Read Prentice Hall's one-day MBA in finance & accounting Online
Authors: Michael Muckian,Prentice-Hall,inc
Tags: #Finance, #Reference, #General, #Careers, #Accounting, #Corporate Finance, #Education, #Business & Economics
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
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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—