Prentice Hall's one-day MBA in finance & accounting (2 page)

CHAPTER 3—REPORTING PROFIT

TO MANAGERS

27

Using the External Income Statement

for Decision-Making Analysis

27

Management Profit Report

31

Contribution Margin Analysis

35

End Point

36

CHAPTER 4—INTERPRETING FINANCIAL

STATEMENTS

39

A Few Observations and Cautions

39

Premises and Principles of Financial Statements

41

Limits of Discussion

46

Profit Ratios

47

Earnings Per Share

51

Market Value Ratios

53

Debt-Paying-Ability Ratios

55

Asset Turnover Ratios

58

End Point

59

ASSETS AND SOURCES OF CAPITAL

CHAPTER 5—BUILDING A BALANCE SHEET

63

Sizing Up Total Assets

63

Assets and Sources of Capital for Assets

66

Connecting Sales Revenue and Expenses

with Operating Assets and Liabilities

69

Balance Sheet Tethered with Income Statement

75

End Point

76

CHAPTER 6—BUSINESS CAPITAL SOURCES

79

Business Example for This Chapter

80

Capital Structure of Business

81

Return on Investment

86

Pivotal Role of Income Tax

89

Return on Equity (ROE)

91

viii

C O N T E N T S

Financial Leverage

92

End Point

95

CHAPTER 7—CAPITAL NEEDS OF GROWTH

97

Profit Growth Plan

98

Planning Assets and Capital Growth

99

End Point

105

PROFIT AND CASH FLOW ANALYSIS

CHAPTER 8—BREAKING EVEN

AND MAKING PROFIT

109

Adding Information in the Management Profit Report 109

Fixed Operating Expenses

112

Depreciation: A Special Kind of Fixed Cost

113

Interest Expense

116

Pathways to Profit

116

End Point

122

CHAPTER 9—SALES VOLUME CHANGES

125

Three Ways of Making a $1 Million Profit

126

Selling More Units

129

Sales Volume Slippage

133

Fixed Costs and Sales Volume Changes

134

End Point

136

CHAPTER 10—SALES PRICE

AND COST CHANGES

139

Sales Price Changes

139

When Sales Prices Head South

144

Changes in Product Cost and Operating Expenses

146

End Point

148

CHAPTER 11—PRICE/VOLUME TRADE-OFFS

149

Shaving Sales Prices to Boost Sales Volume

150

Volume Needed to Offset Sales Price Cut

154

Thinking in Reverse: Giving Up Sales Volume

for Higher Sales Prices

157

End Point

159

ix

C O N T E N T S

CHAPTER 12—COST/VOLUME TRADE-OFFS

AND SURVIVAL ANALYSIS

161

Product Cost Increases: Which Kind?

161

Variable Cost Increases and Sales Volume

163

Better Product and Service Permitting Higher

Sales Price

165

Lower Costs: The Good and Bad

166

Subtle and Not-So-Subtle Changes in Fixed Costs

169

Survival Analysis

170

End Point

177

CHAPTER 13—PROFIT GUSHES: CASH FLOW

TRICKLES?

179

Lessons from Chapter 2

179

Cash Flow from Boosting Sales Volumes

180

Cash Flows across Different Product Lines

185

Cash Flow from Bumping Up Sales Prices

185

End Point

188

CHAPTER 14—DETERMINING INVESTMENT

RETURNS NEEDED

191

TEAMFLY

A Business as an Ongoing Investment Project

191

Cost of Capital

192

Short-Term and Long-Term Asset Investments

195

The Whole Business versus Singular Capital

Investments

196

Capital Investment Example

197

Flexibility of a Spreadsheet Model

206

Leasing versus Buying Long-Term Assets

206

A Word on Capital Budgeting

210

End Point

210

CHAPTER 15—DISCOUNTING INVESTMENT

RETURNS EXPECTED

213

Time Value of Money and Cost of Capital

214

Back to the Future: Discounting Investment Returns 215

x

Team-Fly®

C O N T E N T S

Spreadsheets versus Equations

217

Discounted Cash Flow (DCF)

218

Net Present Value and Internal Rate of Return (IRR) 222

After-Tax Cost-of-Capital Rate

224

Regarding Cost-of-Capital Factors

226

End Point

227

CHAPTER 16—SERVICE BUSINESSES

231

Financial Statement Differences of Service

Businesses

232

Management Profit Report for a Service

Business

234

Sales Price and Volume Changes

237

What about Fixed Costs?

239

Trade-off Decisions

239

End Point

241

CHAPTER 17—MANAGEMENT CONTROL

243

Follow-through on Decisions

244

Management Control Information

244

Internal Accounting Controls

247

Independent Audits and Internal Auditing

249

Fraud

250

Management Control Reporting Guidelines

252

Sales Mix Analysis and Allocation of Fixed Costs

262

Budgeting Overview

270

End Point

273

CHAPTER 18—MANUFACTURING

ACCOUNTING

275

Product Makers versus Product Resellers

275

Manufacturing Business Example

276

Misclassification of Manufacturing Costs

280

Idle Production Capacity

283

Manufacturing Inefficiencies

285

xi

C O N T E N T S

Excessive Production

287

End Point

289

APPENDIX A GLOSSARY FOR MANAGERS

291

APPENDIX B TOPICAL GUIDE TO FIGURES

313

INDEX

315

xii

P R E F A C E

TThis 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 indispen-sable 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 F A 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 F A 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

P A R T 1

Financial

Reporting

Outside

and Inside

a Business

C H A P T E R 1

Getting Down

to Business

EEvery 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

F I N A N C I A L R E P O R T I N G

customers who want lower prices versus employees who want higher wages). Managers should act ethically, comply with a myriad of laws, be responsible members of society, and not harm our natural environment—all the while making profit, generating cash flow, and avoiding insolvency.

ACCOUNTING INSIDE AND OUT

Ask people to describe accounting and the most

common answer you’ll get is that accounting involves a lot of record keeping and bookkeeping. Which is true. The account-

ing system of a business is designed to capture and record all its transactions, operations, activities, and other develop-

ments that have financial consequences. An accounting sys-

tem generates many documents, forms, and reports. Even a small business has hundreds of accounts, which are needed to keep track of its sales and expenses, its assets and liabilities, and of course its cash flows. Accounting systems today are computer-based. The accounts of a business are kept on the hard disks of computers, which should be backed up fre-

quently, of course.

The primary purpose of an accounting system is to accu-

mulate a complete, accurate, and up-to-date base of data and information needed to perform essential functions for a busi-

ness. Figure 1.1 presents a broad overview of the internal and external functions of business accounting. Note the Janus, or TEAMFLY

two-faced, nature of an accounting system that looks in two different directions—internal and external, or inside and out-

side the business.

In addition to facilitating day-to-day operating activities, the accounting department of a business has the responsibility of preparing two different kinds of
internal reports—
very detailed reports for management control and much more condensed reports for decision making. Likewise, the accounting department prepares two different kinds of
external reports—