Financial Concepts for Inhouse Legal Counsel and Contract Manager

Chapter 1 - Introduction Lesson 1- Finance and it’s role. Business is all about money and money in business terms are euphemistically called as Finance which is nothing but better and sophisticated version of money. Actually, Finance has a bigger and more complex meaning and role than money. Money is just a nominal value or a unit of transaction whereas Finance is money plus management of money. The moment management gets associated with money it means the complete detail of money involved in a transaction, its history, present and future interpreted in multiple ways, ratios and features. Anh business person must have, to a certain degree, the understanding of finance as it helps in making big and small business decisions. Regardless of which department a person belongs to, he or she need to have a fair knowledge and understanding of some important concepts of Finance. And this hold true for lawyers as well, especially the lawyers who are employed with corporates as Inhouse Legal Counsels and Contract Managers.   Lesson 2 - Importance of knowledge of finance for Lawyers, Inhouse Counsels and Contract Managers Lawyers in corporate world, especially the Inhouse Counsels and Contract Mangers play a role bigger than what a normal advocate would play. These people have to wear multiple hat on top of the Lawyer’s hat. It is pertinent for a Corporate Counsel to know all about the applicable laws in his or her area of expertise but at the same time the moment one joins a company or an organization as a counsel, he or she has to know and understand the nuances of business by walking few steps beyond the legal world. The usual expectation of the business leaders and other team members from a counsel or a contract manager is that they would understand the underlying risk and help in building the revenue from every business transaction whether within the organization or outside. For a contractual transaction, a counsel or a contract manager is not only supposed to point the legal risk involved in the contract but also to highlight and provide solution, if any, on quantum of money involved, revenue management, money at risk management, service credit implication, invoice and credit cycle etc. It has been observed that a lawyer with finance understanding is always sought after and proves to be a great asset to an organization.   Lesson 3- High level view of financial concepts – Balance Sheet and Profit and Loss Account BALANCE SHEET       The balance sheet tells us what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. It's called a balance sheet because the two sides balance out. It can be elaborated like this:  a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity). Balance sheet is a snapshot of a financial condition of a company. It tells the exact financial conditions at a particular point of time or date as mentioned on the balance sheet. The three major items on the balance sheet are Assets, Liabilities and Shareholders’ equity. The normal formula to balance out the items in a balance sheet is as follow; Total Assets = Total Liabilities + Shareholders’ Equity   Assets - Assets are economic resources that are expected to produce economic benefits for their owner   Liabilities _- Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees. Shareholders’ Equity - Shareholders' equity is the value of a business to its owners after all of its obligations have been met. It generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.   PROFIT AND LOSS ACCOUNT (INCOME STATEMENT) An income statement or profit and loss statement is a financial statement that reports a company's financial performance over a specific accounting period, usually a financial year. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period. Unlike the balance sheet, which covers one moment in time, the income statement provides performance information about a time period. The income statement is divided into two parts: operating and non-operating. The operating portion of the income statement discloses information about revenues and expenses that are a direct result of regular business operations. For example, if a business makes and sells aircraft, it should make money through the sale and/or production of aircraft. The non-operating section discloses revenue and expense information about activities that are not directly tied to a company's regular operations. Continuing with the same example, if the aircraft company investment securities, the gain from the sale is listed in the non-operating items section.   Chapter 2- Balance Sheet- Important Financial concepts Lesson 1 – Asset Assets are sometimes defined as resources or things of value that are owned by a company. Some examples of assets which are obvious and will be reported on a company's balance sheet include: cash, accounts receivable, inventory, investments, land, buildings, and equipment. An asset is an item that the company owns, with the expectation that it will yield future financial benefit. This benefit may be achieved through enhanced purchasing power (i.e., decreased expenses), revenue generation or cash receipts. There are broadly two types of Assets namely, Current Assets and Long Terms Assets. Current Assets - Current assets are those assets that you expect to either convert to cash or use within one year, or one operating cycle?whichever is longer. Examples of current assets include cash, accounts receivable and inventory (e.g., raw materials, work in progress, finished goods). Long Term Assets - Long-term assets are those that you use in the operation of your company and that will continue to offer benefit beyond a single year or operating cycle. Examples of long-term assets include buildings, machinery and equipment (also known as fixed or capital assets). Many long-term assets are amortized as they are used.   Lesson 2- Liability The opposite of assets are liabilities. Liabilities are amounts that the company owes and will have to settle in the future. Like Asset there are two kinds of liabilities namely Current Liabilities and Long Terms Liabilities. Current Liabilities - Current liabilities are those that are expected to be settled within one year, or one operating cycle?whichever is longer. Examples of current liabilities include accounts payable, demand loans and current portions of long-term liabilities.   Long Term Liabilities - Long-term liabilities include ongoing commitments such as loans, mortgages, debentures, finance leases and other long-term financing arrangements.   Lesson 3 – Shareholders’ equity Shareholder's Equity consists of two main things: The initial capitalization of the company (when the shares were first sold, plus extra share issues) and retained earnings, which is the amount of money the company has made over and above capitalization, which has not been re-distributed back to shareholders.   Shareholder's Equity is neither an asset nor a liability: it is used to purchase assets and to reduce liabilities, and is simply a measure of assets minus liabilities that is necessary to make the accounting equation balance. Chapter 3- Profit and Loss Account – Important Financial Concepts Lesson 1- Revenue (Top line) Revenue for a company is the total amount of money received by the company for goods sold or services provided during a certain period of time usually a year. It is the amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is also called as the "top line" or "gross income" figure from which costs are subtracted to determine net income Lesson 2- Expenses An expense is defined as an outflow of money or assets to another individual or company as payment for an item or service. It is the money spent or cost incurred in an organization's efforts to generate revenue, representing the cost of doing business. Expenses may be in the form of actual cash payments (such as wages and salaries), a computed expired portion (depreciation) of an asset, or an amount taken out of earnings (such as bad debts).   Lesson 3- Gross Profit Gross profit is a company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Gross profit is important because it reflects the core profitability of a company before overhead costs, and it illustrates the financial success of a product or service.   Lesson 4- Operating Profit The difference between revenues and costs generated by ordinary operations, before deducting interest, taxes, investment gains/losses and various non-recurring items. Operating profit is the profit earned from a firm's normal core business operations. This value does not include any profit earned from the firm's investments, such as earnings from firms in which the company has partial interest, and the before the deductions of applicable interest and taxes owed.   Lesson 5-  Profit before Tax Profit before tax (PBT) is a profitability measure that looks at a company's profits before the company has to pay corporate income tax by deducting all expenses from revenue including interest expenses and operating expenses except for income tax.   Lesson 6- Profit After Tax (PAT) The net amount earned by a business after all taxation related expenses have been deducted. The profit after tax is often a better assessment of what a business is really earning and hence can use in its operations than its total revenues. It is also called as Net Income After Tax or “Bottom Line”. Lesson 7- Gross Margin Gross margin is a company's total sales revenue minus its cost of goods sold (COGS), divided by total sales revenue, expressed as a percentage.     Chapter 4 – Financial concepts used in Service Contracts -I Lesson 1 – Total Contract Value Total contract value (TCV) represents the full value of a customer contract. It includes both recurring and one-time payments. It is the maximum amount that can be generated from a contract in a normal business scenario. Lesson 2 – Client Budget Client Budget is not an important financial term from Contracts point of view but is important from sales point of view as the knowledge of client budget helps in packaging the solution and offerings in a way that appears lucrative to the Client. Knowledge of client budget helps in creating the contract winning proposal. Lesson 3- Committed Revenue Usually it is Committed Monthly Recurring Revenue (CMRR). Committed Monthly Recurring Revenue is the value of recurring portion of subscription revenue. For term-based subscription businesses, this is the portion of subscription revenue that is recognized each month. In layman’s language, it is the minimum amount that a service provider would get from the Customer each month. Lesson 4- Cost In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service. Lesson 5- Cash Flow In accounting, cash flow is the difference in amount of cash available at the beginning of a period (opening balance) and the amount at the end of that period (closing balance). It is called positive if the closing balance is higher than the opening balance, otherwise called negative.   Lesson 7- Margin (Engagement/ Realised) Margin is the difference between a product or service's selling price and its cost of production or to the ratio between a company's revenues and expenses. For a service contract margin is the amount of revenue that the service would generate minus the cost incurred in delivering the services. There are two kinds of margin for a service contract and which defines the financial success of that contract. Engagement Margin - It is the theoretical margin that one expects while starting a service contract. Realized Margin- Is the actual margin that one realizes at the end of service contract or the financial year. Historically it has been observed that Realized margin is always less than the engagement margin for Service Contracts due to cost escalations.   Lesson 7 – Net Present value (NPV) Net present value is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment. In other words, the amount invested is compared to the future cash amounts after they are discounted by a specified rate of return. For a service contract, the NPV is the present value of the all future revenues that can be generated out of the contract. There is a complex formula to calculate the NPV. Lesson 8 – Profit Dilution or Leakage Profit leakage is a loss of profits due to the difference between actual prices and prices on invoices. Businesses set target prices and figure their financial projections based on those prices. But due to increase in cost or some exceptional events like change in tax the actual cost may go up and thus reduce the profit. Lesson 9- Deferred Expenses The term "deferred expense" is used to describe a payment that has been made, but it won't be reported as an expense until a future accounting period. This method of accounting helps in making the current cash flow positive and reflects more profit for the current financial year but reduces the profit margin for future. Lesson 10- Credit Period The credit period is the number of days that a customer is allowed to wait before paying an invoice. The concept is important because it indicates the amount of working capital that a business is willing to invest in its accounts receivable in order to generate sales. Lesson 11-  Invoice and Invoice date An invoice is a commercial document that itemizes a transaction between a buyer and a seller. If goods or services were purchased on credit, the invoice usually specifies the terms of the deal, and provide information on the available methods of payment. An invoice is also known as a bill or sales invoice.   What is important here is that in a service contract the credit period counting can start from either "date of issue" of invoice or "date of receipt" of invoice as per the agreed terms. Lesson 12- Credit Rating Credit rating is an analysis of the credit risks associated with a financial instrument or a financial entity. It is a rating given to a particular entity based on the credentials and the extent to which the financial statements of the entity are sound, in terms of borrowing and lending that has been done in the past. Why is it important for a service contract? It is important since a service provider gives a credit to a customer in the sense that money is paid to the service provider after few days, usually a month (credit period).   Chapter 5 – Financial concepts used in Service Contracts -II Lesson 1- Internal Rate of Return (IRR) Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment. Lesson 2- First Financial Year Revenue (FFYR) First Financial Year Revenue is the total amount of revenue that will be generated in the current financial year. If the FFYR is more in percentage terms compared to the total revenue then it means that more money is getting realized in the project soon. Lesson 3- Cost of Living Adjustment (COLA). The cost of living adjustment is an increase in income that keeps up with the cost of living. It's often applied to wages, salaries and benefits. In long term service contracts running for more than say 5 years or so the COLA is applied to mitigate the inflation risk associated with the project. Lesson 4- Forex Risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company.   When two or more currencies are involved in a service contract say the billing is done in USD and booking in some other local currency then in such cases there will be a risk associated with USD versus local currency rate.   Lesson 5- Pricing (Fixed and Variable) Pricing for a service contract has two denominations, fixed or variable. When it is fixed it means that for a contract the total amount to be paid by the customer for the services are already agreed and within that limit the agreed services or goods will be delivered. When it is variable it means that the total amount to be paid by the customer is dependent on what service or goods are consumed by the customer. In usual parlance, the variable pricing is also known as “Time and Material” pricing.   Lesson 6- Performance Bank Guarantee A performance bank guarantee provides a secure promise of compensation of a set amount in the event that a seller does not meet delivery terms or other provisions in the contract. The purpose of this sort of guarantee is to solidify the contractual connection between a seller and buyer. Lesson 7- Capex Capital expenditure or capital expense ("CAPEX") is an expense where the benefit continues over a long period, rather than being exhausted in a short period. Such expenditure is of a non-recurring nature and results in acquisition of permanent assets. It is thus distinct from a recurring expense. Lesson 8 – Opex An operating expense, operating expenditure, operational expense, operational expenditure (OPEX) is an ongoing cost for running a product, business, or system. Lesson 9- Service Credit Service credits (or service level credits) are a mechanism by which amounts are deducted from the amounts to be paid under the contract to the supplier if actual supplier performance fails to meet the performance standards set in the service levels Lesson 10– Earn back Earn backs are the received amounts from the already paid penalty or service credit, which is earned back by a service provider after delivering or maintaining the service level at more than expected levels.