You are at work one day and you have a great idea. You know in your heart it is going to work and you are all excited. After a whole night’s work you storm into your executive managers cubicle (because there is a prize for innovation in the company) and you start blurting out the idea. You are excited and you explain how this could work and how that can be managed.
He asks a basic question – what is the ROI? You are stumped. Your mind races – what does ROI stand for? You will be excused if you thought it is a new employee called Roy that joined the company who was never introduced to you. Piece by piece the executive asks questions about the resources that will be required, over what time, what is the payback and how sensitive these assumptions are. The great idea is lost in a range of numbers and without the right terminology and understanding the great idea dies.
So to shed some light on it, it is important to start learning about the world of finance.
ROI stands for return on investment and immediately implies two things. The first is that there is an amount that needs to be invested and that after the whole business, there is something that happens called return. Return is profit. So basically the executive wants to know if it will make money and how much. When talking about this profit is very important to understand if profit is before tax or after tax. When he asked for the ROI, he simply wanted to know if it will make money, and how much.
The investment could be money, time and other resources. And payback basically means that the executive wants to understand how quickly you plan on making money so that he can assess the payback period. Sensitivity talks about the riskiness that underlies the business model for this type of investment and how confident you are in these profit projections.
Yes – your executive manager wants to know how you will move your idea from just an idea to a practical business model and how you will use your budgets, targets and general management skill to turn this into a return for investors.
You may think that this is all too much to learn to just execute on a simple idea – but there is more to it.
At any given point in time a business has a multitude of different investment options and in an ideal world should only invest in ideas that give a return to investors.
In evaluating the different ideas in a business a tool called the required rate of return gives a n insight into the return that is required from new initiatives to satisfy investors expectations, inflation and at a basic level be sufficient to convince the investor to take their money out of the bank and trust management to make them this return. If the company invests in projects that do not have the required return, then capital tends to go to places where the required return can be achieved – and if there are no such places, then it goes back into the bank.
If the return is not high enough then it is simple – back an idea with higher returns. While not always the best way to look at the problem – it is a very deep underlying principle in business.
So to sell an idea it is always important to understand some basic finances. So it starts with understanding that you need to sell something to people.
- The amount of sales is called turnover.
- To get the product to the customer involves a cost of sales.
- The difference between sales and cost of sales is gross profit.
- After all you other expenses – you have net profit.
- Net profit gets taxed.
- Net profit after tax gets distributed to investors.
This is very basic accounting and once you understand this then you can move onto very basic finance
- Income Statements
- Balance Sheets
- Trial Balances
- Cash Flow statements
- Ratio analysis
Everything that we have seen so far looks at the past and sets the stage for starting to look towards the future. The next step is to get up a level and start understanding cost and managerial accounting, financial management and finance.
- Cost accounting looks at how much each aspect of a different costs and also how much it generates.
- Managerial accounting looks at how to evaluate profitability of different options in the business.
- Financial management looks at the controls within a business and how to ensure that there is governance and compliance and accurate reporting. The auditors gives management an overview of how healthy this functions is.
- Finance looks at the decisions related to capital allocation, capital raising and optimising the use of capital across the business.
There are within each of these disciplines a plethora of further disciplines and specialisations.
So what on face value seems to be a basic function that often gets lumped under the general heading of “Finance” turns out to be a complex set of functions, skills and disciplines that is instrumental in making a business work.
While it is not critical that you do all the work, as a manager you benefit greatly from an understanding of finance and being able to interrogate the numbers effectively.
Did you know that the first shares ever issued was to finance shipping missions by Dutch traders that went on risky missions to get spices, gold and other commodities in foreign markets. Because such big ideas required so much money and had a lot of risk, you would have had to explain to people why they should risk this money on a crew that goes into the sea and takes the risk of bringing back cargo. You would have had to explain many things before someone would part with their capital and would have to offer them a portion of the cargo when they returned.
Great ideas become successful when they are invested in and when they can show their shareholders that there is a return on the other side. So innovation is not only about waking up in the middle of the night and making a new product or process, but also about translating this into facts and figures for investors to understand what is going to happen here.