John a tracy - the fast forward mba in finance, 2nd ed

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TE AM FL Y The Fast Forward MBA in Finance SECOND EDITION THE FAST FORWARD MBA SERIES The Fast Forward MBA Series provides time-pressed business professionals and students with concise, one-stop information to help them solve business problems and make smart, informed business decisions. All of the volumes, written by industry leaders, contain “tough ideas made easy.” The published books in this series are: The Fast Forward MBA Pocket Reference, Second Edition (0-471-22282-8) by Paul A. Argenti The Fast Forward MBA in Selling (0-471-34854-6) by Joy J.D. Baldridge The Fast Forward MBA in Financial Planning (0-471-23829-5) by Ed McCarthy The Fast Forward MBA in Negotiating and Dealmaking (0-471-25698-6) by Roy J. Lewicki and Alexander Hiam The Fast Forward MBA in Project Management (0-471-32546-5) by Eric Verzuh The Fast Forward MBA in Business Planning for Growth (0-471-34548-2) by Philip Walcoff The Fast Forward MBA in Business Communication (0-471-32731-X) by Lauren Vicker and Ron Hein The Fast Forward MBA in Investing (0-471-24661-1) by John Waggoner The Fast Forward MBA in Hiring (0-471-24212-8) by Max Messmer The Fast Forward MBA in Technology Management (0-471-23980-1) by Daniel J. Petrozzo The Fast Forward MBA in Marketing (0-471-16616-2) by Dallas Murphy The Fast Forward MBA in Business (0-471-14660-9) by Virginia O’Brien The Fast Forward MBA in Finance SECOND EDITION J O H N A. T R A C Y John Wiley & Sons, Inc. Copyright © 1996, 2002 by John A. Tracy. All rights reserved. Published by John Wiley & Sons, Inc., New York. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. ISBN: 0-471-20285-1 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 for Richard and Robert, my dog track buddies, who have helped me more than they know. CONTENTS xiii PREFACE PART 1 FINANCIAL REPORTING OUTSIDE AND INSIDE A BUSINESS CHAPTER 1—GETTING DOWN TO BUSINESS Accounting Inside and Out Internal Functions of Accounting External Functions of Accounting A Word about Accounting Methods End Point CHAPTER 2—INTRODUCING FINANCIAL STATEMENTS Three Financial Imperatives, Three Financial Statements Accrual-Basis Accounting The Income Statement The Balance Sheet The Statement of Cash Flows End Point 3 4 6 6 8 9 11 11 13 16 18 21 24 vii CONTENTS CHAPTER 3—REPORTING PROFIT TO MANAGERS 27 Using the External Income Statement for Decision-Making Analysis Management Profit Report Contribution Margin Analysis End Point 27 31 35 36 CHAPTER 4—INTERPRETING FINANCIAL STATEMENTS A Few Observations and Cautions Premises and Principles of Financial Statements Limits of Discussion Profit Ratios Book Value Per Share Earnings Per Share Market Value Ratios Debt-Paying-Ability Ratios Asset Turnover Ratios End Point 39 39 41 46 47 49 51 53 55 58 59 PART 2 ASSETS AND SOURCES OF CAPITAL CHAPTER 5—BUILDING A BALANCE SHEET Sizing Up Total Assets Assets and Sources of Capital for Assets Connecting Sales Revenue and Expenses with Operating Assets and Liabilities Balance Sheet Tethered with Income Statement End Point CHAPTER 6—BUSINESS CAPITAL SOURCES Business Example for This Chapter Capital Structure of Business Return on Investment Pivotal Role of Income Tax Return on Equity (ROE) viii 63 63 66 69 75 76 79 80 81 86 89 91 CONTENTS Financial Leverage End Point CHAPTER 7—CAPITAL NEEDS OF GROWTH Profit Growth Plan Planning Assets and Capital Growth End Point 92 95 97 98 99 105 PART 3 PROFIT AND CASH FLOW ANALYSIS CHAPTER 8—BREAKING EVEN AND MAKING PROFIT Adding Information in the Management Profit Report Fixed Operating Expenses Depreciation: A Special Kind of Fixed Cost Interest Expense Pathways to Profit End Point CHAPTER 9—SALES VOLUME CHANGES Three Ways of Making a $1 Million Profit Selling More Units Sales Volume Slippage Fixed Costs and Sales Volume Changes End Point CHAPTER 10—SALES PRICE AND COST CHANGES Sales Price Changes When Sales Prices Head South Changes in Product Cost and Operating Expenses End Point CHAPTER 11—PRICE/VOLUME TRADE-OFFS Shaving Sales Prices to Boost Sales Volume Volume Needed to Offset Sales Price Cut Thinking in Reverse: Giving Up Sales Volume for Higher Sales Prices End Point 109 109 112 113 116 116 122 125 126 129 133 134 136 139 139 144 146 148 149 150 154 157 159 ix CONTENTS CHAPTER 12—COST/VOLUME TRADE-OFFS AND SURVIVAL ANALYSIS Product Cost Increases: Which Kind? Variable Cost Increases and Sales Volume Better Product and Service Permitting Higher Sales Price Lower Costs: The Good and Bad Subtle and Not-So-Subtle Changes in Fixed Costs Survival Analysis End Point CHAPTER 13—PROFIT GUSHES: CASH FLOW TRICKLES? AM FL Y Lessons from Chapter 2 Cash Flow from Boosting Sales Volumes Cash Flows across Different Product Lines Cash Flow from Bumping Up Sales Prices End Point 161 161 163 165 166 169 170 177 179 179 180 185 185 188 PART 4 CAPITAL INVESTMENT ANALYSIS TE CHAPTER 14—DETERMINING INVESTMENT RETURNS NEEDED A Business as an Ongoing Investment Project Cost of Capital Short-Term and Long-Term Asset Investments The Whole Business versus Singular Capital Investments Capital Investment Example Flexibility of a Spreadsheet Model Leasing versus Buying Long-Term Assets A Word on Capital Budgeting End Point Chapter Appendix CHAPTER 15—DISCOUNTING INVESTMENT RETURNS EXPECTED Time Value of Money and Cost of Capital Back to the Future: Discounting Investment Returns x 191 191 192 195 196 197 206 206 210 210 211 213 214 215 CONTENTS Spreadsheets versus Equations Discounted Cash Flow (DCF) Net Present Value and Internal Rate of Return (IRR) After-Tax Cost-of-Capital Rate Regarding Cost-of-Capital Factors End Point 217 218 222 224 226 227 PART 5 END TOPICS CHAPTER 16—SERVICE BUSINESSES Financial Statement Differences of Service Businesses Management Profit Report for a Service Business Sales Price and Volume Changes What about Fixed Costs? Trade-off Decisions End Point CHAPTER 17—MANAGEMENT CONTROL Follow-through on Decisions Management Control Information Internal Accounting Controls Independent Audits and Internal Auditing Fraud Management Control Reporting Guidelines Sales Mix Analysis and Allocation of Fixed Costs Budgeting Overview End Point CHAPTER 18—MANUFACTURING ACCOUNTING Product Makers versus Product Resellers Manufacturing Business Example Misclassification of Manufacturing Costs Idle Production Capacity Manufacturing Inefficiencies 231 232 234 237 239 239 241 243 244 244 247 249 250 252 262 270 273 275 275 276 280 283 285 xi CONTENTS Excessive Production End Point APPENDIX A GLOSSARY FOR MANAGERS 291 APPENDIX B TOPICAL GUIDE TO FIGURES 313 INDEX xii 287 289 315 P R E FA C E T This book is for business managers, as well as for bankers, consultants, lawyers, and other professionals who need a solid and practical understanding of how business makes profit, cash flow from profit, the assets and capital needed to support profit-making operations, and the cost of capital. Business managers and professionals don’t have time to wade through a 600-page tome; they need a practical guide that gets to the point directly with clear and convincing examples. In broad terms this book explains the tools of the trade for analyzing business financial information. Financial statements are one primary source of such information. Therefore financial statements are the best framework to explain and demonstrate how managers analyze financial information for making decisions and keeping control. Surprisingly, most books of this ilk do not use the financial statements framework. My book offers many advantages in this respect. This book explains and clearly demonstrates the indispensable analysis techniques that street-smart business managers use to: • • Make profit. Control the capital invested in assets used in making profit xiii P R E FA C E • and in deciding on the sources of capital for asset investments. Generate cash flow from profit. The threefold orientation of this book fits hand in glove with the three basic financial statements of every business: the profit report (income statement), the financial condition report (balance sheet), and the cash flow report (statement of cash flows). These three “financials” are the center of gravity for all businesses. This book puts heavy emphasis on cash flow. Business managers should never ignore the cash flow consequences of their decisions. Higher profit may mean lower cash flow; managers must clearly understand why, as well as the cash flow timing from their profit. The book begins with a four-chapter introduction to financial statements. Externally reported financial statements are prepared according to generally accepted accounting principles (GAAP). GAAP provide the bedrock rules for measuring profit. Business managers obviously need to know how much profit the business is earning. But, to carry out their decision-making and control functions, managers need more information than is reported in the external profit report of the business. GAAP are the point of departure for preparing the more informative financial statements and other internal accounting reports needed by business managers. The “failing” of GAAP is not that these accounting rules are wrong for measuring profit, nor are they wrong for presenting the financial condition of a business—not at all. It’s just that GAAP do not deal with presenting financial information to managers. In fact, much of this management information is very confidential and would never be included in an external financial report open to public view. Let me strongly suggest that you personalize every example in the book. Take the example as your own business; imagine that you are the owner or the top-level manager of the business, and that you will reap the gains of every decision or suffer the consequences, as the case may be. If you would like a copy of my Excel workbook file of all the figures in the book contact me at my e-mail address: tracyj@colorado.edu. xiv P R E FA C E As usual, the editors at John Wiley were superb. Likewise, the eagle-eyed copy editors at North Market Street Graphics polished my prose to a much smoother finish. I would like to mention that John Wiley & Sons has been my publisher for more than 25 years, and I’m very proud of our long relationship. John A. Tracy Boulder, Colorado March, 2002 xv PA R T Financial Reporting Outside and Inside a Business 1 CHAPTER Getting Down to Business 1 E Every business has three primary financial tasks that determine the success or failure of the enterprise and by which its managers are judged: • Making profit—avoiding loss and achieving profit goals by making sales or earning other income and by controlling expenses • Cash flow—generating cash from profit and securing cash from other sources and putting the cash inflow to good use • Financial health—deciding on the financial structure for the entity and controlling its financial condition and solvency To continue in existence for any period of time, a business has to make profit, generate cash flow, and stay solvent. Accomplishing these financial objectives depends on doing all the other management functions well. Business managers earn their keep by developing new products and services, expanding markets, improving productivity, anticipating changes, adapting to new technology, clarifying the business model, thinking out clear strategies, hiring and motivating people, making tough choices, solving problems, and arbitrating conflicts of interests between different constituencies (e.g., 3
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