecast of income associated with future structure Short-term forecast of of business financing expenditure

Source: The authors’ own compilation on the basis of: [ Jaworski 2014, p. 18].

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Table 2.11. Financial information useful in long-term management of a small business entity Object of information

Scope of information

Scope of data

Financial effects of planned Assessment of future filong-term actions on the nancial condition including entire enterprise consequences of decisions for the entire enterprise Financial standing in the industry and among competitors

Recognition of a firm's strengths and weaknesses, threats and opportunities

Assets and sources of its financing, Forecast of long-term revenue.

Profitability of planned and actual investments

Recognition of profitability of planned investments by comparing their key parameters with current effectiveness of operations

Planned financial surplus generated by investments, Cost of capitals required to finance the investments

Estimate of enterprise's credit rating and solvency

Current and planned own capital Current and planned external capital

Cost of capital

Structure of financing (debt of enterprise) Goodwill of enterprise

Details characterising own financial standing, external information on standing of closely cooperating and competing enterprises

Estimate of weighted average cost of capital financing an enterprise's activities helps to find cheaper financial solutions

Current and planned cost of own capital servicing Current and planned cost of external capital servicing

Representation of an enterprise's key long-term objective in monetary terms helps to track its long-term development

Current and planned assets and capitals Current and planned cost of capital Current and planned income

Source: The authors’ own compilation on the basis of: [ Jaworski 2014, p. 19].

Results of a computer-aided phone interview, conducted in Poland in 2014 with a group of small enterprises and concerning key financial information an enterprise needs to make decisions (each was asked to name the most important financial information required by a manager of a small enterprise to make decisions) suggest the information needed for the purposes of short-

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term decisions and current management is regarded as essential. Aggregated results of the survey are arithmetic means of evaluations by the respondents. They demonstrate significance of the particular types of financial information to the decision-making and thus reflect and evaluate information requirements of managers. The relatively high ratings awarded to both the areas of management show managers of small enterprises treat financial information as very important for making especially short-term decisions. This proves small enterprises focus on current management and rarely think of their businesses in strategic terms. Detailed results are presented in Table 2.12. Table 2.12. Financial information used in decision-making by small enterprises Scope of information Average rating, 3-5 Short-term management Liquidity 4.28 Profitability 4.01 Efficiency 3.92 Cash requirements 3.55 Current and planned income 4.04 Current and planned costs 4.10 Other 3.42 Long-term management Debt levels 3.97 Cost of capital 3.82 Profitability of investments 3.91 Goodwill of enterprise 3.78 Standing in the industry and among competitors 3.86 Effects of long-term plans 3.94 Other 3.09 Source: The authors’ own compilation on the basis of: [ Jaworski 2014, p. 19-20].

2.4. Criteria of selecting forms of business accounts

Book-keeping records of businesses come in two principal types: •• Obligatory – required by law which determines their scope and principles of compilation, •• Facultative (optional) – maintained by businesses which need to record transactions to acquire additional information required in management.

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Extent of recording duties depends on size of businesses and varies with regard to: •• Need to secure fiscal interests (obtain information needed for the purposes of correct tax settlements), •• Securing owner interests (supply of information on property and financial position of an enterprise), •• Supply of information required for efficient enterprise management. In view of these considerations, according to which a recording system should assure proper tax settlements and provide an appropriate information system for owners and efficient enterprise management, small and mediumsized businesses may record their transactions in the following ways: •• Integrated accounts – all business transactions are recorded and statements are compiled at the year's end, •• Abbreviated accounts – only selected business transactions are recorded, chiefly for the purposes of tax settlements. This division implies a division into businesses which keep books of accounts and are subject to balance sheet legislation whose tax liabilities are determined in accordance with fiscal laws, and businesses applying simplified forms of accounts and essentially subject to fiscal legislation. Small and medium-sized entities which keep books of accounts are eligible for simplifications and micro-entities for exemptions stipulated by the Directive 2013/34/EU, for instance: •• Small entities are exempted from the obligation to publish profit and loss accounts and reports of operations, •• Medium-sized entities may publish abbreviated balance sheets and additional notes and information to their financial statements, •• Micro-entities may be exempted from drafting reports of operations and publishing annual financial statements. Criteria of choosing how to record transactions may be addressed from a minimum of two perspectives: information and financial. The information aspect can be viewed from two standpoints: •• as knowledge of a business regarding available forms of accounts. Prior to starting a business, basic information about each form of recording transactions needs to be reviewed and analysis must be conducted which would be appropriate to the profile of a given business and which can be applied in light of legislation in force, •• as a quantity of information a business desires to acquire for itself and for other institutions it will work with. Selection of abbreviated formats may

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mean a business keeps no records and is unable to obtain economic information about its own activities, or that only amounts of its revenue can be gathered from such accounts, which may be insufficient, for instance, to a bank where an entrepreneur wishes to borrow in order to expand operations. More information can be generated by selecting general rules of taxation (on the progressive scale or at the linear rate). Book-keeping solutions employed as part of these variants are more detailed. Books of accounts provide a complete view of a firm's finances. The financial result, the key measure of an enterprise's financial standing, can be calculated. The financial aspect is the fundamental criterion businesses take into consideration when selecting a form of recording their transactions and taxation of their operations. It can be analysed as: •• Taxes payable to fiscal authorities. Their sums due under the different forms of taxation must be analysed before choosing one, •• Costs of organisation and operation of accounting in a business. Choice of a method of taxation is driven by the following factors [Michalski, Prędkiewicz 2007, p. 183]: Organisational and legal form; •• Type, scope and scale of activities; •• Volume of revenue; •• Staffing; •• Eligibility for exemptions and deductions; •• Tax risk; •• Need to minimise numbers and costs of accounts in place. Choice of an appropriate organisational and legal form for a business is a major decision-making issue, as it determines not only a form of ownership but also a scale of owners' financial liability and subsequent management methods. Thus, a legal framework is set for an enterprise to which the entire management organisation should be suited which governs legal relations, forms of organisation and mutual internal and external links. In legal terms, enterprises may be subject to civil and commercial law regulations. The former include sole proprietors and civil partnerships, the latter are commercial companies. Natural persons and individuals in legal partnerships enjoy the greatest freedom of choice of taxation and accounts (Table 2.13). They may select both abbreviated forms of recording transactions and books of accounts. Their tax liabilities may be determined under general or simplified rules. Limited liability and limited partnerships must tax their income according to general rules and essentially record their transactions in books

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of accounts. Private and public limited companies are subject to corporate income taxation and record transactions in books of accounts.

General partnership

Limited, limited liability partnership

Limited liability company

Simplified income taxation / simplified forms of recording transactions

+

+







General rules of income taxation  / books of accounts

+

+

+





General rules of income taxation / simplified forms of recording transactions

+

+

+





Corporate income tax / books of accounts







+

+

Type of taxation / form of recording transactions

Public limited company

Sole proprietorship, civil partnership

Table 2.13. Legal organisation of a business and permissible types of taxation and forms of accounts

Key: + Entity has the choice; – Entity has no choice

Source: The authors’ own compilation

Tax risk is another criterion of evaluation. This is a particular type of business risk, associated both with specific sanctions and sub-optimum control of expenditure. This risk denotes uncertainty as to fiscal consequences of completed, current or future business operations. It stems from actions in the fiscal environment and in an enterprise, as well as regulatory omissions and decisions by a business. It is normally regarded as the risk of error, delayed tax settlements or irregularities which may expose a taxpayer to fiscal arrears and the associated default interest or fines. It is a major decision-making criterion, particularly given unstable and highly complicated legislation governing tax systems which provide severe sanctions. Dedicated supervision of new taxpayers by fiscal authorities for the purposes of monitoring and education in order to minimise violations of fiscal law and eliminate the risk of sanctions is an instance of remedies. Such solutions have been applied in the UK, Sweden, Finland or the United States [Lewiatan 2013, p. 16]. This is part of a novel

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approach to taxpayers, namely, the idea of enhanced cooperation, which limits repressive and sanction-driven relations for the sake of mutual trust and open communication, transparency of actions by both parties and tolerance of fiscal authorities for minor tax irregularities. Selecting a method of income tax settlement is primarily determined by the desire to minimise the tax burden. Businesses, especially SMEs, attempt to maximise their profits and are compelled to reduce their costs. They seek, therefore, a form of taxation under which the tax they pay is minimum. Simplicity of settlements and minimum tax risk are also of importance to choice of a form of taxation. Regrettably, recurrent changes and complexity of legislation, as well as extensive administrative duties, generate costs of following tax legislation associated directly with the administrative duties (financial records and reporting) and cost of securing the risk of wrong application of laws, exacerbated by their excessively numerous changes. Lewiatan report [Lewiatan 2011] claims the Personal Income Tax Act has been amended 219 times, the Corporate Income Tax Act – 154 times, the Value Added Tax Act – 39 times, which adds up to the following average annual numbers of the amendments: 10 - the Personal Income Tax Act, 4 - the Value Added Tax Act, and 7 - the Corporate Income Tax Act. The cost burden of applying fiscal regulations is reaffirmed by the European Commission's survey [COM (2006)] demonstrating the ratio of (income) tax law application, computed as the costs of applying the law divided by the amount of tax paid, is 30.9% for small and medium-sized enterprises and 1.9% for large enterprises. The following measures can reduce costs of applying fiscal legislation: •• Creation of stable and predictable tax laws as part of implementing the principle of Think Small First, formulated by the Commission and requiring interests of the SME sector to be taken into consideration at very early stages of the legislative process to assure the legislation is friendly to the sector [Communication from the Commission to the Council 2011], •• Tax education and information by fiscal authorities, in particular as far as amendments to tax regulations are concerned, •• Maximum possible extent of official interpretations of applicable tax legislation, •• Application of simplified methods of tax accounting, •• Electronic systems of settlements, e.g. e-statements, e-administration, •• Lighter sanctions against small enterprises commencing their activities.

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2.5. Accounting policies and their determining factors The concept of accounting policies

Definitions of accounting policies offered by specialist literature and IAS/ IFRS stress achievement of specific objectives4. D.E. Kieso and J.J. Weygandt [1992, p. 1391] define accounting policies as specific rules and methods of accounting applied on a regular basis and treated as the most appropriate for the purposes of preparing reliable financial statements of an enterprise. According to E.A. Hendriksen and M.F. van Breda [2002, p. 250], accounting policies are sets of accounting standards, opinions, interpretations, rules and regulations employed by enterprises in their financial reporting. E. Walińska [2002, p. 5] sees accounting policies as foundations of the entire system of an entity's financial accounting and reporting, with solutions adopted as their part determining not only forms of financial reports but also recording solutions applied by a given entity. W. Brzezin [1998, p. 22] describes accounting policies as an entire domain of accounts standardisation by a variety of legislation, standards, directives in order to define general and more detailed rules of accounting in a state (community of states) over a certain period of time. He also points out accounting policies have two fundamental scopes of meaning [Brzezin 2000, p. 35]: •• The first represents the microeconomic approach and relates to accounting policies of a business, that is, accounting policies as pursued by individual entities. Accounting policies then encompass development of financial reports in compliance with objectives set by an entity owner yet within applicable accounting regulations and standards, •• The other involves the macroeconomic approach and relates to issues of state legislative policies, in particular, those applicable to balance sheet laws. Such accounting policies set a certain model of accounting in a state 4

Słownik Wyrazów Obcych (Dictionary of Foreign-Origin Words) defines policies as sensible and consistent actions of an individual or a group in order to achieve a specific objective [Tokarski 1971, 589]; after Encyklopedia Powszechna PWN (Universal Encyclopaedia) – policy means conscious and consistent application by management of organised groupings of principles and methods designed to attain specific objectives [Encyklopedia Powszechna PWN 2000, 600], Słownik Języka Polskiego (Dictionary of the Polish Language) defines policies as activities of government and state authorities in the social, economic, cultural, military and other areas of internal affairs or relations with other countries intended to acquire and maintain state authority, as well as goals and objectives of such activities and methods of realising such goals [Szymczak 1988, p. 785].

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or create patterns for compulsory or voluntary obedience by means of laws, standards, and directives. IAS 8 Accounting policies, changes in accounting estimates and errors defines accounting principles (policies) as specific norms, methods, conventions and practices adopted by an entity when drafting and submitting financial statements [IAS 8, § 5]. This definition has been in force since 1997, when accounting principles were identified with accounting policies. Until 1997, IAS had regarded accounting policies as principles, rules, method, contractual arrangements and procedures adopted by enterprise management in development and presentation of financial statements. Accounting principles had not been identical with accounting policies, therefore. Polish balance sheet legislation understands accounting principles (policies) as certain lawful solutions chosen and applied by an entity, including those laid down in IAS (entities obliged to apply IAS), which assure a required quality of financial statements [The Accounting Law 1994, Article 3 part 11]. Definitions of accounting policies cited after IAS and Polish balance legislation identify them with principles of accounting, which does not appear reasonable as the two are different conceptual areas. This is discussed at length by A. Karmańska [2009, p. 45], who summarises differences between accounting policies and principles as well as balance sheet policies in five key points: 1. 'Policies' literally do not mean 'principles' – Dictionary of the Polish Language defines policies in their colloquial sense as somebody's clever, crafty, politic action in order to realise specific intentions [Słownik języka polskiego 1989, p. 786], whereas a principle denotes a thesis incorporating a law governing certain processes, an attitude on which something is based, a rule [Słownik języka polskiego 1989, p. 955]. 2. Policies can follow certain principles whose range depends on the area in which the policies are realised. The area is normally defined in juxtaposition to the word 'policies', e.g. accounting policies. 3. 'Accounting policies' and 'balance policies' indicate a somewhat different scope – 'balance' literally means somebody's clever, crafty, politic action in order to realise specific intentions by concentrating on the balance sheet (or, more broadly, on financial statements). In English-language publications, 'accounting policies' have long been treated as methods of reporting, systems of measurement and disclosure applied by a given enterprise. It is also emphasised accounting policies adopted by management should

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be assessed by accounting experts in respect of conformity with law and described in a separate information section added to financial statements (in the introduction or conclusion), while disclosures of accounting policies should comprise principles of accounting and methods of application based on a choice from among acceptable alternatives, specific nature of a sector, a different application of generally accepted principles of accounting [Siegel, Shim 1990, p. 247]. 4. Accounting policies encompass rules and guidelines. They determine such issues as asset valuation, recognition of income, cost records [Siegel, Shim 1990, p. 247]. 5. Balance policies are soft elements of enterprise management, as opposed to principles of accounting, imposed on management by balance sheet laws. Therefore, concepts of accounting policies, accounting principles and balance policies should not be identified. Balance policies are all lawful decisions of businesses designed to manage assets, liabilities and other sources of financing disclosed in the balance sheet with a view to optimum realisation of economic assumptions. An appropriate (given knowledge of balance theory) application of law to proceed at discretion or to choose from among various procedures allowed by legislation is a means of these policies [Wohne 1990, p. 267]. A. Karmańska [2009, p. 46] defines balance policies as all lawful choices by enterprise management made to present performance and potential in a way that is at the same time true, reliable and supportive of business goals. This definition highlights achievement of goals, which is also underlined in the notion of balance policies developed by G. Sieben, M.J. Matschke, E. Koenig [2005, p. 226] – all undertakings during a business year and at the time of drafting financial statements which are to influence addressees of the balance sheet and persuade them to adopt a desirable conduct. Thus, balance sheet policies comprise lawful rules and principles of compiling financial statements (accounting policies) and certain (unwritten) principles a business has adopted to define the role of financial reporting in realisation of objectives. Balance policies frequently consist in searching for a golden means, a kind of optimum between two extreme tendencies: •• To create an excessively positive business image whereby creditors will tend to maintain and increase their readiness to lend (+) but also expect more interest (-); shareholders will be encouraged to acquire or sell shares (+) but will also demand more profit to be distributed (-); staff will be secure

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in their employment (+) but will demand higher wages and benefits (-); customers will have confidence in uninterrupted delivery of contracts (+) but will demand price reductions (-). •• To create an excessively negative business image whereby creditors will tend to restrict their readiness to lend (-) but will also be convinced there is still some 'air' left in the balance sheet (+), shareholders will not demand dividend and profits will be injected into the business (+), but may lose confidence in management competence (-), customers should believe they do not pay too much as profits are meagre (+), Treasury should be convinced the enterprise does not generate taxable profit. Management of balance policies has its limits, however, since [Cebrowska 1994, p. 230]: •• Principles of correct accounting and, first of all, of true and fair view should be observed in all undertakings, •• Choice to disclose as assets, equity or liabilities applies only to some specific facts, •• The strict duty to disclose the accounting policies adopted in the introduction to financial statements and in additional notes and information helps readers to decode the policies, •• Freedom of manoeuvre may be restricted in part by expert auditors examining the annual statements, •• Balance policies must always seek a balance of diverse interests, •• Means of balance policies in a given business year affect policies of the successive years, just like they are themselves influenced by policies of the preceding years. Policies of accounting mean a specification of methods chosen from the available and legal alternatives which ensure drafting (as part of financial accounting information system) financial statements of a quality required by balance sheet legislation, determined and accepted by an enterprise as part of its business policies. Thus, they encompass attributes arising from material principles of accounting and formal decisions (e.g. choice of a reporting period, forms of presenting the profit and loss account, etc.) [Karmańska 2009, p. 48]. Principles of accounting, on the other hand, are standards (rules) of accounting conduct, including fundamental concepts and conventions as well as procedures (methods) of accounting [Helin 2004, p. 120]. These are laws governing procedures of a financial accounting information system which cannot be identified with formal decisions as the former always prevail over the latter [Karmańska 2009, p. 48].

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These definitions of accounting policies stress individual solutions applied by entities in accordance with applicable law and serving to compile financial statements that provide for an appropriate quality of economic information. Each entity can be therefore said to have its unique accounting policies in line with applicable law, considering the extent and scale of its operations as well as principles of finance management. It must be pointed out accounting policies cannot be identified with accounting principles and balance policies.

Rules of selecting accounting policies

Business entities must apply their adopted accounting policies in a clear and reliable manner to present their property and financial standing and financial results. Thus, a reliable presentation of assets and capitals and of the financial result, mainly by reporting transactions in compliance with their economic contents, is the key element impacting accounting policies in place. Accounting policies must be determined to assure: •• Distinction of all transactions essential to assessment of property and financial standing and of financial result, •• Adherence to the precautionary principle, •• Presentation of an entity's position in a clear and reliable manner. Regulations a business must apply are a major determinant of accounting policies selected as two situations are possible: •• A business applies IAS/IRFS, •• A business adopts domestic balance legislation as applicable. Businesses may apply IAS/ IRFS to choose policies of accounting where it is not governed by domestic legislation. In line with IAS 8 Accounting policies, changes in accounting estimates and errors, usefulness, reliability and significance of information in financial statements decide selection of accounting policies [IAS 8, § 8]. Therefore, principles and, above all, their appropriate application (in conformity with IAS/IFRS) should ensure proper quality of information in financial statements. Two scenarios are possible when accounting policies are developed in line with IAS/IFRS: •• All principles affecting transactions in a business are regulated by IAS/ IFRS (standards or interpretations) – accounting policies are based on IAS/IFRS,

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•• Some transactions in a business are not reflected in IAS/IFRS – account-

ing policies are then based on IAS/IFRS and sound judgement in developing and application of principles. When exercising its sound judgement, management of a business considers the following sources in the sequence listed below [IAS 8, § 11 and 12]: a) Requirements and guidelines of standards and interpretation relevant to similar and related situations, b) Definitions, criteria presentation and valuation of assets, liabilities, income and costs laid down in the conceptual assumptions, c) Up-to-date regulations of other businesses that base their standards on similar conceptual assumptions, accounting literature and solutions adopted by the industry insofar as they comply with IAS/IFRS or conceptual assumptions. Information generated by application of accounting principles (policies) should be [IAS 8, §10]: 1. Useful to users in the process of making business decisions, 2. Credible, i.e.: –– Faithfully representing financial standing and performance and cash flows of an entity, –– Representing economic contents, not only legal form, of transactions, other developments and conditions, –– Objective, or impartial, –– Compliant with the principle of conservative valuation, –– Complete in all important aspects. Accounting principles (policies) in place should be coherent, which should be construed as [IAS 8, §13]: •• Application of the same principles of accounting to the same type of transactions, other developments and conditions, •• Choice of the most appropriate principles of accounting and their consistent application to narrower categories to which various principles may be applied. This discussion implies generating information of specific qualitative characteristics, namely, coherence, usefulness and broadly defined credibility, is the decisive factor governing choice of accounting policies. This is not a simple goal, evidently, particularly if a business relies on its sound judgement, associated with a considerable risk of information without the desirable qualitative characteristics.

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Both IAS/IRFS and broadly understood national balance legislation require the information to have certain characteristics, expected to assure the information is credible and adequately presents financial results, property and capital position of a business entity.

Changes of accounting policies

In general, accounting policies should be applied on a continuous basis. This is not practicable, though, as legislation and reality change, new broadly defined products and developments continue to emerge which affect property and capital standing of entities and must be represented or require variations of principles of disclosing transactions for the purposes of improved presentation, leading to a more reliable and accurate representation of economic realities. Therefore, changes of accounting policies may be compulsory or voluntary and be driven by two principal causes: •• Amendments to applicable laws, •• Intention to improve presentation of an entity's property and capital standing. This concept of accounting policy changes is governed both by domestic legislation (the Polish Accounting Act) and by IAS 8, where §14 points out a business may change its accounting policies only if required by provisions of the standard or interpretations or if such a change considerably improves usefulness and credibility of financial statements. Rules of changing accounting policies in line with these regulations are shown in Table 2.14. The information in Table 2.14 implies the two regulations exhibit a number of differences. Generally speaking, IAS 8 governs many issues in more detail, e.g. scope of information disclosures in case of accounting policy changes [§ 28, IAS 8], principles of converting comparative figures of previous years, methods of presenting accounting policy changes in books of accounts. The Polish Accounting Act fails to clearly specify methods of presenting accounting policy changes in books of accounts, therefore, compilation of KSR 7, addressing accounting policy changes in more detail than the general treatment of the Polish Accounting Act, must be applauded.

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Table 2.14. Comparison of rules for accounting policy changes in accordance with the Polish Accounting Act and IAS 8 Characteristic compared

Reason for changes of accounting policies

Polish Accounting Act

Reliable and clear presentation Only if: of an entity's standing (Article 8 a) Required by provisions of the standard section 2) or interpretations, b) It leads to more useful and credible presentation of the information in financial statements (§ 14).

Change Not defined exclusions (not treated as changes of accounting policies in place)

Types of changes

Voluntary, Obligatory.

Effects of accounting policy changes resulting from amended regulations

Not defined

Effects of voluntary changes to accounting policies

IAS 8

Date of changes – since the first day of a business year regardless of the date of decision. Presentation: –– Additional information – impact of changes on financial statements, i.e. statement of reasons and their quantitative impact on the financial result. –– Ensure comparability with details in the financial statement relating to the previous year.

§ 16: –– Application of accounting principles (policies) to developments and transactions whose contents differ from those occurring before, –– Application of new accounting principles (policies) to developments and transactions which have not occurred before or were negligible.

Voluntary, Obligatory – amended regulations.

Date of changes: –– Retrospectively, unless impracticable, –– From the first period to which new accounting policies may be applied (the earliest possible date). Presentation – effects of accounting policies are referred to undistributed finances result (retained profits).

–– Presentation in line with detailed transition regulations of a given standard, –– Failing the regulations, the retrospective method must apply – conversion of comparative data and appropriate corrections, –– Changes to accounting policies relating to initial application of a standard or interpretation – retrospective approach, –– Transition to IAS – IRFS 1 First application of IRFS must be applied.

Source: The authors’ own compilation on the basis of: [Polish Accounting Act and IAS 8].

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Components of accounting policies

Accounting policies encompass [KSR 7]:

•• Principles of classifying and grouping economic transactions under ap-

propriate items of financial statements - as assets, equity and liabilities, revenue and profits, costs and losses - or cash flows, •• Valuation methods of assets, equity and liabilities at the time of initial disclosure in books of accounts and at the balance closing date, •• Principles of determining financial result, •• Method of data presentation in financial statements. Documentation of accounting principles (policies) adopted in Polish balance legislation is set out in Article 10 section 1 parts 1–4. In turn, IAS 8 does not specify the extent of accounting policy documentation, yet Article 2 section 3 of the Accounting Act stipulates that entities compiling their statements in accordance with IAS/IRFS must follow provisions of the Act where issues are not governed by international standards or interpretations. Thus, scopes of the Act and IAS/IRFS converge in the Polish reality [Szaruga 2012, p. 23]. In light of Polish balance legislation, accounting policies comprise: •• A business year or settlement year, commonly equivalent to a calendar year. It may also be another period of 12 successive calendar months. •• Reporting periods – periods in respect of which statements are compiled. Application of shorter reporting periods is frequently dictated by internal management requirements, reporting requirements of a capital group, as well as tax settlement requirements. A method of determining assets and provisions must be indicated in accounting policies, at the end of either a month or a business year where the reporting period is shorter than a year [Foremna-Pilarska 2011, p. 9]. •• Valuation principles of an entity's assets, equity and liabilities. The following should be specified in particular: –– Principles of determining the initial value (i.e. acquisition or purchase price, cost of production) of intangible and tangible assets and of materials acquired, –– Criteria of treating fixed assets as the so-called low-value assets, subject to full depreciation at the time such assets are issued for use, –– Principles and periods of depreciation write-offs and criteria for revaluation write-offs for tangible, intangible and working assets, –– Valuation methods of inventory rotation (LIFO, FIFO and weighted average),

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–– Valuation methods of long- and short-term investments, –– Valuation methods of shares in subsidiaries and affiliated entities, –– Scope and principles of deferred cost and income settlements, Scope and methods of creation and valuation principles of provisions, Scope of deferred income tax liability. The particular assets, equity and liabilities can be assessed in line with Article 28 of the Act, by application of proper valuation categories, e.g. at acquisition price, purchase price, real cost of production, net selling price, market value, fair value, face value, sum of due payment, corrected acquisition price. With reference to the division of accounting policies into their broader and narrower meanings which has been discussed above, valuation methods of assets, equity and liabilities can be classified into two categories. The first, broader category involves a selection of specific rules which serve to represent business realities of an entity. These rules relate, for instance, to depreciation of fixed assets in line with their actual use. Impact of valuation principles on the financial result is not taken into account in this variant. The other sense of accounting policies employs solutions targeted at financial statement users. Selection of specific valuation rules is up to an entity willing to obtain an appropriate view of its financial and property standing and its financial performance [Takẚtsi 2012, pp. 25-26]. G. Takẚtsi [2012, p. 27] is of the opinion the Polish Accounting Act merges three different accounting policies which address principles of valuation in different ways, namely: •• Conservative, •• Liberal, •• Mixed principles. Conservative principles are based on historical costs with valuation at acquisition prices in consideration of impairment and the possibility of only negative value adjustments. The maximum valuation is set by the historical cost. In effect, adjustments are accounted for as costs or revenue in case of value reversals. The author admits the historical cost is an appropriate method of initial valuation since it is objective, verifiable and reflects an actual market transaction. In addition, verification of this method is liable to minimum uncertainty and is therefore regarded as the most credible. A drawback of historical cost, on the other hand, is that it ignores value changes in time, that is, fluctuations of money value and technical progress. It fails to represent expected future benefits after a longer period of time, therefore. Adjustments are needed for this reason, yet the Polish Accounting Act only allows the

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105

historical cost (acquisition price) to be adjusted below the initial value. This is guided by the principle of prudent valuation, typical for the conservative approach prevailing in Polish balance legislation [Takẚtsi 2012, p. 26-28]. Liberal thinking tends to be more open about the precautionary principle and follow the principle of matching revenue and costs, a counterbalance to the former rule. This line of argument is more suitable to investor requirements. Fair value is the main valuation category that can be adjusted both down and upwards. Effects of valuation are accounted for as costs – if the value has declined – or revenue – if it rises. In light of mixed principles, the market value or otherwise defined fair value may be adjusted both up and down, the difference being that value reductions are disclosed as costs and value increases are carried over to the revaluation capital, thereby increasing equity and liabilities. Market value denotes a current value based on discounted cash flows. A profit-oriented business employs liberal (mixed) principles, whereas a liquidity-oriented business prefers conservative principles prevailing in Polish balance legislation and guided by the precautionary principle. The principles of valuation admissible under the Polish law can be compared to the principles defined by the conceptual assumptions. The standards mention four possible principles of valuation: •• Principle of historical cost, •• Principle of current acquisition price, •• Principle of obtainable (realisable) value, •• Principle of current value. The three latter refer to the model of assessment at fair value. The first method prevails in the Polish conditions. Although it is regarded as the most reliable for the purposes of verifiability or initial valuation, it fails predictive requirements of financial statements, fulfilled, on the other hand, by valuation models according to current acquisition price, realisable value and current value, that is, assessments based on fair value. It envisages reliance on estimated values based on real or anticipated market conditions. Fair value often coincides with assessments as per market values. An active market is not always available, however. Therefore, G. Takẚtsi [2012, p. 23] believes fair value can be taken to mean estimated carrying values of any assets on the basis of current market prices of similar assets or recent prices of the same assets in a less active market, or projected future cash flows associated with use of a given asset. This implies value estimations based on market data or data from a less active market, or an appropriate estimation of

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anticipated values. Determination of current value requires cash flow forecasts on the basis of a discounting factor. Such forecasts incur a great risk of error and current or, more generally, fair value methods may enjoy little credibility, although they are useful to investors as they are designed to show an appropriate profitability. It should be pointed out the standards do not offer guidelines as to which of the methods, of historical cost or fair value, should be applied. It depends on objectives of a business and its knowledge about information recipients. •• Financial result is computed pursuant to Article 42 of the Accounting Act by setting out its components: operational result, result of financial operations, result of exceptional operations, which are added and reduced with statutory deductions from the financial result, namely, income tax, to produce the net financial result. The latter may be reported in the byfunction format (including costs by their sources) or comparative format (including simple costs by type and change of products). •• Book-keeping. This involves: determination of a company chart of accounts, listing books of accounts, and a description of a data processing system. Article 10 section 1 part 3a of the Act specifies the extent of a company chart of accounts which lists general ledger accounts, principles of classifying transactions adopted, of maintaining subsidiary ledger accounts and linking them to the general ledger accounts. Charts of accounts come in two types: model and company charts of accounts. A method of book-keeping is a list of ledgers or, if computer-aided, a list of data sets making up books of accounts on computer media, defining their structure, mutual links and functions as part of the entire book-keeping organisation and data processing. Books of accounts comprise the following documents (sets of book entries): •• Journal, •• General ledger, •• Subsidiary ledgers, •• Statements of: turnover, balances of general and subsidiary ledger accounts, •• Inventory [Article 13 of the Accounting Act]. A description of a data processing system is a compulsory element of accounting principles (policies) which should comprise: •• A description of finance-accounting modules in place and their mutual links, •• A description of computer-aided calculation and accounting procedures, •• Principles of data input, control of documents, of 'input' and 'output' data,

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•• Principles and methods of data processing, printout and other types of

issuance,

•• Handling and correction of errors, principles of data security and links

with internal control,

•• Information on updates to software in place, its correctness and conform-

ity with the Act, dates of software implementation and update, area of changes [Zaleska 2011, pp. 96-97]. Data retention is governed by Article 74 of the Act that stipulates periods of data set maintenance – in general, from the beginning of a year following on the business year to which data relate for a maximum of 5 years, with the exception of financial statements to be maintained in perpetuity. To sum up, principles of accounting determine scopes of accounting policies that can be adapted to requirements of a particular entity, of course within applicable laws. In light of these requirements, SMEs are bound by principles of accounting laid down by national legislation (the Accounting Act in the case of Poland) and by IRFS, if the latter is applied. Events (including transactions) are shown in books of accounts and disclosed in financial statements in line with their economic content, segregated, classified, aggregated and processed as appropriate and included in reports according to principles and guidelines set out in company charts of accounts, internal regulations and instructions.

2.6. Reporting duties of SME enterprises As per EU Directive regulations

Scope of and principles for compilation of financial statements from business entities of various sizes, including small and micro-entities, are governed by the Directive 2013/34.EU. Separation of small businesses has allowed for consideration of their information requirements and application of simplified financial reporting, since the Directive assumes reporting duties and requirements increase as business entities grow in size. Article 6 of the Directive 2013/34/EU lays down the following general principles of disclosing items in annual financial statements: •• An entity is assumed to be a going concern, •• Principles of accounting policies are applied consistently in successive business years,

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•• Disclosures and valuations base on the precautionary principles, in

particular: –– Only profits generated at the balance closing date may be taken into account, –– All liabilities arising in this or previous business year must be disclosed, even if information about such liabilities is obtained only between the balance closing date and date of balance sheet compilation, –– All negative revaluations must be disclosed regardless of whether a business year closes with a profit or a loss. •• Sums disclosed in the balance sheet and profit and loss account are computed on the accrual basis, •• Opening balance of a business year is equivalent to the closing balance of the preceding business year, •• Particular assets, equity and liabilities are valued separately, •• It is prohibited to set assets against equity and liabilities and revenue against costs, •• Items of the balance sheet and profit and loss account are presented in consideration of economic content of a given transaction or contract, •• Financial statement items are assessed at their purchase prices or costs of production (domestic regulations of the member states may allow valuation of certain balance sheet groups at their updated prices or fair values), •• Requirements set out in the Directive 2013/34/EU may not be applied if their application is immaterial. Micro-entities can only draft abbreviated financial statements (Table 2.15), though this should be decided by domestic laws of the member states. Article 36 of the Directive provides micro-entities may be exempted from the following duties: •• Disclosure and presentation of accruals and deferred income, •• Compilation of additional notes and information to financial statements, providing the required information (sums of financial liabilities, guarantees, pledges, contingent liabilities, advances and credits to members of administrative and management bodies indicating rates of their interest, which are excluded from the balance sheet) is disclosed in notes to the balance sheet •• Compilation of operational report on condition information about own share acquisitions is disclosed, •• Publication of annual financial statements, provided the balance sheet information is properly submitted to a minimum of one competent authority of a given member state.

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109

In accordance with Article 36.2 of the Directive, micro-entities cannot employ the category of fair value to balance sheet valuations, which implies their assets, equity and liabilities are assessed at historical costs. Table 2.15. The abbreviated arrangement of micro-entities' financial statements as per the Directive 2013/34/EU Balance sheet Profit and loss account Assets Net sales revenue Equity and liabilities A. Unpaid subscribed capital A. Equity Other revenue B. Cost of undertaking B. Provisions against liabilities Cost of materials establishment C. Fixed assets HR costs C. Liabilities D. Working assets Revaluations Other costs Taxes Profit or loss

Source: The authors’ own compilation on the basis of Article 36 of Directive 2013/34/EU.

Small and medium-sized entities draft financial statements consisting of balance sheets, profit and loss accounts and additional information. Simplifications may chiefly apply to presentation of financials, namely, items designated with letters and Roman numerals in the model financial statement (balance sheet) and gross result expressed as a single amount (profit and loss account). The profit and loss account may be presented in its comparative or by-function variant at an entity's discretion. The abbreviated arrangement of financial statements by small and medium-sized entities is shown in Table 2.16. In line with Article 31 of the Directive, medium-sized entities must supplement the following balance details and disclose them either in the balance sheet or in additional information: •• Goodwill, •• Extent of tangible assets, •• Extent of financial assets, •• Receivables from assessed entities, •• Shares in associated entities, •• Own shares, •• Extent of liabilities, i.e. liabilities for issue of debt securities, liabilities to credit institutions and associated entities, deferred income and expenses.

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Table 2.16. The abbreviated arrangement of financial statements by small and medium-sized entities as per Directive 2013/34/EU Assets A. Unpaid subscribed capital

Balance sheet

Equity and liabilities A. Equity I. Subscribed capital II. Share premium III. Revaluation capital IV. Supplementary capital V. Profit (loss) of previous years VI. Profit (loss) of the business year B. Provisions against liabilities C. Liabilities I. Long-term II. Short-term

B. Cost of undertaking establishment C. Fixed assets I. Intangible assets II. Tangible assets III. Financial assets D. Working assets I. Inventories II. Receivables 1. Long-term 2. Short-term III. Investments IV. Cash in hand and in bank Profit and loss account Comparative variant By-function variant 1. Gross profit (loss) 1. Gross profit (loss) 2. HR costs: 2. Distribution costs (including a) payroll revaluations) b) national insurance 3. General administrative costs (including 3. Revaluations revaluations) a) of undertaking establishment costs, tangible and intangible assets b) of working assets 4. Other operational costs Revenue from capital participations Revenue from other investments and long-term loans Other due interest and similar revenue Revaluations of financial assets and investments treated as working assets Interest payable and similar costs Income tax Net profit (loss)

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Chapter 2: Accounting information system  ... Table 2.16. Continued. Assets

Balance sheet

Equity and liabilities

Other fiscal charges Profit (loss) of the business year Additional information Small entities Medium-sized entities 1. Value and revaluations of particular fixed Full additional information under Article 17 of the Directive asset items. 2. Nature and economic objective of the entity's contracts not shown in the balance sheet and their effect on the financial result. 3. Nature and financial effects of major events after the closing balance date which have not been disclosed in the balance sheet or profit and loss account. 4. The entity's transactions with associated entities.

Source: The authors’ own compilation on the basis of Articles 14 – 16 of Directive 2013/34/EU.

It can be concluded the scope of financial statements in conformity with the Directive 2013/34/EU is dependent on size of a business entity. Microentities may present their financial (financial result), asset and capital (balance sheet) positions in very general terms and are not bound to compile additional information. The extent of financial statement information applicable to small and medium-sized entities is defined jointly, with medium-sized businesses obliged to supply certain additional balance sheet data, which brings the scope of their financial statements closer to that applicable to large entities.

According to IFRS for SMEs regulations

Principles of compiling financial statements by SME sector entities are regulated by IFRS for SMEs, which cover enterprises that fulfil both following conditions: 1. They are not publicly accountable, i.e. their debt or capital instruments are not traded in the regulated market, they are not in the process of issuing such instruments and do not hold assets entrusted to them by a broad

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range of stakeholders as part of their core business (banks, credit institutions, insurance companies, etc.) [§ 1.3 IFRS for SMEs]. 2. They publish general-purpose financial statements to meet general information requirements of users who are not in a position to demand statements suited to their specific needs [P8 IFRS for SMEs]. This scope implies the standard is addressed to both large unquoted companies and small entities that keep books of accounts. The latter will not be interested in additional accounting and reporting burdens, however. Therefore, ISAB has designated beneficiaries of IFRS for SMEs. These are small and micro enterprises which fulfil at least one of the following conditions [ISAB 2007, p. 19]: •• Minimum one owner is not a manager of the entity, •• The entity is applying or intends to apply for external crediting, •• The entity is applying or intends to apply for support from government or other public sources. Financial statements of micro, small and medium-sized enterprises are designed to provide information on financial standing, performance and cash flows of an entity which is useful for the purposes of decision-making by users unable to require statements suited to their specific information needs [§ 2.2 and 2.3 IFRS for SMEs]. In line with §3.17 IFRS for SMEs, therefore, financial statements consist of the following elements: •• Statement of financial standing, •• Statement of total revenue, •• Statement of cash flows, •• Statement of equity changes, •• Additional information. The standard assumes arrangement of a statement is at the discretion of individual enterprises as neither a form nor a sequence of the particular elements are defined and only items requiring presentation are listed. The minimum extent of information disclosures for the particular parts of financial statements is described in Table 2.17. The list of minimum information requirements applicable to SME enterprises in light of IFRS for SMEs is not very much different from data to be disclosed by large entities in accordance with IAS 1. The scope of information is narrower in the case of total other revenue owing to limited principles of valuing assets generating capital revenue and costs. These only relate to worker benefit programmes, conversion of financial statement items of entities operating abroad, and fair value changes of security instruments.

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113

Table 2.17. Minimum extent of information disclosures as per IFRS for SMEs

Element of financial Extent of information disclosures statements Statement of financial –– Cash and equivalents, standing –– Supply and other receivables, [§ 4.2 IFRS for SMEs] –– Financial assets, –– Inventories, –– Tangible fixed assets, –– Investment real estate at fair value, with revaluation differences carried over to the result, –– Intangible assets, –– Biological assets assessed at their cost less depreciation write-offs and value impairment, –– Biological assets at fair value, with revaluation differences carried over to the result, –– Investments in associated entities, –– Investment in subsidiaries, –– Financial liabilities, –– Current income tax receivables and liabilities, –– Deferred tax assets and reserves, –– Provisions, –– Shares disclosed as part of equity, divided into those of controlling and non-controlling entity owners. Statement –– Revenue, of total revenue –– Financial costs, [§ 5.5 IFRS for SMEs] –– Shares in results of associated and co-owned entities settled using the equity method, –– Tax charges, –– Result of discontinued activities net of tax, –– Result of fair valuation less net costs of sale or liquidation of assets connected with discontinued activities net of tax, –– Result – profit or loss, –– Other total revenue by type, –– Shares in other total revenue of associated and co-owned entities settled using the equity method, –– Sum total of revenue. Cash flow statement The standard fails to specify minimum contents of a cash flow statement. [§ 7.4 IFRS for SMEs] It only requires matching of cash and equivalents with an appropriate balance sheet item and determination of restricted funds. Statement –– Sum total of revenue for a given period, with separate amounts due of equity changes to controlling owners and non-controlling shares, [§ 6.3 IFRS for SMEs] –– For each equity item, impact of retrospective application or retrospective conversion, –– For each equity item, matching of opening and closing balance values to disclose changes arising from: –– result, –– each item of total other revenue, –– investments contributed and dividend and other payments to owners, separately disclosing share issue, transactions involving own shares, dividend and other payments to owners and changes of non-controlling owner shares in subsidiaries

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Table 2.17. Continued.

Element of financial Extent of information disclosures statements Additional information –– Declaration the financial statement has been drafted as per IFRS [§ 8.4 IFRS for SMEs] for SMEs, –– Material principles (policies) of accounting applied, –– Supplementary disclosures of particular statement items in the same sequence as the sequence of individual financial statements and their items, –– Other disclosures.

Source: The authors’ own compilation on the basis of IFRS for SMEs.

Regulations of IFRS for SMEs and Directive 2013/34/EU exhibit substantial differences of reporting duties and scopes of financial statements (Table 2.18). The Directive's regulations, according to which financial statement contents vary in line with enterprise size, are more suitable to the nature of the SME sector. IRFS for SMEs are designed for an entire grouping without varying content of financial statements. What is more, these requirements frequently coincide with those laid down by IAS 1 for large enterprises. Drawbacks of the standard include: the need to compile extensive financial statements comprising all the elements, complicated procedures of the standard's first implementation, existence of specialised organisations in entities. Table 2.18. Differences between IRFS for SMEs and Directive 2013/34/EU Issue

Scope of application

IFRS for SMEs

Entities meeting two conditions: –– They are not publicly accountable, –– They publish general-purpose financial statements.

Scope of financial The full scope of all entities applystatements ing the standard, including: –– Statement of financial standing, –– Statement of total revenue, –– Cash flow statement, –– Statement of equity changes, –– Additional information.

Directive 2013/34/EU

Businesses are divided into micro, small, medium-sized and large entities. The division is based on three criteria: –– Average employment in a business year, –– Balance sheet total, –– Net sales revenue.

Dependent on size of a business: –– Micro – balance sheet, profit and loss account, –– Small – balance sheet, profit and loss account, additional information, –– Medium-sized - balance sheet, profit and loss account, additional information.

115

Chapter 2: Accounting information system  ... Table 2.18. Continued.

Issue IFRS for SMEs Information con- Not specified. The standard sets out the tained in financial minimum scope of information for the statements particular elements of financial statements except cash flow statement. Classification Not permitted of exceptional revenue and costs Goodwill Goodwill should be valued at costs of acquisition including net value of acquired assets less depreciation for a maximum of 10 years. Valuation meth- At the end of an accounting period, all ods of financial financial instruments should be asinstruments sessed using the fair value method. Presentation of Receivables for capital instruments unpaid capital as issued before receiving funds or other a shift to equity resources must be presented as a shift within equity Prompt recogni- Negative goodwill must be immedition of negative ately disclosed in the profit and loss goodwill account.

Source: The authors’ own compilation.

Directive 2013/34/EU Information to be contained in financial statements is defined for micro, small and medium-sized entities. Permitted Goodwill can be depreciated for up to 5 years.

The EU allows freedom of choice of valuation methods. Unpaid capital must be part of assets Negative goodwill cannot be immediately disclosed in the financial statement if the goodwill is related to poor future results.

2.7. Information generated in the accounting system and information requirements of enterprises

Information created by accounting varies in scope depending on size of an enterprise. Full information is generated by accounting of large businesses. In line with regulations, the remaining entities may apply simplifications which restrict the extent of information created by accounting, though this should take place in keeping with their information requirements. This seems to be the right solution – the larger a business, the greater its information requirements as it engages in more extensive operations on a larger scale and is exposed to higher risks. Small entities may apply maximum simplifications as their records may only serve to determine tax liabilities. This implies information limitations, however, that fail to offer a complete view of financials and obstruct efficient management.

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It should also be pointed out information requirements of enterprises depend on their strategies and objectives – they will be different for the purposes of short-term and long-term management. Mutual relations among information requirements of enterprises for the purposes of short-term and long-term management and information generated by the accounting system as dependent on enterprise size are shown in Tables 2.19 and 2.20.

Small companies – book keeping

Medium-sized enterprises

Large enterprises

Current activities and development potential: –– Current revenue –– Planned revenue –– Current costs –– Planned costs Profitability of enterprises: –– Current financial performance –– Planned financial performance –– Current revenue –– Planned revenue –– Current costs –– Planned costs –– Current assets –– Planned assets –– Current capitals –– Planned capitals

Micro-enterprises – book keeping

Information needs of enterprises

Records only for tax purposes

Table 2.19. Accounting information system and information requirements of enterprises (short-term management) Accounting information system Simplified Full

+ – +1) –

+ – + –

+ – + –

+ +2) + +2)

+ + + +

+3) – + – +1) – – – – –

+ – + – + – + – + –

+ – + – + – + – + –

+ +2) + +2) + +2) + +2) + +2)

+ + + + + + + + + +

117

Chapter 2: Accounting information system  ... Table 2.19. Continued.

Micro-enterprises – book keeping

Small companies – book keeping

Medium-sized enterprises

Large enterprises

Efficiency: –– Current costs –– Planned costs –– Current revenue –– Planned revenue –– Current assets –– Planned assets –– Current capitals –– Planned capitals Financial liquidity: –– Current working assets –– Planned working assets –– Current liabilities –– Planned current liabilities –– Current inventories –– Planned inventories –– Current cash –– Planned cash Cash requirements: –– Forecast of income –– Forecast of expenditure

Records only for tax purposes

Information needs of enterprises

Accounting information system Simplified Full

+1) – + – – – – –

+ – + – + – + –

+ – + – + – + –

+ +2) + +2) + +2) + +2)

+ + + + + + + +

– – – – – – – –

+ – + – + – + –

+ – + – + – + –

+ +2) + +2) + +2) + +2)

+ + + + + + + +

– –

– –

– –

– –

+ +

1) Costs are not recorded under certain forms of fiscal settlements as tax liabilities are calculated on the basis of revenue, e.g. a flat rate on recorded revenue 2) Provided forecasts and plans are prepared 3) Financial result for fiscal purposes, not necessarily the same as the financial result of an enterprise. It's not necessary to calculate it under some forms of fiscal settlements.

Source: The authors’ own compilation.

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Micro-enterprises – book keeping

Mediumsized enterprises

Large enterprises

Financial effects of planned longterm action on the entire enterprise: –– Current assets –– Current capitals and liabilities –– Forecast of long-term revenue Financial standing in the industry and among competitors: –– Profitability of enterprises –– Profitability of industry –– Financial liquidity of enterprises –– Financial liquidity of industry –– Efficiency of enterprises –– Efficiency of industry –– Debt of enterprises –– Debt of industry Profitability of planned and actual investments: –– Financial performance generated by investments –– Cost of capitals required to finance the investment Cost of capital: –– Current cost of equity servicing –– Planned cost of equity servicing –– Current cost of external capital servicing –– Planned cost of external capital servicing Debt of enterprises: –– Current equity –– Planned equity –– Current external capital –– Planned external capital

Records only for tax purposes

Information needs of enterprises

Small companies – book keeping

Table 2.20. Accounting information system and information requirements of enterprises (long-term management) Accounting information system Simplified Full

-

+ + -

+ + -

+ + +1)

+ + +

-

+ + + + -

+ + + + -

+ +1) + +1) + +1) + +1)

+ + + + + + + +



+

+

+

+



+

+

+

+

– – –

+ – +

+ – +

+ +1) +

+ + +







+1)

+

– – – –

+ – + –

+ – + –

+ +1) + +1)

+ + + +

119

Chapter 2: Accounting information system  ... Table 2.20. Continued.

Small companies – book keeping

Medium-sized enterprises

Large enterprises

Goodwill of enterprises: –– Current assets –– Planned assets –– Current capitals and liabilities –– Planned capitals and liabilities –– Current cost of capital –– Planned cost of capital –– Current income –– Planned income

+ – + – + – + –

+ +1) + +1) + +1) + +1)

+ + + + + + + +

Micro-enterprises – book keeping

Records only for tax purposes

Information needs of enterprises

Accounting information system Simplified Full

– – – – – – – –

1) Provided forecasts and plans are prepared

+ – + – + – + –

Source: The authors’ own compilation.

This research suggests information requirements of enterprises are not always fulfilled by accounting. This primarily applies to information required by longterm management, based to a substantial extent on forecasting. Such financials must be supplied by dedicated functions preparing forecasts and plans necessary for long-term assessments of an enterprise and comparisons of its financial standing to the situation of an entire sector. Establishment of such functions in small enterprises is frequently impracticable as costs must be reduced. These enterprises consciously choose simplified recording in order to cut costs of book-keeping. Financial data for the purposes of short-term management can be obtained provided an enterprise maintains books of accounts. Records of transactions solely for the purposes of fiscal settlements fail to provide required information. It must be noted the scope of accounting information expands as an enterprise grows. Small and medium-sized enterprises are eligible for a number of simplifications that may restrict their information requirements, though. They are not a duty but a privilege from which an enterprise may resign if a broader scope of information is needed for efficient management. Thus, each enterprise may select an accounting policy to suit its individual information requirements. It may take advantage of the privilege of simplifying its financial records and reporting if this is considered beneficial.

120

2.8. Conclusion

Financial tools in management of small ...

American Accounting Association defines accounting as the process of identification, measurement and provision of economic information for users to make evaluations and decisions. It can be defined, therefore, as a set of legal norms and standards, a system of transaction measurement and recording and of business information. Accounting is perceived as a scientific discipline and a language of business, since it supports the communication process between individuals and firms by supplying information necessary to make decisions. For these goals to be achieved, certain conditions must be fulfilled and principles followed so that data provided are reliable, complete and timely. Information generated by the accounting system should display specific qualitative characteristics to become useful, i.e. to provide foundations for decisions being made, therefore. It is for these reasons that a range of general legal regulations, universally applicable to all businesses, and regulations applying solely to a given entity and considering its unique nature, including size understood as scale of operations measured with the balance sheet total, net revenue and average annual employment. All these solutions are designed to provide credible and reliable information and faithful representation of the actual state of affairs. It is important for a system of accounting information to have certain attributes that are pre-requisite to its usefulness. These attributes undoubtedly comprise: 1. Creation of useful information of definite qualitative characteristics – accounting has always adapted itself to information needs of its users, which is reaffirmed by research into a variety of qualitative characteristics of financial statements governed by conceptual frameworks in various countries in different periods of time. Credibility of information is a prerequisite for usefulness of an accounting system, which makes the concept of true and fair view of continuing significance, though other principles of accounting are not certain to remain valid, for instance, the precautionary principle, gradually superseded by the principle of fair value. Usefulness and qualitative characteristics of information are overwhelmingly important elements of the decision-making process in each business, including SME enterprises, therefore, their assurance by accounting information systems is a key condition of correct information policies. 2. Principles of establishing and amending accounting policies – for accounting to properly discharge its information function, businesses should apply

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a range of principles and norms concerning creation, application and variation of accounting policies. Such regulations mainly ensure comparability of data generated by accounting systems. 3. Extent of regulations incorporated in accounting policies which, by a formal specification of component parts, orders a number of issues and imposes a range of principles that affect quality of accounting information systems. Thus, the role of accounting policies consists in preparation of information to be used in decision-making and management processes in conformity with applicable principles. It should display an appropriate scope and quality, therefore. For accounting to fulfil its information function, the financials supplied must be sufficiently useful, which essentially means credibility and comparability of figures created by accounting systems. To ensure this usefulness of information, accounting should abide by a range of principles to be applied by all businesses, though in consideration of their specific nature and information requirements. This is addressed by the Directive 2013/34/EU and IFRS for SMEs, where drafting of financial statements by SME enterprises is regulated. It should be pointed out, however, the Directive 2013/34/EU, matching reporting duties and contents of financial statements to enterprise size, is better suited to needs and specific nature of the SME sector. Thus, the scope of financial information contained in financial statements expands in line with scale of a business. IFRS for SMEs was intended to facilitate operations of small and medium-sized entities. Its introduction gives rise to some issues contrary to those overall assumptions, though. It appears legal regulations should take into consideration characteristics of enterprises to which the laws are going to apply. Small and medium-sized enterprises should not be grouped together given the substantial differences between them, therefore, applicability to both small and medium-sized entities is a drawback of the standard. The question of financial statement recipients is also problematic as the standard chiefly designates external recipients, whereas they include business owners themselves as a matter of fact. It can be noted, therefore, that the standard pays too little attention to characteristics unique to small and medium-sized entities. Benefits of the standard's introduction are not suitable to needs of small entities, either, because international comparability of data and attracting of foreign capital are its main advantages, apparently out of reach of small businesses given their standing in the market.

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Chapter 3

Tools for evaluation of financial condition of enterprises

3.1. Financial analysis as a financial management tool

Regular preparation and analysis of financial statement information helps business managers and owners detect the problems that experts continue to see as the chief causes of small business failure, such as high operating expenses, sluggish sales, poor cash management, excessive fixed assets, and inventory mismanagement. By comparing statements from different periods, you can more easily spot trends and make necessary management decisions and budget revisions before small problems escalate. Financial analysis is an important and substantial part of financial management because, as presented by Knápková, Pavelková a Šteker [2013, p. 17], its role is to provide feedback on a business`s situation - where a business entity is, whether its expectations were met, and whether it experienced any unexpected events. Grünwald [1996, p. 59] states that financial analysis is an instrument connected with financial accounting and financial management whereby these two tools are interconnected. All of these statements show that financial analysis has a key position in financial management, that is, the management of financial processes. Financial management has four parts: 1. Financial planning The main task of financial planning is formulating financial objectives that are based on a firm`s financial expectations. In business practice, the main objective is to maximise a firm`s market value for its owners. 2. Financial decisions There are two main types of decisions – strategic (involving a business`s connections to its environment) and operational (focused on on-going financial management).

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3. Organisation of financial processes Organisation of financial processes refers to the daily operations of a firm that ensure that properly authorized decisions will be carried out. 4. Financial analysis and control As noted above, financial analysis evaluates the degree to which a company achieved the financial objectives in previous periods. This ex post financial analysis is distinguished from ex ante financial analysis, which predicts a business`s future financial situation. Financial analysis can provide incentives for the operational management of a business, and at the same time provide underlying data for preparation of future financial plans. One of the primary roles of financial analysis is providing qualitative, adequate and timely information for financial management processes and for financial planning. This role applies regardless of the size or type of a company. Size criteria are then relevant depending on the way and extent given financial information (external or internal) will be used for financial decision making. So why does usage of financial analysis in the financial management of SMEs differ from that of large companies? In principle, there are substantial differences between financial characteristics of large companies and SMEs that influence their financial statements and hence results of financial analysis: 1. SMEs tend to have a lower level of long-term indebtedness than large companies. SMEs tend to use short-term financing vehicles such as bank overdrafts, trade credit or bank bills of exchange. 2. SMEs tend to have higher levels of volatility and variability of profits and hence higher levels of business risk. This is because they have a relatively limited ability to diversify their investment activities, across industries or geographically. Some studies have uncovered additional financial contrasts between SMEs and large companies. These contrasts are common but not universal. 3. SMEs tend to have lower dividend pay-out ratios. This is consistent with their tendency to favour retained earnings over equity financing. 4. SMEs tend to have lower liquidity ratios. This suggests that current liabilities are their most important source of short-term debt. The most important factor influencing results of financial analysis is the quality and amount of financial and non-financial information. In contrast to large companies, preparation of financial information by SMEs is heavily dependent on knowledge and experience of financial management. Financial information can be prepared either by outsourcing from external professional consulting and advisory companies or, if they are sufficiently experienced and

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can access sufficient data, relying on internal managers or company owners. In some cases a mixture of internal and external staff is possible. Obtaining financial information from external or internal sources is a very important step in the decision-making process. But much more important is how to use this information. Even if SME managers have reliable information, there are still practical problems about its use and interpretation before it can bring positive results for a company. This fact increases the importance of access to experienced financial management as a key determinant of future success for SMEs, specifically, survival followed by profitability, growth and sustainability. The relationship between financial information, financial analysis and financial decision-making, including performance management, can be illustrated by the following conceptual framework: Preparation of financial information

Utilisation of financial information in financial decision-making

External information (outsourced) Knowledge and experience in financial management

Internal information

Performance of SME

Company´s objectives: • Survival • Profitability • Growth • Sustainability

Fig. 3.1. Conceptual framework of SME financial information and performance Source: The authors' own compilation.

The conceptual framework shows that financial analysis, financial information and their use in financial management in SMEs are influenced by several specific factors. The first factor is formulation of main business objectives. The general consensus in the financial literature is that a firm`s main financial objective is value maximisation. Almost all financial decisions are then aimed at achieving this objective. However, it is not necessarily the primary objective for SMEs as these may be specific to owners. Such personal objectives can impact – positively or negatively – on the financial statements that are the main source of financial information for the purposes of financial analysis. Thus, the source

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of distortion in SME analysis and decision making can be lack of separation between management and ownership. The second factor is that the survival objective usually takes priority not only over an SME`s other financial objectives but also over optimising financial processes. The reason is that SMEs usually have only limited access to capital markets because they are riskier borrowers for commercial banks, and their owners may be unable to provide adequate guarantees to set against this higher level of credit risk. Financial and capital structure, together with choice of financial sources, is often connected with unwillingness of SMEs` owners or managers to widen ownership structure or face a creditor´s interference with business management and activities. In other words, ownership and control may dictate preferences in financing SMEs. Choices surrounding equity and debt for SMEs are not entirely the same as those facing large companies. An example could be a change in capital structure caused by credits granted to the owner by a company. The personal risk preferences of the owner do not always correspond with the objective of capital structure optimisation and cost of capital minimisation. Because of their higher exposure to risk, SMEs may have a stronger preference for liquidity over profitability. SMEs are much more dependent on their current cash position than larger companies. Therefore, the need for rigorous cash flow management is very strong within SMEs, especially in fast growing industries and in companies facing rapid changes. All the above mentioned factors emphasise the differences between smaller and larger companies in their use of financial information and outputs of financial analysis for decision-making processes. The outputs of financial analysis for corporate financial management could be classified from other viewpoints. In the following sections we will consider the most important groups of financial ratios along with their impact and use in SME decision making processes. Besides the advantages of financial analysis for financial management and decision-making process, it is necessary to mention also its limitations. Overall, studies demonstrate that a limited amount of key figures can give a precise picture of a company’s situation. However, results must not be overestimated, as insight from a financial analysis is limited. First of all, the analysis gives only a general picture of whether business continuity is at risk and it does not show where the source of risk lies. This has to be found with help of more specific analysis [Coenenberg 2005]. Furthermore, the standard ratios can

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never deliver a completely reliable picture of the financial situation of a company, although they aim to eliminate effects in balance sheets which are based on balancing choices. Beside use of key figures and ratios, an understanding of business processes and economic developments is needed. In addition, it has to be taken into consideration that a database comes from a most recent period and hence it is only partly useful for evaluating future prospects. It has to be assumed that past developments are a valid indicator for future ones [Coenenberg 2005]. Furthermore the static picture of the financial situation can only deliver an approximation of a company’s liquidity and duration of the particular balance sheet items. Additionally, it does not show future financing options of a company, either [Coenenberg 2005]. Furthermore, methods of financial analysis are in their current form not applicable for the use in a company - especially not an SME. All of them require a large data set of annual reports as basis for computer based analysis - especially neuronal nets are highly complex. Therefore, they are used in banks and rating agencies but not in other companies.

Liquidity management

A general problem about understanding how financial management and decision making influence future development is that the topic is often discussed as though only the long-term strategic management of financial sources and the investment process influence goodwill. Less attention is paid to short-term operational decisions about working capital. Current assets and short-term financial sources determine the liquidity of a company and its cash flow. In the end, they have a substantial influence on profitability and value of a company. Although it is relatively hard to measure effect of current assets on a company`s returns, they are essential for its growth. Let us take efficient management of receivables or stocks as an example. It influences future growth of a company by signalling changes in business conditions, and by maintaining a sufficient level of stocks in order to serve consumers` needs, especially when there are fluctuations in the demand for a company‘s products. The importance of current asset management is reinforced by the fact that investments in those assets consume limited and precious company cash. On the other hand, short-term sources of financing are used mainly during seasonal fluctuations in the volume of current assets. They offer liquidity to reach goals of future company growth and ensure timely payment of liabilities. Therefore, the main goal of current assets management and short-term li-

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abilities management is the highest possible efficiency. In practice, this means minimising volume of unnecessary current assets and maximising usage of cheap short-term financial sources, particularly payables (trade crediting). Financial managers or financial analysts may gain a reliable view of a company’s financial situation from liquidity analysis. That is an analysis of a company’s ability to pay for its liabilities. It must be stressed we refer to total short-term liabilities, which consist of: •• Short-term payables (short-term trade credits, employee liabilities, etc.) •• Short-term bank loans. •• Short-term provisions •• Accruals According to Zalai et al. [2013, p. 84], the ability to pay for short-term liabilities is influenced by many factors. The most important are: 1. Structure of assets. 2. Adequate and regular cash flow. The „structure of assets” means classification of assets according to their liquidity. This is the rate at which an asset is transformed into cash. Many authors classify assets, based on their liquidity, into the following groups: 1. The most liquid assets, i.e. short-term financial assets (cash, bank accounts, shares). 2. Those that can be sold in the short-term, i.e. short-term receivables. 3. Less liquid assets, i.e. stocks. 4. Long-term non-liquid assets, i.e. bonds, long-term receivables, bank deposits. 5. Non-liquid or almost non-liquid assets, i.e. long-term assets. Specialist literature also offers a reverse classification – from less liquid to more liquid assets. Alaxy and Sivák [2001] propose the following categories: 1. Almost non-liquid assets (tangible and non-tangible long-term assets). 2. Long-term non-liquid assets (financial instruments). 3. Less liquid assets, i.e. stocks, further classified into: –– Stocks of finished goods and products – cashable faster. –– Stocks of production material – cashable more slowly. 4. Assets cashable in the short-term (receivables). 5. The most liquid assets (cash, short-term financial instruments). We can assess the liquidity level using liquidity indicators. The following indicators are taken into consideration: •• Static liquidity indicators (ratios and differential indicators). •• Dynamic liquidity indicators.

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•• Non-typical liquidity indicators.

When constructing static indicators, financial managers use balance sheet data to create a link between values of assets and liabilities. In corporate life, the most commonly used liquidity indicators are ratios constructed based on the questions: “With what do I pay?” and “For what do I pay?” We recognise three levels of liquidity ratios: the cash ratio, the acid test and the current ratio. Cash ratio =

Cash Total short -term liabilitie s

The cash ratio links the most liquid assets and total short-term payables. The value of this indicator should be in the interval 0.2 - 0.6. Specialist literature commonly mentions the “one to five” rule. This means that for every euro of total short-term liabilities, there are 20 cents of cash. However, it is necessary for financial managers to make sure the upper limit of 0.6 is not exceeded. From a company´s perspective, it is not good to hold too much cash, because it generates little profit. Acid test =

Cash + Short -term receivable s Total short -term liabilitie s

Short-term receivables are added to the numerator of the Cash Ratio. The recommended interval for the acid test is 1-1.5. According to Zalai et al. [2013, p. 86], short-term liabilities do not have to be higher than cash and short-term receivables combined. It is better if they are lower. But this is not exactly valid for companies that sell exclusively for cash, especially retails. In this case, higher liquidity is not a threat, but just a result of an industry´s specific nature. Current ratio =

Cash + Short -term receivable s + Stocks Total short -term liabilitie s

Here the numerator is the value of current assets, excluding long-term receivables. The recommended values of the current ratio are 2-2.5. It is considered dangerous if a company`s ratio is less than 1. In that case, even selling all the company´s current assets would not cover payment for all its shortterm liabilities. Note that where companies run with low levels of stock, their current ratios are close to those of their acid tests.

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Differential liquidity indicators are sometimes called funds of financial resources. According to Lesáková [2001, p. 62], a “fund is an aggregation of given static indicators, explaining assets or liabilities or the difference between some items of current assets and current liabilities (the so called net fund).” The differential indicators involve: •• Net working capital, •• Net cash •• Net cash and accounts receivable Net working capital represents the difference between the value of current assets and current liabilities. It is the most commonly used indicator from this group. Since other indicators are little used in practical financial analysis, we will not explain them in detail. An important fact that influences the ability of a company to pay its shortterm liabilities is a regular and adequate cash flow. Dynamic liquidity indicators are based on cash flow. For their computation, the cash flow from operating activities is used [Vorbová 1997]. Cash flow liquidity =

Operating cash flow Total short -term liabilitie s

This indicator describes the ability of a company to repay its short-term liabilities with cash flow generated by its operating activity. Literature also offers more specialist liquidity indicators. They are the solvency ratio, the current assets-debt capital ratio, the equity quota (current assets cover VI), long-term assets covered by long-term debt, and long-term assets covered by long-term financial sources. Solvency ratio =

Liabilitie s (narrow understand ing) Receivable s

This indicator describes the extent to which receivables cover liabilities. It also indirectly signals the degree to which liabilities could be covered by receivables, should they need to be instantly repaid. An indicator value greater than 1 means a company uses more trade crediting than it supplies. Current assets-debt capital ratio =

Current assets Debt capital

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This indicator compares the level of current assets to the level of debt capital, measured in euros. Equity quota =

Equity Long -term assets

This is the ratio of long-term assets financed with equity, measured in euros. Long-term assets covered by long-term debt capital =

Long-term debt capital Long-term assets

This indicator focuses on long-term assets and long-term debt capital rather than on total assets and total debt capital. Long-term assets covered by long-term sources =

Long-term capital Long-term assets

According to Kotulič et al. [2010], this is a measure of the level of undercapitalisation or overcapitalisation. If we want to use the above liquidity indicators in the financial management process, we have to stress that liquidity analysis is a very important part of financial analysis, especially for SMEs. Their correct evaluation may have an existential influence on such companies because they are more vulnerable to cash flow disturbances. For short-term financial management, a correct reading and evaluation of different liquidity indicators, particularly net working capital [Bhattacharya 2014], is especially important. From a practical viewpoint, a financial manager has to be able to answer two essential questions: is there a need for net working capital, and if so, in what volume? There is no simple answer. A majority of owners, investors and creditors in the market are more or less risk averse. At the same time, most managers prefer more certainty, even at the cost of lower profits. The process of companies deciding on their working capital targets involves solving an optimisation problem. Companies will accumulate working capital taking account of its cost, owners` and creditors` degrees of risk aversion, managers` expected levels of certainty, and the level of risk in the environment in which a company operates. The optimal ratio depends on specific expectations of actual or potential owners, creditors, experience and opinions of managers, as well as

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uncertainties in an industry or region where a company operates – especially those about customers and suppliers. Volume of working capital in a company has a primary connection to its liquidity. We can say that the volume of working capital is a result of liquidity management. It is actually the current ratio, which compares current assets and current liabilities and enables a relative analysis of working capital and its management. The current ratio clearly suggests that the more working capital a company has, the higher its liquidity is (and vice versa). A company should not attempt to maximise or minimise its liquidity, which is the case of other indicators such as profit. The aim should be to reach optimal values. These depend mostly on an industry in which a company operates. Even if the final result of a liquidity analysis is within a recommended range, a deeper analysis is required as well. We have to focus on quality and real value of current assets and short-term liabilities. We must investigate age structure of receivables, saleability of stocks and volume of short-term liabilities to be paid. One option in measuring and monitoring a company´s activity in terms of working capital are turnover indicators of individual items of working capital. They describe how long a company holds working capital until it is turned into sales. They also serve as a measure of working capital management efficiency. The so-called company operating cycle is of special importance in the case of short-term financial management and liquidity analysis. An operating cycle is a given time loop which starts with a received invoice for production material delivered, and ends with collecting cash for selling finished goods and services. The operating cycle is an important factor for a company, because it influences the need for internal or external sources of financing. In general, the longer the operating cycle, the longer the need for financing. We can, however, estimate length of the operating cycle by summing average stock turnover period and average period of receivables settlement. Even if we are aware of the length of the operating cycle, we still do not know how much additional finance we need until the receivables are settled. A majority of companies acquire a substantial volume of resources via trade credit, represented by payables. By using trade crediting, a company reduces the need to look for other sources of financing. It also reduces the volume and time period required for holding working capital. Therefore, it is important to know both the operating cycle and the working capital process (cash con-

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version process). It is computed as working capital minus average settlement period for short-term liabilities. Normal characteristics of an operation cycle vary by industry and type of production. Its length and respective liquidity level will be significantly influenced by industry requirements. Companies in the retail sector should need relatively less working capital and a lower level of liquidity because their operation cycle is usually shorter and safer. In their operation cycle, there is no settlement period for receivables because they are operating in a cash industry. The only cash danger they face is unexpectedly slow stock turnover. Service industries are similar. The operating cycle of such a company depends mostly on the average settlement period of receivables. Stocks are an insignificant influence. In effect, working capital volumes and optimal liquidity level will be lower. Wholesalers have a more complicated operation cycle. In this case, turnover of both finished goods and receivables are relevant and the risk is consequently higher. Therefore, demand for working capital and liquidity is greater. Production companies are the most difficult businesses in terms of operating cycles. In such companies, the operating cycle involves a material stock turnover period, non-finished goods stocks, finished goods stocks and receivables. As a consequence, there are four potentially critical areas that may cause a longer operating cycle and a more restricted cash flow. Problems can be anticipated, e.g. when supplying a company with raw materials, in the production process, in sales of finished goods or cashing of receivables. Therefore, the optimal values of liquidity and working capital will be maximum in production companies. We have stressed several times the important role of management in optimising working capital, having regard to the industry and the specific company goals. On the one hand, high values of working capital mean a safe business, on the other hand, the more capital is held, the higher the risk that current assets are invested inefficiently. A second approach is to deviate from optimal values and try to minimise working capital and liquidity. This would mean a company uses cheap sources of financing and does not hold excessive cash in stocks or receivables. However, this is a quite dangerous tactic which could result in insolvency, because the company may not have enough liquid resources to cover its liabilities.

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Capital structure management

Debt indicators describe structure of a company’s financial resources. Based on their values, financial analysts can evaluate companies` debt ratios and their ability to handle debt. Those final values are not only important for company owners, but they also represent an important criterion for assessing a company`s financial situation when applying for a bank loan. At the same time, it is important to stress that there is a mutual relation between debt indicators and liquidity indicators that we may describe by noting that „what a company borrows today has to be repaid in the future” [Zalai et al. 2013, p. 91]. 1. We may classify debt indicators into the following three groups: 2. Financial structure indicators (debt ratio, self-financing ratio). 3. Debt structure indicators. Indicators describing the ability of a company to deal with debt and interest repayment. Debt ratio =

Debt Total assets

The indicator gives the ratio of total debt (liabilities) to total assets, i.e. to what extent assets are covered with debt capital. Specialised literature notes that it is very hard to state any recommended value. The average is in the range 30% - 60%. A higher value of the indicator may negatively affect a firm`s whole financial stability from the creditors´ viewpoint. On the other hand, it is important to realise that from a company´s perspective it is more interesting to use debt, because debt is cheaper (i.e. has a lower cost of capital) than equity financing. According to Jenčová and Rákoš (2010, p. 70), a higher debt ratio is beneficial for a company if it can achieve a higher return from total capital invested. Self - financing ratio =

Equity Total assets

The self-financing ratio is a complementary indicator to the debt ratio (they add up to 1). The self-financing ratio records the extent to which assets are covered with equity. Degree of financial leverage =

Debt Equity

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The concept of financial leverage is used for indicators that describe the structure of resources. It records the debt/equity ratio.

Long-term debt ratio =

Long-term debt Total assets

This indicator records the ratio of long-term debt to total assets. Longterm debt in a company consists of long-term statutory reserves, long-term provisions, long-term liabilities and long-term bank loans.

Bank loan-term debt ratio =

Bank loans Total assets

The indicator measures the extent of reliance on bank loans. Interest coverage ratio =

Earnings before taxes (EBT) + Interest Interest

The interest coverage ratio measures a company`s ability to finance debt, i.e. how many times a company can repay the cost of debt from its profit. The recommended reference value is 5, but it should not be lower than 3. Debt-to-cash flow ratio =

Liabilitie s Balance sheet cash flow

The indicator measures how many years it will take a company to repay its liabilities, given the present cash flow. Debt analysis is generally connected to decision making about financial and capital structure. Implementing results of a financial analysis is of a rather theoretical nature for SMEs, because of the limited volume and structure of financial resources available to these companies. Regardless of company size, the fundamental instrument and essential factor in the decision making process about financial resources is the cost of capital. There is a definite imperative for every company to minimize the capital cost, i.e. setting a debt level that would minimise these costs. A realistic cost of capital must be used in assessing companies. Unrealistic cost assessment may result in overpaying to acquire a company, or in entering the wrong asset value in a company`s balance sheet (especially in the context

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of accounting standards such as IAS 23 or IAS 39). Furthermore it may lead to mistakes in assessing a company`s debt capacity [Ogier et al. 2004]. Using a basic calculation, we may find out that a drop in capital cost by 1 percentage point may increase fair value of assets originally priced at € 50 million by another € 5 million. It is, however, impossible to avoid this problem in practice. In order to ensure correct corporate decisions and to grow a company´s value, it is necessary to know exact capital costs. This rule is as valid for large publicly traded companies as for SMEs. In the past, capital costs served as an instrument of preservation of the financial function of a company as well as position of financial managers. Nowadays, capital costs are recognised as having a wider role i.e. in the context of liquidity management and relations with financial markets. The key competence in financial management, important for the correct application of capital costs, has more of an economic than an accounting nature. It is based on real behaviour and te reactions of financial markets, especially in terms of debt, evaluation of debt instruments and anticipated return on equity. Understanding capital costs has its own purposes. A substantial reason for their fair assessment is to specify a company`s capital structure, i.e. the balance of internal and external resources, where the costs of capital used often appear to be minimal. In order to calculate an optimal capital structure, it is necessary to apply the theory and analysis of capital costs across a range of different situations: for example, to calculate financial implications of changing the balance of equity and debt, or to assess how to finance acquisition of a company. The optimal debt level computation is in fact straightforward. So is the computation of optimal capital structure. It `only` requires estimates of equity and debt costs for a range of different situations. The optimal debt level is where weighted average capital costs (WACC) are minimised, and goodwill is maximised. After calculating debt and equity costs at different debt levels, we can sum them and thereby determine the debt level at which total capital costs will be minimised. Using the classic simple model of discounted cash flow, with capital costs as the discount factor, it is then possible to predict the influence of a change in optimal capital structure on goodwill and equity. This cost analysis is illustrated in Figure 3.2.

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Goodwill

Goodwill (EUR)

WACC (%)

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Optimal debt level (point 1)

WACC Debt level ( %)

Fig. 3.2. Optimal debt level and WACC Source: The authors' own compilation.

Based on Figure 3.2, several conclusions can be drawn that are important for financial management and decision making in the field of debt and capital structure: 1. First, this analysis produces an estimate of the optimal capital structure level of a company and, depending on its complexity, also allows for involvement of a wider group of company financial managers in search of optimal capital structure. 2. Second, it also models and estimates goodwill before and after any change in capital structure. In Figure 3.2, the value is maximised at point 1, because this corresponds to the debt level that minimises the cost of capital. 3. Third, in practice capital costs are slowly and continuously decreasing towards the point of optimal debt, but after this point they start to rise very rapidly. In other words, if debt level is lower than optimum, then in a sense owners are penalised for not maximising advantages of external financing. However, beyond the point of optimal debt level a company`s value from an owner`s perspective is reduced. For instance, a similar situation occurred in the telecommunication industry at the end of 1990´s. 4. Fourth, a company may not always attain the exact optimal debt level if, as in Figure X, costs rise rapidly beyond the optimal debt level. If there is some doubt about the exact location of the optimal level, it may be safer to operate slightly under this level.

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The analysis of debt levels and capital structure has strong descriptive and analytical potential and in the end has a fundamental influence on final goodwill.

Profitability management

Return indicators express the return on company effort and they synthesise the descriptive value of liquidity, activity and debt indicators. A typical return indicator has profit (earnings) in the numerator. In corporate practice, several return indicators may be used, depending on the particular type of profit that a company uses for analysis. Zalai et al. [2013, p. 95] note that return indicators may differ because there are two main choices for their denominators: 1. Denominators containing consumed inputs. 2. Denominators containing tied inputs. Consumed inputs are the most accurate expression of costs but also of sales (revenues). Tied inputs are measured by company assets, but it is also possible to use sources of long-term finance and equity as well. The literature also notes that using indicators based on tied inputs is more complex, because they are sensitive not only to consumption levels but also to tied inputs. Return on equity (ROE) =

Earnings after tax Equity

Return on equity measures how a company profited from its equity. It describes how many euros of earnings after tax (EAT) are associated with one euro of equity. Obviously a company tries to maximise ROE for a given investment. ROE must exceed the bank interest rate for the company to stay in business. Return on assets (gross) =

Earnings before tax Assets

This indicator measures the efficiency of total invested capital without regard to its origin, measured by earnings before tax. Usage of this indicator is recommended in case we need to compare company returns from different countries (in this case the problem of different tax policies is eliminated). Return on assets (ROA) =

Earnings after tax + (1 - tax rate) Assets

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ROA describes the total efficiency of invested capital, without regard to its sources. It records how many cents of EAT can be harvested from one euro of capital. It is important to ensure the following relationship: ROE > ROA > bank deposit interest rate. Operating return on sales =

Profit from operating activities Sales

The indicator measures profit from operating activities per euro of sales. As we mentioned before, return indicators are primarily based on input parameters, where profit (earnings) is the difference between costs and revenues. Return indicators reflect the incentive managers have to control both the important items – costs and revenues. It is not easy to define cost and revenue management as an activity or process in a straightforward way. We could say that it involves managers making short-term and long-term decisions that increase the value for customers and decrease costs of products, goods and services [Drury 2012]. Cost and revenue management has a wide scope. It involves mainly activities connected to cost reduction and relates to the budgeting process (especially the budgeting of revenues and profit). Amongst the most typical costs and revenues management calculates are the costs of products, services or other items, information gathering and planning, control and performance measurement and analysis of information relevant for decision making. From a financial management perspective, we focus our attention mostly on the last-mentioned attribute. It has a direct connection with the basic activity of financial management – financial decision making. One has to be clear which revenues and costs have to be considered and which ignored in the process of financial decision making. In such cases an analysis of costs may be very helpful. It is the analysis of relevant information (e.g. about costs), a key aspect of decision making. In managerial decision making, the concept of relevance matters. Relevant costs are expected future costs and relevant revenues are expected future revenues. Relevance means that costs and revenues will occur in future as a result of decisions and will differ for every alternative of a given decision [Horngren et al. 2011]. Costs and revenues that do not depend on any decision are mostly irrelevant and can be ignored. Cost analysis and its reflection in managerial decision making can be illustrated in some typical decision making situations.

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A good decision making example based on the concept of relevant costs and revenues is a situation of accepting or rejecting a one-time special production order. It is about the possibility of using spare production capacities and accepting larger orders, even if at a lower price. In this case, fixed costs are already covered and they are treated as irrelevant. In deciding to accept such an order at a price, it is not useful to only consider calculated cost prices, but better to consider real costs, which will or will not be affected by accepting or rejecting the order. During the decision making process, we consider only those costs that will change. Therefore, this concept of relevant costs helps us make an objective decision and eliminate distortions caused by irrelevant costs. If the order is accepted, several problems may be identified: •• There is a risk that we sell our free capacity for a low price, even though there will be no further room for accepting another order at a higher price. •• Selling the same product at a different price may result in a loss of reputation among those customers who pay a higher price. •• If a company is not able to continuously sell its whole capacity at a stable price, reducing capacity to cut fixed costs is worth considering in the long run. •• An advantage of accepting the order could be a potential penetration of a new market with a good price. Another strategic decision significantly related to the concept of relative costs concerns insourcing versus outsourcing. Outsourcing means purchasing goods or services from external suppliers, instead of direct production in a given company (insourcing). The main driver of outsourcing/insourcing decisions are costs. Decisions in favour of outsourcing are inspired by the idea that buying from a supplier is a variable cost whereas production within a company causes mostly fixed costs: in producing a given volume of goods or services, we use our own capacities, which we have to finance regardless of the volume of output. It is obvious that cost management is easier in case of variable costs. We can also illustrate it graphically. The classic concept of a break-evenpoint (BEP) is illustrated in the profile of profit or loss (Figure 3.3) for two companies, A and B that have different ratios of fixed to variable costs. The break-even point is the minimum volume of goods or services that need to be sold to achieve a zero profit. In the Figure, we see the illustration of BEP through line (A or B), which represents the fact that by selling zero goods or services, a company will suffer a loss equivalent to its fixed costs (F). With every commodity or service sold well, the loss is lower by the amount of the so called contribution margin

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(the difference between the unit price and the unit variable costs) up to the break-even point. Beyond this point the company makes a profit. Profit A

B

BEPB 0

BEPA

X

FB

FA Loss

Fig. 3.3. Profile of profit and loss by different ratios of fixed and variable costs Source: The authors' own compilation.

Line A represents a company with a higher volume of fixed to variable costs. In comparison to a company with a higher ratio of variable costs (line B), company A is more risky, because even the smallest changes of output volume against budget cause higher volatility of profit/loss. Typical companies with higher volumes of fixed costs are production companies in heavy industry, where a large volume of long-term assets and hence depreciation, high energy or payrolls cause high fixed costs. In many cases even small falls in sales lead to significant falls in profits. One easier type of decision involving cost relevance is the issue of machinery change. An irrelevant cost, which can be ignored in this case, is the book value (purchasing price minus accumulated depreciation) of the original machinery that the company would like to change. This cost was incurred in the past and therefore is an irrelevant or sunk cost. However, it is worth noting that decisions regarding capital investments are complex and involve estimations of discounted cash flows. Yet sunk costs remain sunk.

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Costs and revenues are usually booked to particular cost objects (products or departments) separately, so it would be possible to assess their relative efficiency individually. Standard calculation systems connect every cost object with direct costs and its portion of indirect costs (overheads). This may create a situation where some cost objects will appear as loss-producing and there will be pressure to drop the product from a production line, or to close a department. Before deciding whether to drop a product or close a department, we must approach the problem using the concept of fixed and variable costs. Generally, every product or department generating a positive contribution margin should be retained, unless that will also lead to lower fixed costs. Where a department or a product line generating a positive contribution margin are closed yet a drop in fixed costs is still insufficient, we lose that part of the contribution margin and some fixed costs will only be transferred to other departments or products. This may result in lower profits than were achieved before we shut the department or dropped the product. Many companies facing capacity restrictions have to decide which products to make and in what volume. In other words, if a company is at full capacity, its managers are forced to choose a product mix and scale of production that maximise operating profit. Such decisions are mostly of a short-term nature. If we consider, for instance, a car manufacturer, its managers have to adjust the spectrum of offered models continuously, according to short-term fluctuations in material costs, selling prices or demand structure in order to stay within limited production capacities. From a long-term viewpoint, it is always possible to acquire additional capacities. This is beneficial when the profit from those capacities is higher than the costs of their purchase. This type of decision making forces us to realise that any given manufacturer or businessman faces a challenge to maximise total operating profit for the whole spectrum of products in the presence of fixed factors. There may be problems formulating the most profitable solution for a chosen programme and product mix, and maximisation of the contribution margin suffers from a lot of limitations. In those cases, quantitative techniques such as linear programming may be useful. Focusing on operating profit maximisation as a quantitative factor is valid under the condition of “ceteris paribus”. When deciding on a product mix, we have to remember qualitative factors which may, from a strategic viewpoint, be more important than short-term profit orientation. An example may be

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the loss of reputation among customers whose orders cannot be fulfilled because of production restrictions. In financial management practice, its own special attitudes towards management and decision making apply. Nevertheless, the decision making process should be to some extent objectivised by using relevant financial information, including cost information, as part of cost management. Such information enables realisation of correct and non-distorted decisions and adoption of optimum solutions.

3.2. Financial analysis and risk management in SMEs

Clearly, any business entity needs an efficient and effective risk management system. In the case of SMEs, the need is especially strong since this group of enterprises usually does not have enough financial and/or human resources to control and manage risk. The reason is size and many other constraints. This is not a problem in larger companies because they have specialist departments dealing with management of large scale risks, and all other departments that face any kind of risk have to respect the specialist department`s rules, procedures and control. On the one hand, understanding financial market risk in SMEs depends to a large extent on the character and integrity of the companies` founders or owners. On the other hand, risk management in SMEs is based more on individual managers` subjective assessments than on the unbiased technical analysis typical of larger companies. Therefore, financial analysis is both a practical and a useful tool for risk management in SMEs. A bankruptcy model would be a simple model for risk assessment and risk management in SMEs. Such a model uses a selection of appropriate ratios that can help assess particular types of financial risk. The problems and limitations of financial analysis caused by using historical and limited input data can be partly eliminated by employing internal data and other information that may not be accessible to external analysts. For example, data for a shorter than standard accounting period may be more reliable and hence useful for predicting future trends. Also for internal rather than publically available analysis, we can use information such as the planned future values of certain key items in financial statements, data on capacity and effectiveness of production equipment, and on age structure of receivables and payables. The ratios that are included in the risk analysis model should meet two basic requirements. First, they should provide a comprehensive risk assess-

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ment, focused on a firm`s specific financial risk environment. Second, the different ratios should measure different aspects of a firm`s performance or environment, and be capable of distinguishing between healthy and distressed companies. The chief internal factors creating financial risk in SMEs can be found by comparing them to large businesses. The financial structure of smaller firms is much more “fragile” because they have relatively less equity finance and lower levels of liquidity than large companies. Moreover, because access to financial resources falls gradually as risk increases, it is important to monitor a firm`s liquidity and capital structure. Because a lower volume of equity implies a reduced capacity to generate financial reserves against potential losses, in its risk management a company also has to assess its profitability and its ability to create such reserves. In addition, we should consider the impact of external risk factors such as interest rates, exchange rates and commodity prices. However, we need to take into account that their impact will be finally transmitted to internal factors. A summary illustration of relationships between risk factors is shown in Table 3.1. An SME`s main internal financial risks can be assessed by means of liquidity, profitability and debt ratios. The analysis should also include external risks that affect internal risks, and in such cases additional financial market input data is required. Choosing specific ratios from wider groups of ratios and using them in the risk management model requires particular care to fulfill the requirements of comparability and to allow healthy firms to be distinguished from distressed firms. The best place to find ratios that meet these criteria are empirical studies where the models have been tested on large samples of firms. To illustrate risk management model design, we can use the classic bankruptcy model of Altman [1968] or the more contemporary empirical studies of Porporat and Sandin [2007], Cerovac and Ivičič [2009] and Khong, Ong and Yap [2011]. From these studies, which directly or indirectly examine firms` internal risk factors, we can select a set of ratios to help with SME financial risk management. Different types of risk are assessed using different sub-sets of ratios. Each of the six ratios can be used to decide whether a firm is healthy or distressed, and taken together they provide a conceptual basis for the risk assessment and risk management of SMEs. The table below gives an overview of the relationships between the types of risk and how they are measured. It is important to note that, in practical application of this model, if the value of any given ratio is moving closer to the value typical for distressed

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companies, this does not necessarily imply that the company is on the verge of bankruptcy, though it does indicate that the its risk profile is deteriorating Table 3.1. Relationships between risk factors, their impact and ratios for their assessment Risk factor type Internal risk factors

Risk

Potential consequence for a firm

Financing

Liquidity

Solvency

External risk Interest rates factors Exchange rates Commodity prices

As indebtedness increases, so does the impact of bank interest costs, and leverage risk grows ⇒ liquidity risk Insolvency Inability to generate financial reserves ⇒ insolvency risk and financial distress Inability to generate financial reserves ⇒ insolvency risk and financial distress Higher expenditures Lower revenues ⇒ liquidity risk

Ratio Debt ratios

Liquidity ratios

Profitability ratios Additional financial market information

Source: The authors' own compilation.

Table 3.2. A simple model of financial risk management in SMEs Risk

Group of ratios

Ratio

Financing Debt ratios

1. Debt ratio (debt/total assets) 2. Interest coverage ((earning before tax + interest)/interest) 3. Long-term assets/long-term capital

Liquidity Liquidity ratios

4. Net working capital/total assets

Solvency Profitability ratios 5. Earnings before interest and taxes/total assets 6. Retained earnings/total assets Source: The authors' own compilation.

The functions of risk management should respect a company`s specific characteristics, as measured by its size, asset volume, complexity of its activi-

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ties, technical and professional skills of its employees, and the quality of its business information system. All risk management models are only as good as their input data. As we already noted, risk is about changes for the worse. Risk management emphasises the fact that a firm`s survival is heavily dependent on its ability to forecast change and to be proactive rather than reactive to change. Its management has to be aware that risk management objective is not necessarily to prevent or avoid risk – much risk is inseparable from engaging in business – but to ensure that the risk is appropriately identified and measured, because we can only manage what we can measure.

3.3. Ratio analysis

Financial ratios are coefficients based on information in financial statements of an enterprise. Thus, a ratio is a relation of appropriate assets and liabilities in the balance sheet, financial result as well as between items of a profit and loss account and balance sheet. Nearly a hundred ratios are proposed currently. Calculation of 'anything that can be calculated' does not make much sense, even if computer-aided techniques are employed. A qualitative selection of ratios and their proper interpretation become more important than their quantity, therefore [Gołebiewski 2005, p. 103]. Nonetheless, 5 groups of the most common ratios can be distinguished: a) Profitability; b) Liquidity; c) Debt; d) Efficiency (turnover); e) Solvency (debt servicing).

Profitability ratios

Profitability is a correctly computed financial result of an enterprise's operations. It may be positive, indicating profitability, or negative, pointing to deficits. The profitability ratio is then a percentage rate of profit (or loss) to turnover or commitment of resources [Bednarski, 2007, pp. 96-103]. This definition of the ratio is very broad. Depending on a frame of reference adopted, one can speak of sales profitability (where the result is referred to sales revenue), asset profitability (if the result is referred to assets) and capital profitability (where equity is the point of reference). There are several varieties

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or levels of analysing profitability in respect of the sales profitability ratio as net or gross profit provide the starting points for the calculations, or whether depreciation or interest received are taken into account [Korol 2013, p. 31]. Sales profitability (also termed turnover or trade profitability) ratios express the rate of profits earned to sales revenue [Sierpińska, Jachna 2004, pp. 195-196]: Sales profitabil ity =

Net profit ⋅ 100% Net sales revenue

Gross profit margin =

Gross sales profit ⋅ 100% Net sales revenue

Gross sales profitabil ity =

Net sales profitabil ity =

Gross profit ⋅ 100% Total revenue

Net profit ⋅ 100% Total revenue

Sales profitability indicates how an enterprise manages in the market of products it offers to its customers. Thus, it represents: •• Quantity of products sold; •• Structure of product ranges of varying profitability; •• Pricing policies; •• Unit costs of sales. Levels of sales profitability depend on profile of enterprise operations and specific nature of its sector. It reflects standing of a firm in a market of products (services) offered as part of its core business. Gross margin signals how much of a gross sales profit as related to turnover is outstanding after costs of production. Its part covers costs of general management and sales. The share remaining is the sales profit (or loss). Gross sales profitability in particular businesses is commonly lower than operational profitability since financial costs (interest, discounts), expressions of an enterprise's financing policies, exceed financial revenue. Thus, high costs of debt servicing ultimately generate a deficit due to high costs of debt servicing even in spite of relatively high sales profitability. In the case of a holding, for instance, which derives financial revenue from dividend

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and shares in profits of subsidiaries, from loan interest and discounting of debt stock of such subsidiaries, gross sales profitability will be greater than operating sales profitability. Net sales profitability is also referred to as return on sales. It describes the share of net profits in value of sales. The lower the profitability ratio, the greater the sales that must be realised to generate a certain profit. Consequently, a higher ratio points to a better financial standing of a firm. In practice, high capital-consuming industries of long operating cycles which commit significant working capitals generally exhibit lower profitability than sectors with a high commitment of qualified personnel and short operating cycles [Sierpińska, Jachna 2004, p. 198]. The ratio of overall asset profitability defines the relation of net profit to assets of an entity. It indicates how effectively an enterprise uses its assets. Redundant property, as well as its partial use, will adversely affect this ratio. The higher the dependence between these items of financial statements, the better it is for an enterprise. It is computed as follows [Bień 2011, p. 100]: Return on assets (ROA) =

Net profit ⋅ 100% Total assets

Return on equity or financial profitability is the net profit per unit of (own or share) capital. It denotes ability of a business to generate profits from capitals invested by owners. A high value of this relation normally translates into greater dividend and more development opportunities for an undertaking [Bednarski 2007, p. 113]. This ratio is of particular interest to investors and shareholders, therefore.

Return on equity (ROE) =

Net profit ⋅ 100% Equity

All the profitability ratios are stimulants, that is, their growth has a positive impact on financial standing of an enterprise. Their levels depend not only on strategy of an enterprise (including financial liquidity) but also on such external factors as intensity of competition, product life-cycle, rates of exchange, economic cycles, customer structure, etc. [Korol 2013, p. 31]. The profitability ratio can be represented in diverse formats, therefore, DuPont analysis (pyramid) is of considerable assistance in such analysis (Fig. 3.4). DuPont analysis helps to examine profitability of an enterprise by means of easily available data from the profit and loss account and balance sheet.

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Employing simple techniques, this analysis can serve to explore structure of an enterprise's profitability in far more depth than using the standard ratio analysis only. DuPont analysis shows what elements and in what ways affect return on an enterprise's capitals, i.e. invested funds. ROE

ROA

Profit margin

X

Net profit

/

Sales

Sales

-

Total costs

X

Equity multiplier

Asset rotation

/

Total assets

/

Fixed assets

+

Equity

Working assets

Fig. 3.4. DuPont model Source: The authors' own compilation

Liquidity ratios

Maintaining the ability to meet short-term liabilities is a key issue of dayto-day management of enterprise finances. Short-term liabilities comprise those with due dates below a year and a portion of long-term liabilities falling due in a given year. These are primarily payable to suppliers, state budget, financial institutions and employees. An enterprise's ability to honour its short-term liabilities in time is named financial liquidity and depends on a relation of working assets to such liabilities [Nowak 2008, p. 203]. Static liquidity ratios encompass: a) Current liquidity; b) Fast liquidity; c) Cash liquidity. This division arises from different scopes of financial assets used to determine the ratios.

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The current liquidity offers an overall view of an enterprise's ability to meet its short-term liabilities. It demonstrates whether an enterprise would be capable of paying all of its current liabilities if they became payable immediately by liquidating its working assets. Resorted to in particular by shortterm lenders, the current liquidity is formulated as: Current liquidity =

Working assets Short-term liabilitie s

The ratio indicates the relation between working assets and short-term liabilities. Its optimum value, proof of a solid ability of a business to fulfill its liabilities, ranges around 2. Levels far above 2 may point to excessively cautious policies of working asset management by enterprise authorities. Ratios below 1.5 can be treated as a warning of payment difficulties. The ratio equal to or less than 1 is the most worrying proof of a firm losing or being very likely to forfeit its ability to meet current liabilities on time. It suggests all working assets of an enterprise are financed with short-term liabilities, part of which serve to cover fixed assets as well [Bień 2005, pp. 97-98]. Working assets used to calculate current liquidity are characterised by varying degrees of liquidity and thus provide an insufficiently specific view of a firm's ability to meet its current liabilities. A more detailed representation of liquidity is provided by the high liquidity ratio. It reflects the instant ability of an enterprise to repay its liabilities. This is the proportion of liquid working assets to short-term liabilities [Kusak 2006, p. 44]. Liquid working assets are working assets less inventories and prepayments. In other words, liquid working assets are short-term receivables and investments, i.e. cash in hand, cash in bank and securities. The ratio is expressed as: High liquidity =

Liquid working assets Short-term liabilitie s

Its levels equal to or above 1 may be evidence of a solid liquidity as they demonstrate a firm covers its short-term liabilities with liquid working assets. Ratios below one may point to issues with timely repayment of liabilities. Levels far in excess of 1, on the other hand, suggest overliquidity. The gap between current and high liquidity ratios should not be excessive. A great difference would mean an enterprise maintains excessive inventories which freeze working funds. The cash ratio is also employed to analyse financial liquidity by means of statistical methods. It shows what portion of current liabilities could be

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159

honoured promptly if required, without waiting for accounts receivable from business partners or for liquidation of inventories. This ratio is formulated by [ Jerzemowska 2004, p. 138]: Cash ratio =

Cash + Short-term securities Current liabilitie s

It is hard to estimate its optimum value, yet it is assumed the cash ratio should be within the range 0.1 – 0.2. Its high values prove a firm is capable of meeting its current liabilities. A ratio of 0, where an enterprise has no cash in bank, on the other hand, does not spell an instant loss of financial liquidity as repayments are received from commercial partners. The ratios discussed above suffer from a variety of imperfections, including [Kusak 2006, pp. 46-47]: •• Working assets fail to represent actual payment capabilities of a firm; the latter are decided by actual receipts from sales of products and services; •• Asset categories exhibit varied degrees of liquidity; •• The ratios define the extent to which short-term liabilities are covered with working assets, ignoring the question of time; •• Value of finished product inventories is recorded at production costs; •• Carrying and market values of working assets may differ; •• Short-term liabilities fail to exhaust all expenditure of a business in a current period; in addition, the liquidity ratios ignore the maturity structure of liabilities; •• Optimum values applied to assessments of liquidity are imprecise; •• Working assets and short-term liabilities greatly vary in time. This causes fluctuations of liquidity ratios, therefore, ratios from several consecutive periods (years) must be compared when examining financial liquidity of a business. This will serve to determine positive or adverse trends of the liquidity. These weaknesses are substantial obstacles to proper evaluation of a firm's financial liquidity, though they can be partly eliminated or remedied with appropriate adjustments and interpretation of the ratios.

Debt ratios

The liquidity ratios are complimented with debt ratios, also termed ratios of financial support. They link liabilities of an enterprise to its capital and assets and offer information on both origin and commitment of the capital. They include:

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a) Overall debt; b) Long- and short-term debt; c) Debt to equity. Specialist literature fails to offer unambiguous interpretations of values of these ratios, which means analysis of data depends on the analyst's knowledge. Overall debt =

Total liabilitie s Total assets

The overall debt ratio represents the entire debt of an enterprise as a share of its assets. Thus, the lower it is, the better the standing of a business, especially as the overall debt encompasses long-term liabilities including loans and credits. As a result, rising of overall liabilities will be probably tantamount to a growing commitment of external capital to financing of an entity. This in turn requires repayments of the capital and interest. Such an increase of liabilities in relation to assets may be reasonable where average rates of credit and loan interest are lower than profitability of assets [Bednarski 2001, p. 83]. Long-term debt =

Long-term liabilitie s Total assets

Short-term debt =

Short-term liabilitie s Total assets

The two foregoing ratios supplement the overall debt and indicate its structure. With a view to financial stability of a business and the fact that long-term debt can be regarded as fixed capital, values of the long-term debt ratio should not be very different from overall liabilities [Nowak 2008, p. 233]. The long-term debt may be supplemented with its structure, that is, share of long-term liabilities in overall liabilities. This is of secondary importance, however. Debt to equity =

Total liabilitie s Equity

Debt to equity ratio carries the information what amount of liabilities corresponds to a unit of equity. In effect, it offers a general view of capital relations in a firm and its policies of financing operations.

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Lower debt ratios are better from the viewpoint of enterprises cooperating with a given business since they suggest operations are financed with own funds and business risk is not shifted to suppliers or lenders. A combination of liquidity and debt ratios offers a view of capital and asset relations in an enterprise. Liquidity ratios, based as they are on assets of a business, provide information on its short-term solvency. They will be analysed by financial institutions providing short-term crediting and by suppliers of goods and services. A substantial coverage of working assets with liabilities points to a greater risk of such crediting or of delayed payments. Low liquidity signals the jeopardy of losing liquidity, although short-term losses are not dangerous as a rule. Overliquidity means smooth repayments of liabilities on the one hand and reduced profitability on the other hand [Kopczyńska 2007, p. 358]. Debt ratios are grounded in equity and liabilities indicate sources of assets. They are more important in the long run. They also describe policies a business pursues to use the available capitals for the purposes of financing its activities.

Efficiency ratios

Efficiency ratios are also referred to as ratios of turnover, rotation or business activity. They assess effective use of an enterprise's assets and thus determine if they are adequate to requirements. Key relations comprise: a) Turnover of assets; b) Turnover of fixed and working assets; c) Turnover and rotation of inventories; d) Turnover of receivables. Turnover of assets, the relation of sales to assets, is the most general ratio. Turnover of assets =

Sales revenue Average assets

Adoption of 'average assets' is reasonable as it levels out seasonal fluctuations of assets or their incidental accumulation. The ratio determines what sales are generated by each unit of assets committed. Therefore, the higher the ratio, the better it is for a business, since it denotes more effective use of existing resources and improved business performance. The ratio will vary depending on type (industry, trade) or even sector of an enterprise due to capital consumption of manufacturing – fixed assets display poor turnover as they transfer their value to products over many production cycles. It is there-

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fore important to determine shares of fixed and working assets in revenue [Kopczyńska 2007, p. 365]. Turnover of fixed assets =

Turnover of working assets =

Sales revenue Average fixed assets

Sales revenue Average working assets

This is reflected in the above two ratios. Both net and gross fixed assets may be considered, though the former appears more reasonable in longer time-frames as ignoring depreciation will increase the ratio and such a change will offer insights into condition of the assets. The other ratio offers supplementary information on how assets are utilised. This is a mathematical addition to the first, general turnover ratio, yet it signals the rate at which financial assets circulate. Working assets consist of both cash (including short-term investments) and inventories. Therefore, analysis of turnover cannot ignore rotation of inventories, including both materials, production in progress and finished products. Inventories of materials are directly related to production volumes and inventories of finished products to anticipated sales. Deficits of material inventories will interrupt manufacturing and excessive inventories mean unnecessary freezing of finance. Aside from the logistics, inventory turnovers matching production cycles are of importance. Turnover of inventorie s =

Sales revenue Average inventorie s

Turnover of inventories indicates how many times in a given period a business has refreshed its inventories. The higher it is, the greater the turnover and the better standing of a business, therefore. There is a risk, of course, that this is due to low stock levels and a hazard to continuity of production and sales. A low ratio points to an excess of inventories compared with production and sales capacities and the consequent reduced profitability. Turnover of inventories in days may be extremely useful in the process of management. To this end, the reversed ratio should be multiplied by the number of days in a year, as formulated by:

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163

Average inventorie s ⋅ 365 Sales revenue 365 or Turnover of inventorie s in days = Turnover of inventorie s Turnover of inventorie s in days =

The ratio representing the average time after which receivables are repaid, or turnover of receivables, is another major efficiency ratio, defined as the relation of sales revenue to sales receivables: Turnover of receivables =

Sales revenue Average receivables

The result specifies how many times a year (or another period for which the ratio is computed) a business reproduces its accounts receivable. By American standards, this should range from 7 to 10 [Sierpińska, Jachna 2004, p. 184], equivalent to an average time of repayment of between 5 and 8 weeks (35-64 days). Turnover of receivables basically depends on trade policies of an enterprise and is determined by both sector of its operation and competition in the market. Importantly, accounts receivable should not exceed sales profits, as this would mean the accrued profit does not reflect cash flows. All the turnover ratios can be converted into rotation ratios by multiplying their reversed values by the number of days in a period under analysis. A cycle of complete change in days will result. The individual ratios can also be made more specific (like the turnover of assets) by calculating rotations of particular inventory items or by analysing structure of accounts receivable (overdue, bad) in more detail. Level of the detail depends on precision of analysis.

Solvency ratios

Each entity employing external sources of financing must repay capital and due interest. As a result, solvency of enterprises, that is, their ability to service their debts, needs to be analysed. Solvency ratios are therefore fundamental instruments of business evaluation by potential lenders, beside the debt ratios. They include: a) Debt coverage with profit; b) Interest coverage with profit; c) Debt coverage with financial surplus.

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Coverage of debt servicing is the basic ratio estimating the ability to service debts. It comes in several varieties: Debt coverage ratio 1 =

Debt coverage ratio 2 = Debt coverage ratio 3 =

Gross profit + Interest Capital instalment s + Interest

Net profit Capital instalment s + Interest Net profit + Interest Capital instalment s + Interest

The first debt coverage ratio informs to what degree profits generated are sufficient for servicing of debt. The numerator contains pre-tax profit and is thus insensitive to different rates of taxation in various states and can serve for the purposes of comparison. Since it represents coverage of long-term liabilities, it absolutely must be greater than one. Liabilities to the state take precedence over others in the Polish circumstances, therefore, its minimum value cannot fall below 1.2. Only 2.5 is considered optimum, though, as it provides for debt servicing even if profits decline by a half. The remaining debt coverage ratios are based on net profits. This is reasonable insofar as profits after taxation may be used to repay credit instalments. Banks apply yet another ratio, however. This is a development of the ratio based on net profits and interest and comprises taxation of that interest: Debt coverage ratio 4 =

Net profit + Interest ⋅ (1 − Rate of income tax ) Capital instalment s + Interest

Since this ratio encompasses net profit, it can be a little more than one. One means that the entire profits are assigned to repayment of liabilities, therefore the higher it is, the better for an enterprise and its potential lenders. Its decline over time may signal ineffective management or overinvestment. Persistently low values are a sign that renegotiation of credit agreements must be attempted. An enterprise's ability to service interest is an equally important ratio. Terms of renegotiated credit agreements commonly envisage suspension of capital instalments and only repayment of interest. Interest coverage =

Gross profit + Interest Interest

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165

As the ratio ignores capital instalments, its value of one is virtually unacceptable. This would mean a business is only capable of repaying interest on the external capital made available. 4 – 5 are its assumed optimum values [Sierpińska, Jachna 2004, p. 171], though always with reference to position of an enterprise (debt levels, rate of credit interest, profits generated). Long-term crediting is chiefly taken to finance development projects. In effect, the financial surplus defined as the sum total of net profit and depreciation must be employed to assess solvency in these circumstances. Debt coverage with financial surplus =

Net profit + Depreciati on Capital instalment s + Interest

1.5 is the preferred value, which means the financial surplus should be 50% greater than total periodic credit repayments and interest as a minimum.

3.4. Simplified methods of evaluating financial standing of an enterprise

Analysis of economic effects and processes is inevitable for successful company management and execution of company activities. The analysis is a general methodological procedure of scientific research, the method of recognition. When analysed, an object of research is divided into smaller parts so that the result of their deeper understanding is more profound cognition and determination of the object, phenomenon or process [Lesáková 2007, p. 7]. Business management in a continuously changing environment, rising customer needs and intensifying competition requires actions to boost functional efficiency. To eliminate errors when making such decisions, information about internal and external position of an enterprise must be accessible on an ongoing basis. In this way, managers learn about causes of shifts in the environment, consequences of intended actions and factors interfering with the planned course of economic processes and phenomena.

Discriminant models

Discriminant models are the most popular method of examining financial risks in enterprises. Evaluation of financial standing of enterprises and early detection of bankruptcy tendencies become feasible then. These models, also called early warning systems, refer to the area of finance in a given enterprise

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by analysing its payment capabilities, since it is solvency issues, not unprofitability, that are the main causes of bankruptcies. As far as numbers of variables are concerned, the discriminant models can be divided into; •• Linear models – developed at initial stages of development of bankruptcy forecasting; financial standing of an enterprise is characterised with a set of single equations describing selected economic ratios, •• Multiple models – based on parallel analysis of many financial ratios.

Linear models

The first early warning system, based on linear discriminant analysis, was developed by P. J. Fitzpatrick in 1932. The model was a response to frequent bankruptcies which plagued the United States during the Great Crisis at the turn of 1920s and 1930s. Fitzpatrick [1932] distinguished two ratios that can serve to divide enterprises into solvent and insolvent: Ratio X1 = net financial result / equity capital (fund), Ratio X2 = equity capital (fund) / external capital.

His analysis was applied to 38 businesses, a half in good financial condition and the other half in bankruptcy. Enterprises in the same sector had similar balance sheet totals, turnovers and geographical locations. Research into financial ratios of maximum diagnostic power was undertaken on a broader footing by the National Bureau of Economic Research [Merwin 1942]. 939 American companies, including 538 in bankruptcy and 401 of solid standing in 1926-1936, were analysed. The following ratios were found to exhibit maximum diagnostic power: •• Net working capital/ total capital •• Equity capital (fund) / external capital •• Current assets/ current equity and liabilities. The study demonstrated the ratios varied widely between solvent and insolvent enterprises six years before de-registration. C.L. Merwin's fundamental contribution was the first-ever calculation of arithmetic means for particular groups of solvent and insolvent businesses. W. H. Beaver's [1966, pp. 77-111] is among the best known linear discriminant models. The author examined 79 solvent and 79 insolvent American companies. They were from diverse industries, yet of similar sizes and legal status. 6 ratios were selected that, in their different ways, indicate deteriorating economic and financial position of enterprises.

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X1 = net profit + depreciation / total liabilities X2 = net financial result / total assets X3 = total liabilities / total assets X4 = working capital / total assets X5 = working assets / short-term liabilities X6 = working assets - inventories / operating costs- depreciation. If a dynamic adverse trend can be observed in an enterprise, bankruptcy can be expected. It is the most likely where all the 6 ratios point to such a risk. The first ratio, defining the ability to meet liabilities out of financial surplus, classified bankrupt enterprises with a probability of 87% a year before bankruptcy. The author claimed the first out of six ratios is of a maximum weighting. Its probability of error is very low, 13%. Ratio two also displayed considerable predictive power. Statistical values of the third ratio grew steadily for the five years under examination in the case of enterprises exposed to bankruptcy. High debts and liquidity problems have always led to bankruptcy. Table 3.3. Predictive errors in subsequent years prior to bankruptcy determined as part of W. H. Beaver's system Design of ratio

Net financial surplus / total liabilities Net financial result /total assets Total liabilities /total assets Net working capital /total assets Current assets /liabilities Ratio of credit-free gap

1

Errors in subsequent years 2

3

4

5

(0.10)**

(0.18)

(0.18)

(0.24)

(0.22)

(0.12)

(0.15)

(0.22)

(0.28)

(0.25)

(0.19)

(0.24)

(0.28)

(0.24)

(0.27)

(0.20)

(0.30)

(0.33)

(0.35)

(0.35)

(0.20)

(0.27)

(0.31)

(0.32)

(0.31)

(0.23)

(0.31)

(0.30)

(0.35)

(0.30)

0.13* 0.13 0.19 0.24 0.20 0.23

0.21 0.20 0.25 0.34 0.32 0.38

0.23 0.23 0.34 0.33 0.36 0.41

0.24 0.29 0.27 0.45 0.38 0.38

0.24 0.28 0.28 0.41 0.45 0.17

* Error committed when dividing the second sub-group (using critical values based on the ratio values in the first sub-group). ** Error committed when dividing the first sub-group (on which the critical value is based).

Source: [Rogowski 1999, p. 62].

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W. H. Beaver believes an enterprise is exposed to a very high risk of insolvency if all the six aforementioned ratios are in the area of high risk. If more than three ratios are below boundary values, an enterprise is insolvent. If one or two ratios are at critical levels and the others in the grey area, an enterprise must be subjected to additional analysis. W. H. Beaver drew two conclusions from his research: 1. Not all the ratios have identical predictive power. 2. Analysis of financial ratios is only of use to assessing symptoms of an imminent bankruptcy for at least five years before its actual occurrence.

Multiple models

Z –score method Ratios signalling imminent problems are of particular interest to analysis of an enterprise's financial standing. Fast recognition of these signals frequently decides effective counteraction and overcoming of difficulties. Financial decline of an enterprise may be a slow, gradual and nearly imperceptible, as well as an abrupt and distinct process. It is therefore reasonable to track appropriate ratios and draw conclusions not only during a single period (year) but also considering several years. Superficial observations and estimates may be especially misleading at a time of inflation. Difficulties may be perceptible only with regard to some ratios concerning only selected areas of enterprise operations. Symptoms and signals of risks to financial standing of an enterprise can be roughly divided into: external and internal, financial and non-financial. External symptoms are signals from the environment where an enterprise functions. They can be split into [Bednarski 2002, p. 166]: •• Foreign symptoms, •• Domestic symptoms, •• Sectoral symptoms. Internal symptoms relate to a variety of factors associated with certain property, capital and human resources of an enterprise and their use, organisational standards and actual qualifications of management staff, suitable to management of business information systems, in particular, of management accounting and financial analysis. Financial symptoms are mainly derived from reliable data in financial statements, calculated and interpreted financial analysis ratios. Such symptoms of a deteriorating financial position of an enterprise may include in particular [Bednarski 2002, p. 168]:

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•• Substantial reduction of gross (and net) profit or a net loss, that is, declin-

ing levels of basic profitability ratios,

•• Low financial liquidity ratios and the resultant shrinking financial cover-

age (solvency) – commonly linked to growth of bad accounts receivable,

•• Recurrent preponderance of extensive over intensive factors in cause-and-

effect evaluations of sales revenue and financial result,

•• Distinctly rising requirements of loans and crediting and their irregular

repayments, Escalating liabilities to suppliers and public institutions, also overdue (in spite of sanctions), Increasing costs of financial operations, •• Funding of current operations with discounted promissory notes and securities and occasionally with sales of fixed assets at lower prices, •• Expanding freezing of resources in delayed investments, •• Growing stock of production in progress and products (goods) of poor saleability, obsolete material inventories and their defective structure. –– Special attention should be paid to the following non-financial (operational) symptoms of a shaky financial standing of enterprises: –– Lack of future-oriented, realistic plans of enterprise development, limited numbers of own patents and useful purchased licences, –– Frequent changes in management posts, absence of adequately qualified and competent backup personnel, no changes of directors' conduct and lifestyle, –– Lack of a properly organised and functioning internal control, –– Relatively shrinking share of an enterprise in total sales of a given sector, –– Adverse ageing of plant and equipment, negligence of repairs and maintenance, low technological standard of production, high energy consumption and impact on the environment, –– Strong negotiating position of trades unions in the enterprise, –– Loss of key clients and financially reliable customers or good sources of supply, –– Considerable redundancies, reduction of effective working time and restriction of employee benefits. American literature offers a number of ways of evaluating financial position of enterprises threatened with bankruptcy. Z-score (or Zeta-analysis) system, developed principally by Edward J. Altman [1968, pp. 589-609], regarded as the father of Z-score index, deserves particular attention. The system relies on application of appropriately designed analytical ratios. Real

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Financial tools in management of small ...

values of these ratios, multiplied by appropriate adjustment coefficients and then summed, produce a synthetic (global) ratio helping to assess the situation. Boundary values of Z-score ratio range from 1.81 (risk of bankruptcy) to 2.99 (satisfactory situation). Calculations are based on the following ratios and corresponding adjustment coefficients [Gajdka, Walińska 2000, p. 203]: X1 – relation of working capital to total assets – coefficient 1.2, X2 – relation of retained profits to total assets – coefficient 1.4, X3 – relation of gross profit adjusted for interest to total assets – coefficient 3.3, X4 – relation of share capital's market value to total liabilities – coefficient 0.6, X5 – relation of sales revenue to total assets - coefficient 1.0. E J. Altman went on to modify the Z-score system, chiefly for joint-stock companies. Retaining the above model and the five ratios, the following modified coefficients were applied: Z - score = X1 0.717 + X2 0.847 + X3 3.107 + X4 0.420 + X5 0.998 The following boundary values of the ratio were defined:

•• Below 1.20 – high risk to the financial situation, •• Above 2.90 – satisfactory position of an enterprise.

Z is below 1.23 for entities exposed to bankruptcy, whereas solvent enterprises display values above 2.9. E.I. Altman described the range 1.23–2.9 as 'the grey area' – potentially including both enterprises which are solvent and tackling problems of timely repayments, that is, jeopardised with bankruptcy. Interest in extrapolating the risk of enterprise insolvency in Poland dates back to the early 1990s. The discriminant method was based on analysis of enterprises in solid and poor economic and financial standing. The particular sectors and enterprise groupings by location and type were analysed. A set of ratios was then constructed to determine standing and development opportunities of enterprises as well as levels of the ratios. Individual ratios were then weighted by means of the statistical method of discrimination. The weightings represent dependences between levels of the ratios and overall condition of an enterprise. Six ratios deciding condition of an enterprise are applied to a simplified discriminant analysis. These are [Rolbiecki 2000, p. 22]: 1. Relation of gross profit and depreciation (surplus cash) to liabilities (external capital), 2. Relation of the balance sheet total to liabilities (external capital), 3. Relation of gross financial result to assets (ROA), 4. Relation of gross financial result to sales (ROS),

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Chapter 3: Tools for evaluation of financial condition  ...

5. Relation of inventories to turnover, 6. Relation of sales to assets (asset rotation). Weighting of the particular ratios, expressing significance of a ratio to the overall standing of an enterprise, was determined based on results of analysis. The simplified discriminant analysis places special emphasis on surplus cash (profits and depreciation) earned by enterprises, therefore, profitability of assets and turnover are the key ratio weightings. Weights of the six ratios employed in the multiple discriminant analysis are illustrated in Table 3.4 below. Table 3.4. Discriminant ratios No. 1.

2. 3. 4. 5. 6.

Ratios Gross result + depreciation Short-term and long-term liabilities Balance sheet total Short-term and long-term liabilities Gross result Assets Gross result Turnover Inventories Turnover Turnover Assets

Weighting 1.50

0.08 10.00 5.00 0.30 0.10

Source: [Rolbiecki 2000, p. 22].

The sum total of the six weighted ratios (W ) estimates standing of an enterprise against a scoring scale based on empirical research. The scoring scale is as follows: W