TE
AM
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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:
[email protected].
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?
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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:
[email protected].
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