Financial Analysis and Decision Making

FINANCIAL

ANALYSIS AND

DECISION MAKING

FINANCIAL

ANALYSIS AND

DECISION MAKING

Tools and Techniques to Solve

Financial Problems and Make

Effective Business Decisions

DAVID E. VANCE, MBA, CPA, JD

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CONTENTS

PREFACE

ACKNOWLEDGMENTS

Chapter 1

Financial Statements and Accounting Concepts

Income Statement

Balance Sheet

Statement of Cash Flows

Accounting Definitions

Generally Accepted Accounting Principles

Summary

Chapter 2

Financial Ratios and Other Measures of Performance

Measurement of Operating Performance

Measures of Financial Performance

Risk Measurement

Cautions on Ratios

Summary

Chapter 3

Factors Determining Interest Rates and Required

Debt Yields

Components of Interest: Risk-Free Rate of Return, Default, Liquidity,

and Maturity Risk Premiums

Effect of Supply and Demand on Interest Rates

Summary

Chapter 4

Forecasting Yield and Risk

Forecasting with A Priori Probabilities

Forecasting with Historical Data

Using Expected Values and Standard Deviations to Make Decisions

Portfolio Theory

How to Use Required Rate of Return

Summary

Chapter 5

Time Value of Money

Four Classes of Time Value Problems

Future Value

Future Value: Annual Growth Rates

Future Value Formula

Present Value Theory and Mathematical Formula

Present Value Using Tables

Present Value of an Annuity

Loan Payments

Loan Amortization Schedules

Mathematical Formula for Present Value of an Annuity

Future Value of an Annuity

Mathematical Formula for Future Value of an Annuity

Summary

Chapter 6

Bond Valuation

Bond Valuation

Callable Bonds

Convertible Bonds

Bond Yield

Yield to Call

Interpolation Theory

Summary

Chapter 7

Leases

Operating Versus Capital Leases

Imputed Interest Rates

Effect of Deposits and Prepayments on the Imputed Interest Rate

Capitalizing Leases

Summary

Chapter 8

Stock Valuation

Stock Valuation

Computing Stock Value

Stock Yield

Stock Valuation Based on Cash Flow

Stock Valuation Based on Earnings

Stock Valuation Based on Sales

Summary

Chapter 9

Cost of Capital

Cost of Debt Capital

Cost of Preferred Stock Capital

Cost of Common Equity

Cost of New Common Equity Capital

Cost-Free Capital

Weighted Average Cost of Capital (WACC)

When Should New Common Stock Be Issued?

Cost of Leased Capital

Marginal Cost of Capital

Decision Rules for the Optimal Capital Budget

Summary

Chapter 10

Capital Budgeting

Methods for Evaluating Capital Projects

Payback Method

Discounted Payback Method

Net Present Value

Internal Rate of Return

Modified Rate of Return

Comparison of Capital Budgeting Methods

Summary

Chapter 11

Cash Flow Estimation for Capital Budgeting

Capital Budgeting Ground Rules

Capital Budgeting Format

Replacement Equipment

Inflation and Price Pressure

Spreadsheet Modeling

Summary

Chapter 12

Product Costing

Cost Versus Expense

Financial Accounting Versus Managerial Accounting

Unallocated Manufacturing Overhead

Expenses Versus Inventory

Full Absorption Cost of Purchased Merchandise

Make or Buy Decisions

Managerial Accounting

Gross Profit Versus Contribution

Summary

Chapter 13

Break-Even Analysis and Modeling

Break-Even Analysis

Modeling Profit

Sales Volume Break-Even

Relevant Range

Reality Testing

Break-Even and Risk

Summary

Chapter 14

Working Capital and Cash Budgeting

Working Capital

Cash Budgeting

Opening a New Facility

Line of Credit

Seasonal Cash Demand

Managing Working Capital

Summary

Chapter 15

Master Budgets and Variance Analysis

Basic Budgets

Master Budgets

Master Budgets Versus Financial Statements

Supplemental Budgets

Summary

Chapter 16

Pricing Theory

Cost-Centered Pricing

Market-Centered Pricing

Engineered Cost

Price Elasticity

Product Life Cycle

Transfer Pricing

Opportunistic Pricing

Microeconomics Pricing

Summary

Chapter 17

Advanced Cost Concepts and Allocation of Resources

Cost Drivers

Activity-Based Costing

Job Costing

Cost Drivers as a Method for Overhead Allocation

Traditional Overhead Allocation

Joint Products: Two Product Problem

Theory of Constraints

Profit Ladder

New Product Selection

Summary

Chapter 18

Labor Costs

Overtime

Turnover Costs

Workers’ Compensation

Unemployment Compensation Taxes

Summary

APPENDIXES

Appendix A: Future Value Interest Factor: FVIF(i, n)

Appendix B: Future Value Interest Factor for an Annuity:

FVIFA(i, n)

Appendix C: Present Value Interest Factor: PVIF(i, n)

Appendix D: Present Value Interest Factor for an Annuity:

PVIFA(i, n)

Appendix E: Chapter Exercises

Appendix F: Exercise Answers

INDEX

PREFACE

Financial analysis is about shaping the future. It provides the tools management needs to make sophisticated judgments about complex and challenging business issues. As a corporate controller, chief financial officer, and retired CPA, I found that outside auditors, purchasing managers, accountants, and corporate executives were making bad decisions because they didn’t understand how to apply financial analysis to real-world situations. One example was a company president who was signing leases with a 24% imputed interest rate because neither he nor his auditors understood how to analyze leases.

Three principles guide this book: (1) it should get to the point without forcing the reader to wade through a lot of text, (2) there should be plenty of examples, and (3) the rationale for each analytical technique should be plainly stated.

In this book, we provide an overview of the three main financial statements: income statement, balance sheet, and statement of cash flows, and we discuss the major landmarks in each. We discuss financial ratios and other measures of performance that management can use to detect problems and isolate their root cause.

Interest rates are a factor in a number of decisions, including the required rate of return on a project, expansion, refinancing, lease versus buy decisions, and others. We discuss the factors that cause interest rates to rise or fall and what can be done about them.

The world is complicated, and things never unfold exactly according to plan. We discuss measures of risk in terms of yield or output and ways to manage that risk.

In the chapter on the time value of money, we discuss the accumulation of future wealth in terms of both a single investment and periodic investments. We also find the present value of investments, that is, the value in today’s dollars of cash that will not be received until some future date. The principles discussed can be applied to savings, loans, mortgages, leases, annuities, and capital budgeting decisions. This chapter also provides the formulas needed to create computer programs or spreadsheets tailored to the needs of individual businesses.

The chapter on bond valuation demonstrates how the value of bonds rises as interest drops, and how the value of bonds drops as interest rates rise. This has implications for both investments and issuance of bonds. We also discuss bond yield to maturity and yield to call.

The chapter on leases builds on the time value of money principles and integrates the effect of deposits, prepayments, and application fees to find the real cost of leasing in such a way as to make leases with different terms comparable to each other and to other financing sources.

A number of methods to value stocks are discussed along with the strengths and weaknesses of each. Stock valuation is important for investing, deciding on convertible bond terms, and initial public offerings.

The cost of capital is the composite cost of all sources of capital used by a company. It is used as a benchmark for determining whether management is creating or destroying wealth, and in making decisions about investments in new projects or acquisitions. The marginal cost of capital is the cost of incremental blocks of capital, which can be compared to the return on projects to determine the optimum capital budget.

In the chapter on capital budgeting, we discuss five methods for analyzing capital projects, that is, projects for which the payback is stretched out over several years. These methods include (1) payback, (2) discounted payback, (3) net present value, (4) internal rate of return, and (5) modified internal rate of return. We also discuss decision rules for ranking projects for each method of analysis. There is also a chapter on estimating cash flow for capital budgeting.

Correct product costing is critical to decisions about pricing, make versus buy, and production volumes. We discuss full absorption costing, which is used for valuing inventory, and the cost of goods sold, and we discuss variable costing. Each approach to costing is used to make a different class of decision.

We discuss break-even analysis, a technique that can be expanded to address issues of production volume, target profits, and overhead targets. It can also be used to model strategic decision options and test the reasonableness of each.

Cash is oxygen to a company, and cash budgeting and working capital management are important keys to assure that a company has enough cash. We discuss the cash demand of opening a new facility, cash required for accounts receivable and inventory to support sales growth, and working capital as a source of cash.

Operating budgets are an important tool for management to guide a company’s progress, but traditional budgets often fail to account for changes in sales volume. Master budgets, on the other hand, are designed to be flexible as sales volume changes. This flexibility improves variance analysis and helps improve placement of responsibility.

Most finance books concentrate on costs, but few discuss pricing in any depth even though correct pricing decisions are crucial to a company’s financial health. We discuss a number of price setting techniques as well as the effects and strategic implications of supply and demand, market segmentation, product differentiation, and product life cycle.

We also discuss a number of financial analysis and decision-making techniques that don’t fit neatly into any of the foregoing categories. These include cost drivers, activity-based costing, and job costing. We discuss two approaches to resource allocation: the theory of constraints and the profit ladder. We also discuss issues arising when discontinuing old products and selecting new products for introduction.

Finally, we discuss labor costs. Labor is one of the largest costs of any company, but it can be significantly reduced without layoffs by managing overtime, turnover, workers’ compensation, and unemployment costs. We discuss techniques for better management of these areas and quantify the impact of improvements.

In sum, this book embraces a broad range of financial analyses and can be used as a primer by finance, accounting, and general management on the tools and techniques to solve financial problems and make effective business decisions.

Dave Vance

ACKNOWLEDGMENTS

I would like to thank the more than 300 corporate managers and graduate and undergraduate students who have used, commented on, and vetted various versions of this text. Their comments, questions, and criticisms have helped sharpen explanations and make sample problems more realistic. Their relentless probing of why things work as they do has shifted the focus of the book from the theoretical to the practical. Anything good about this book I owe to them. The faults are my own.

CHAPTER 1

Financial Statements and

Accounting Concepts

How does a company make money? A company can succeed only if it identifies and meets its customers’ needs. It must also make a profit, but is that enough? Not quite. A company can make a profit every year and still run out of cash.

This chapter discusses three financial statements that provide a good understanding of company performance: (1) the income statement, (2) the balance sheet, and (3) the statement of cash flows. We will also define some of the terms accountants use and the philosophy underlying why accountants do what they do.

If you have a strong accounting background, you may want to skip this chapter. However, if you have no accounting background, or if it has been a long time since your last accounting course, take a few minutes to review this chapter. It will provide an overview of the accounting concepts that support financial decision making.

INCOME STATEMENT

Consider the income statement of the Gladstone Book Store (Figure 1–1). Last year it had revenue of $1,000,000. Revenue is another name for sales. The books they sold cost them $500,000. This is called the cost of goods sold (COGS). The difference between revenue and COGS is called gross profit. Gross profit is the amount generated from the sale of books before operating expenses are subtracted. Gladstone has a gross profit of $500,000.

FIGURE 1–1

Gladstone Book Store Income Statement

Expenses are separated into cost of goods and operating expenses because they have different characteristics. Cost of goods sold tends to increase in rough proportion to sales, whereas operating expenses should not increase in proportion to sales.

Gross profit allows us to compute gross margin, which is gross profit divided by revenue. The relationship between revenue, COGS, gross profit, and gross margin is given in Eq. 1–1.

Gross margin represents the percentage of each dollar available for operating expenses, financing costs, taxes, and profit after COGS are subtracted from revenue. Gross margin is important because it can be used to help forecast gross profit as revenue rises or falls. The gross margin for Gladstone Books is

Operating expenses are sometimes called overhead. It includes things like advertising, sales, and marketing costs; salaries and rent for store operations; and depreciation. Gladstone’s operating expenses were $410,000.

Operating profit is gross margin less operating expenses. Operating profit is a measure of the fundamental performance of a company, independent of a company’s financing or tax structure. It is also called earnings before interest and taxes (EBIT). Gladstone’s operating profit was $90,000.

Since interest is tax deductible, it is subtracted from operating profit before taxes are computed. Gladstone’s earnings before taxes (EBT) were $65,000. On an income statement, taxes mean taxes on income. Real estate, franchise, or other taxes not related to income are included in either the cost of goods sold, if they are related to the purchase or manufacture of a product, or the operating expenses, if they are not. Gladstone’s income taxes were $15,000.

Net income is income after all expenses, including interest and taxes, are subtracted. It is the amount available for distribution of profits or to increase retained earnings. Gladstone’s net income is $50,000.

The Gladstone Book Store example uses a number of important terms. Having crisp definitions for these terms will be important as we discuss decision making in this and other chapters. The terms are as follows:

Cost of goods sold Cost of goods sold are all the costs necessary to make a product or to deliver a service. It also includes the cost to make an item ready for sale. In Gladstone, the cost of goods sold (COGS) includes the cost of books, the cost of transportation if Gladstone paid for it, and any other work that had to be performed to prepare the goods for sale. Suppose, for example, books had to be uncrated by store employees; the labor for uncrating would become part of the COGS. Other names for cost of goods sold are cost of products sold (COPS) or cost of services (COS).

Gross profit Gross profit is the amount of revenue left over after the cost of goods sold is subtracted. Gross profit increases more or less linearly with increases in revenue. Conversely, as revenue drops, the gross profit available to cover operating expenses, interest, taxes, and profit drops as well.

Gross margin Gross margin is simply the ratio of gross profit to revenue. In Gladstone, gross margin is 50%, that is, gross profit of $500,000 divided by revenue of $1,000,000. Gross margin is important because it can be used as a performance measure. It is also important because it can be used as an estimator for break-even analysis, budgets, and other analytical techniques.

Overhead Overhead, also called operating expenses, is all expenses not included in the cost of goods sold except interest and taxes.

Earnings before tax Earnings before tax (EBT) is revenue less all expenses except income taxes.

Taxes Only taxes assessed on income are included in this income statement line.

Net income Net income is the amount of income available to the owners or shareholders of the business.

Performance Standards

Suppose a company has a 50% cost of goods sold and a 50% overhead cost. How do we know whether 50% cost of goods sold is good or bad? How do we know whether overhead costs are out of control or as good as can be expected?

Ratios for other companies are summarized and published by Robert Morris Associates (RMA) and by Dun & Bradstreet. Ratios are provided by industry, as determined by SIC (standard industrial classification) code, and by the size of business in terms of revenue. RMA and D&B reports are available in most libraries. A U.S. Department of Commerce manual, available in most libraries, cross-references industries and SIC codes.

Another way to determine whether a company’s cost of goods sold, overhead, or gross margin is appropriate is through benchmarking. Benchmarking is the process of gathering the financial statements of the best companies in an industry, and computing their financial ratios.

Closing the Books and the Income Statement

At the end of each accounting period, say, a year, sales and expense transactions are summarized into categories like revenue, cost of good sold, and overhead. Certain period-end adjustments, for example, depreciation, are added or subtracted as appropriate, and the result of these transactions for a period are then formatted into an income statement.

After the income statement is formatted, revenue and expense accounts are zeroed out by transferring their balances to a profit account. Profits are then transferred (added to) retained earnings, as are losses, if any.

BALANCE SHEET

A balance sheet has three major sections: assets, liabilities, and equity. Assets are all the things a business has to make money with. Liabilities are the money it owes to others, and equity is what would be left over if all assets were sold at their stated value and all debts were paid off. Another way to think about a balance sheet is that assets are the resources a company has, and liabilities and equity are the means for financing those resources. These have a critical relationship because assets must always equal liabilities plus equity.

Figure 1–2, the Balance Sheet for Gladstone Books, shows that it has assets of $181,000 at the end of 2002. It also had liabilities of $88,200, and equity of $92,800.

Assets At its simplest, assets are everything a company has at its disposal to use: real estate (whether or not financed), furniture, fixtures, machinery, cash, securities, accounts receivable, and inventory.

FIGURE 1–2

Balance Sheet for Gladstone Books

Liabilities Liabilities are money owed to others. Examples of liabilities include mortgage balances, bank loans, accounts payable, accrued payroll (wages earned by employees at the financial statement date, but have not yet been paid to them), and lease capital balances (the present value of lease payment obligations).

Equity Equity is the amount that would be left over if all assets were sold at book value, and all liabilities were paid off. Equity includes invested capital and retained earnings. Retained earnings is the sum of all the profits and losses from the time the business was formed to the present, less dividends paid. Net income increases retained earnings; losses reduce retained earnings.

Note that the income statement is a summary of revenue and expenses in a year. In contrast, a balance sheet is a snapshot at a point in time.

Current Assets, Current Liabilities,

and Working Capital

Assets and liabilities are divided into current and noncurrent accounts. Current assets include cash and anything expected to be converted to cash within a year. Examples include accounts receivable, inventory, and securities held for investment purposes.

Current liabilities are debts that will come due within a year. Examples include accounts payable, accrued payroll, lines of credit, and the principal portion of bank and lease payments that must be paid within a year.

The reason for segregating assets and liabilities into current and noncurrent accounts is to help determine whether a company has the capacity to pay its bills. If more bills come due in a year than a company can pay, serious consequences could follow, including bankruptcy.

We will see that most transactions in the course of normal business affect current assets and current liabilities. Therefore, these accounts are often called working capital accounts. Net working capital is current assets less current liabilities, as shown in Eq. 1–3.

The amount of net working capital is a measure of whether a company can pay its bills as they become due. If it is zero or negative, the company is in trouble. If the company has a lot of net working capital, it means they should have no trouble paying their bills.

Gladstone’s net working capital can be computed as follows:

One of the problems with using net working capital is that we know zero or negative amounts are always bad, but we can’t tell from this one calculation whether $70,800 is good. It might be terrific for a million-dollar bookstore, but dangerously close to zero for a billion-dollar company. In the next chapter, we will discuss ratios and other techniques to determine whether a company is at risk.

Relationship Between Income Statement and

Balance Sheet

What is the relationship between the income statement and the balance sheet? Suppose Gladstone bought a book for $11 and sold it for $20. This activity would cause a series of transactions to be generated in the accounting system. If the book were purchased on credit, we would have to reflect the fact that Gladstone created a liability. On the other hand, it also acquired an asset, the book, which would become part of its inventory.

Accounting transactions are often represented by journal entries. A journal entry identifies the accounts that are affected by a transaction and the amount of the effect. Transactions are debits, which mean the left side, and credits, which mean the right side. Think of the accounting equation (Eq. 1–2): assets are on the left, or debit side of the equal sign, and liabilities and equity are on the right side of the equal sign. So purchase of an $11 book on credit can be represented by the following journal entry:

We have increased our assets, and we financed that increase in assets by increasing a liability, accounts payable.

Suppose we sell the book for $20 cash. This triggers two transactions in the accounting system. First, let’s consider the effect of receiving cash. We increase (debit) cash, an asset, by $20, and since we have to maintain the balance demanded by Eq. 1–2, we have to increase something on the credit side of the equation.

As it turns out, there are temporary accounts inside equity that can be used. These temporary accounts are revenue and expense accounts. We call them temporary because we know that they are closed out to the profit account each year, which returns their balance to zero. Sometimes these temporary accounts are called nominal accounts. We can now rewrite Eq. 1–2 as Eq. 1–4 to reflect these nominal accounts.

The expansion of Eq. 1–2 to Eq. 1–4 should make sense on an intuitive level because during year-end closing procedures the balances in revenue and expense accounts are ultimately folded into the retained earnings account, which is an equity account. So the credit side of the equation for the book sale is revenue. The debit is to cash. The journal entry to record the sale is:

Here, for the first time, we see how transactions cross over from the balance sheet to the income statement. The crossover is required to keep Eq. 1–4 in balance.

There are two more transactions to complete this cycle. Since we sold the book, we no longer have it in inventory. Ordinarily, we increase things on the left-hand side of the equal sign, assets, with debits, and decrease them with credits. We usually increase things on the right-hand side of the equal sign—like liabilities, equity, and revenue—with credits, and decrease them with debits. But there is always an exception. The exception is expenses; the way to remember this it that expenses always work against revenue. If revenue is increased with a credit, then expenses must be increased with a debit.

Let us reduce inventory to reflect the sale of the book, and that reduction will have to be a credit. Then what is the debit? Logically, it should be something that offsets revenue, some kind of expense. Actually, it is a specific expense called cost of goods sold.

The final transaction to complete this cycle involves paying the publisher for the book. We know that we will have to reduce cash, an asset, by $11, which means we will have to credit cash. But what do we debit? We have already accounted for the expense, so it can’t be an expense account. The answer is to debit accounts payable, which offsets the liability created when Gladstone purchased the book. Credits are used to increase liabilities like accounts payable, so to reduce accounts payable, we will have to use a debit. The journal entry to do this is

Generally accepted accounting principles (GAAP) require a double entry accounting system. The equation assets = liabilities equity is one of the double entry rules. Another double entry rule is that debits must always equal credits. Double entry bookkeeping rules are designed to determine whether a mistake has been made in data entry. Income statement and balance sheet accounts have been carefully arranged so that double entry bookkeeping rules can always be followed and the final result makes sense.

STATEMENT OF CASH FLOWS

What in the world is a statement of cash flows? Isn’t it enough to know whether a company is profitable by looking at the income statement? Isn’t it enough to know a company’s assets and liabilities? What else could anybody want to know?

Actually, for a long time, most businesses did very well without a statement of cash flows. However, as businesses got bigger and more complex, investors, banks, and managers wanted more information to tie the income statement to the balance sheet, to see where money was coming from and how it was being used.

Before actually looking at a statement of cash flows (at one time called a sources and uses of funds statement), let’s think about some of the concepts involved.

All businesses hope that a big source of cash is profits. In addition, there are several other sources of cash. Depreciation is a source of cash. Why? Depreciation is one of the expenses subtracted from revenue to get net income. But depreciation, unlike rent, is not a cash expense. It is just a bookkeeping entry.

Suppose a company purchased a $3,000 computer in 2001 that had a three-year life. It would be depreciated over three years. That is, some of the cost of the computer would be allocated to each year it contributes to company operations.

So as we see, some deductions from revenue represent cash payments, and some do not. To get cash generated by operations, we must add noncash deductions back to net income. Therefore, a good estimate of a company’s cash flow is given by Eq. 1–5.

If net income