In addition to having appropriate products and services, a company’s taxation and financial issues must be in order to ensure successful and sustained operations. Financial diagnostics helps with this.

Large companies generally have the necessary staff. It is not unusual for the finance manager to be supported by separate financial and accounting staff, and for additional controlling staff or a team to help define the appropriate cost structure and keep costs within limits. In this way, thorough knowledge of cost structures supports these companies with pricing. It is also natural that other functions required for acquisition, manufacturing, sales and operations have independent responsibilities too, with a specialised manager and staff and a control mechanism adjusted to the professional area.

Challenges for SMEs

By contrast, the majority of the above functions often either overlap or, in unfortunate situations, are completely missing in small and medium-sized companies in Hungary. The managing director and the owner are often the same person, managing acquisitions, manufacturing and sales, and also bringing in business and actively participating in product development. Generally speaking this means there is no longer sufficient time and energy for finances. This is particularly true if the manager is not a financial professional but comes from an engineering, technical, chemist or sales background, and lacks the inclination to pay sufficient attention to the company’s financial issues.

Yet a company may flounder even with the best product or service, or can be doomed to fail if its finances are not in order. Do not forget that a business is primarily established to make a profit.

Additionally, Hungarian SMEs have to stand their ground in the same economic environment and generally have to comply with the same legal regulations as large companies. Indeed, in certain cases they have to make significant efforts to obtain appropriate funding.

Financial awareness

By the time some managers recognise that their company can only be sufficiently successful if its finances are in order, years may have passed without paying substantial attention to this area. Even worse, a problem arises that compels the manager to think about why his company makes losses when their product is believed to be successful and of high quality.

If the situation can still be saved (even in such cases), the problematic areas, which can make the company profitable or put it on a faster growth path if they receive more attention, can be identified through quick and professional financial diagnostics. And by maintaining financial awareness, the risk that the company might face a difficult situation again due to its finances can be mitigated.

Conducting financial diagnostics

Although financial problems may differ by company, there are areas to which attention should definitely be paid during the conducting of financial diagnostics.

For example, it is important whether a given business line or product is profitable or not. If it is, what does this mean precisely? How much profit does it generate? Does it cover variable costs only, or is the profit also enough to cover the given proportion of fixed costs? If a product makes losses does its production really have to be terminated, or will this put the company in an even worse situation?

It is also worth reviewing who generates cash inflows and outflows and at what pace within the company. Is the company not too generous with customers in terms of payment conditions? Do its suppliers offer payment assistance options that are perhaps due based on the size of the order?

WTS Klient Hungary has been able to help many companies by performing financial due diligences. The diagnosis not only gives a clear picture, but also helps specify the path and tools necessary to ensure stress-free growth. How does this work in practice? Send us an email, we will make an appointment, and you’ll find out the most important issues within a quarter of an hour.

 

Csaba Baldauf
senior manager
Tel: +3618873792
csaba.baldauf@wtsklient.hu

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Advantages of calculating depreciation 

In this case we have to calculate the period over which our invested capital will be recovered. We can apply a simple formula for this in which we should define time in terms of years.

R=I/G where “R” indicates the recovery of the investment amount, “I” is for the one-off investment amount, and “G” stands for the annual profit.

Let’s take an example. The value of our investment is HUF 10 million (approx. EUR 32,000) and we would like to achieve an annual profit of HUF 2 million (approx. EUR 6,400).

R = HUF 10,000,000/2,000,000 (approx. EUR 32,000/6,400) = 5 years

The method is simple, and is used very frequently for investments. We can compare the required recovery period easily and quickly. But this is also its disadvantage, since it means the evaluation aspects can only include liquidity and security. The remaining term of the investment after the recovery period and the profit that it can generate are ignored here. An additional risk is that the formula does not take into account the period of the depreciation itself.

Where should we use the method for calculating depreciation? 

Applying this method is mostly justified in the case of venture capital investments using external financing and for investments where we know the time of the asset’s replacement and its optimal useful life in advance.

It can be really useful if it is applied together with another investment evaluation method, for example, with the profitability calculation previously described, thus collectively they can form an appropriate basis for comparing the capital utilisation options.

Advantages and disadvantages of static investment calculation methods

Since calculating depreciation is the fourth and last static investment calculation method, it is worth evaluating the static procedure itself.

Its greatest advantage is manageability and transparency. We can obtain the necessary information relatively quickly. This is probably the most obvious method to assess traditional and smaller investments.

We can recommend static methods most easily for cases when you can fix the target figures and their components in your project in advance.

The disadvantage of static methods is that they cannot manage interdependencies between different areas of a company, they do not assess the relationships between the various investments, and do not assess temporal changes in profits or the useful life itself either.

To sum up, the static procedure is simple and easy to manage, but if the investment is supported with a more sophisticated IT and communication system then it can be mapped better with a more complex assessment method.

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Under the static methods we first examined cost comparisons, establishing that this is simple, but if we are interested in the performance side of a project it is not enough. If we can plan the performance or output expected from the asset to be acquired, it can be worth examining the profit comparison method.

In what sense does a profit comparison do more?

In this case, not only the costs of the project or the investment are compared, but also its result and income-generating capacity. Thus, the performance of the individual projects becomes measurable too. This means an investment can be deemed more favourable even if it would otherwise have been neglected because of its higher overall cost.

If we manufacture products of nearly the same quality, then looking at the very costly investments it is worth selecting the one where production ensues at a lower unit price due to the higher capacity utilisation. Let us compare our planned costs for the whole year, but also consider the generated results. During a profit comparison calculation we can convert potential quality differences between the products to be manufactured into HUF, using the expected sales price difference.

A simple example of a profit comparison may look like this:

From the example it is clear that while the cost is higher (nearly HUF 7 million – approx.  EUR 22,900 – for the new asset as opposed to HUF 1.8 million – approx. EUR 5,900), the expected revenues are also higher (HUF 18 million – approx. EUR 59,000 – for the new asset, and HUF 9.6 million – approx. EUR 31,500 – for the old asset, so the difference is HUF 8,400,000 – approx. EUR 27,500). If we base our decision on the profit comparison, then obviously we will choose to replace the old asset.

What are the advantages and disadvantages of a profit comparison?

It does have a decisive advantage in that, as opposed to the cost comparison mentioned above, it also considers the revenue aspect.

The potential disadvantages of the method are as follows:

• We receive no information on the extent of any capital investment.
• We do not see the profitability.
• If the useful lives of the assets to be acquired are different, we can draw the wrong conclusions in the case of an incorrect calculation.
• We did not examine the risks of the investment.

Where can we use it?

• If the assets to be acquired are relatively independent of each other, use of a profit comparison is limited.
• It is the most practical method for a capacity expansion, especially when a profitability ratio can clearly be allocated to the assets.

Finally, do not forget that a profit comparison, as a frequently used static investment evaluation method, does not consider the cost of external financing or depreciation.

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Quick evaluation of investments – can this be done professionally?

Yes, it can, but we have to clarify some principles and find appropriate practical solutions. Then we have to keep to the set path.

Necessary principles:

• investment calculations should be the starting point of any investment decision
• select the appropriate calculation method for each investment category
• make more thorough and quicker decisions with the new method

There are two main groups in terms of the methods applied for investment calculations: static and dynamic methods. With the static methods, we can focus on costs (cost comparison is important here), profits, profitability and depreciation. With the dynamic methods, the value of capital, annuity calculations and possibly the internal rate of return can be important.

Cost comparison

In this case, we compare the costs of two or more processes or projects. Generally speaking we have a process, and we already know what kind of result it will produce; then we choose an alternative process for it, which at the very least has to reach the same result in terms of output, and ideally at a lower cost.

The disadvantage of the cost comparison is that it does not take the project’s capital investment requirements and potential yields into account, we can only define the annual costs once, so they remain unchanged. Additionally, we cannot record the changes in value occurring during the project, so we have to work with averages.

One great advantage though is that this is one of the simplest calculation methods. Determining costs is still the simplest task, and defining the value of future benefits does not complicate our lives either.

When is it worth applying the cost comparison method?

• for initial investments, when we know what the required performance is and we can achieve it with several alternatives
• for supplementary investments, when we want to achieve a specific increase in turnover, and we can choose from several investments
• for replacement or rationalising investments, when we replace some of our manufacturing capacity, so only costs can be compared

When is the cost comparison method not enough?

If the investment focuses on two assets with very similar performances (in terms of both technical parameters and the initial acquisition value), then the annual costs due in the following period have to be taken into account during the investment.

If we see there is a difference in performance between the investment options, we have to switch to defining item costs.

However, this latter alternative is only useful as long as the investment with the greater utilisation level enables a lower item cost with unchanged quality. If the quality changes in the meantime, the performance will also change, and then we have to examine the results too, so the profit comparison method will be the right option instead of cost comparison.

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