FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES CHAPTER 1 pptx

The Challenge of Financial/Economic Decision-making 1Lessons for the Millennium 2 Some Key Questions 3 The Basics Never Change 6 The Economic Manager 7 Understanding Business Economics 8

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FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES

A Guide for Managers

ERICH A HELFERT, D.B.A.

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A B O U T T H E A U T H O R

Erich A Helfert is an internationally recognized management consultant in

cor-porate finance, strategic planning, and executive education in financial/economicdecision making and shareholder value creation He gained his professional expe-rience from a combination of distinguished business and academic careers

Dr Helfert was vice president, corporate planning, at Crown Zellerbach tion, a major integrated paper and forest products company Prior to his 20-yearcorporate career, he served on the faculty of the Harvard Graduate School of Busi-ness for eight years, teaching finance and managerial economics in the MBA pro-gram, and consulting in management development and strategy with majorcompanies

Corpora-A native of the Sudetenland, formerly Corpora-Austria, he received his BS from theUniversity of Nevada and earned both an MBA (with high distinction) and a DBA(as a Ford Foundation Fellow) at the Harvard Business School Dr Helfert writesand lectures extensively in his field, and his books and articles have been pub-

lished in the United States and abroad His first literary work, Valley of the Shadow, a factual historical novel about his experiences in central Europe at the

end of World War II, was published recently

Dr Helfert is cofounder, chairman and CEO of Modernsoft, Inc., San

Ma-teo, California, developers of Financial Genome, an advanced knowledge-based financial analysis and business modeling software, which is complementary to Fi- nancial Analysis: Tools and Techniques.

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The Challenge of Financial/Economic Decision-making 1

Lessons for the Millennium 2

Some Key Questions 3 The Basics Never Change 6

The Economic Manager 7

Understanding Business Economics 8 Appropriate Economic Tools 9

The Practice of Financial/Economic Analysis 10

Day to Day Decisions and Operational Planning 10 Supporting Strategy Development 11

Performance Assessment and Incentives 12 Valuation and Investor Communications 14

The Value Creating Company 15

Relevant Decision Information 15 Economic Incentives 17

Total Systems Management 18

Chapter 2

A Systems Context for Financial Management 21

A Dynamic Perspective of Business 22

Decision Context 22 The Business System 26 Investment Decisions 29 Operating Decisions 31 Financing Decisions 33 Interrelationship of Strategy and Value Creation 36

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x Contents

The Nature of Financial Statements 37

The Balance Sheet 38 The Income Statement 40 The Cash Flow Statement 42 The Statement of Changes in Shareholders’ (Owners’) Equity 46

The Context of Financial Analysis 50Key Issues 55

Analytical Support 57

Chapter 3

Managing Operating Funds 59

Funds Flow Cycles 61

The Funds Cycle for Manufacturing 64 The Funds Cycle for Sales 67

The Funds Cycle for Services 69

Variability of Funds Flows 70

Growth/Decline Variations 70 Seasonal Variations 74 Cyclical Variations 75 Generalized Funds Flow Relationships 77

Interpreting Funds Flow Data 78Funds Management and Shareholder Value 89

Working Capital Management 90 Investment Management 91

Key Issues 91Analytical Support 93

Chapter 4

Assessment of Business Performance 95

Ratio Analysis and Performance 95Management’s Point of View 97

Operational Analysis 98 Resource Management 107 Profitability 112

Owners’ Point of View 115

Disposition of Earnings 121 Market Indicators 123

Lenders’ Point of View 126

Liquidity 126 Financial Leverage 128 Debt Service 130

Ratios as a System 132

Elements of Return on Assets 133 Elements of Return on Equity 134

Integration of Financial Performance Analysis 137

Some Special Issues 139

Inventory Costing 140 Depreciation Methods 141 The Impact of Inflation 144

Key Issues 145

Analytical Support 147

Chapter 5

Projection of Financial Requirements 161

Pro Forma Financial Statements 163

Pro Forma Income Statement 164 Pro Forma Balance Sheet 167 Pro Forma Cash Flow Statement 171

Cash Budgets 174

Operating Budgets 178

Sales Budget 179 Production Budget 181

Interrelationship of Financial Projections 181

xii Contents

Target Profit Analysis 202 Financial Leverage 203

Financial Growth Plans 209

Basic Financial Growth Model 210 Sustainable Growth and the Sustainable Growth Equation 214 Integrated Financial Plan 217

Key Issues 220

Analytical Support 222

Chapter 7

Cash Flows and the Time Value of Money 223

The Time Value of Money 224

Discounting, Compounding, and Equivalence 224

Components of Analysis 231

Net Investment 232 Net Operating Cash Inflows 232 Economic Life 233

Terminal (Residual) Value 233

Methods of Analysis 234

Simple Measures 234 Economic Investment Measures 237 Net Present Value 237 Present Value Payback 242 Profitability Index (BCR) 244 Internal Rate of Return (IRR, Yield) 245 Annualized Net Present Value 247

Applying Time-Adjusted Measures 250

Incremental Cash Flows 263 Relevant Accounting Data 264 Sunk Costs 265

Refinements of Investment Analysis 266

A Machine Replacement 266 Net Investment Refined 267 Operating Cash Inflows Refined 268 Unequal Economic Lives 271 Capital Additions and Recoveries 272 Analytical Framework 272

A Business Expansion 275

Mutually Exclusive Alternatives 277

Maintain versus Replace 277 Full-Fledged versus Economy Solution 279

Comparing Different Scenarios 280

Dealing with Risk and Changing Circumstances 282

Specifying Risk 283 Ranges of Estimates 284 Business Investments as Options 285 Probabilistic Simulation 287 Risk-Adjusted Return Standards 288

When to Use Investment Measures 289

Some Further Considerations 291

Leasing—A Financing Choice 291 Accelerated Depreciation 292 Inflation and Investment Analysis 292 Accuracy 293

Cost of Operating Funds 300

Cost of Long-term Debt 304

xiv Contents

Cost of Shareholders’ Equity 305

Preferred Stock 305 Common Equity 306

Weighted Cost of Capital 312

Cost Choices 312 Weighting the Proportions 313 Calculating the Weighted Cost of Capital 315

Cost of Capital and Return Standards 317

Cost of Capital as a Cutoff Rate 318 Risk Categories 319

Cost of Capital in Multibusiness Companies 321 Multiple Rate Analysis 322

Key Issues 322

Analytical Support 324

Chapter 10

Analysis of Financing Choices 325

Framework for Analysis 326

Cost of Incremental Funds 326 Risk Exposure 327

Flexibility 328 Timing 328 Control 329 The Choice 330

Techniques of Calculation 330

Current Performance 331 Long-Term Debt in the Capital Structure 332 Preferred Stock in the Capital Structure 335 Common Stock in the Capital Structure 336

Range of Earnings Chart 339

The Optimal Capital Structure 345

Some Special Forms of Financing 347

Leasing 347 Convertible Securities 350 Stock Rights 351

Warrants 352

Key Issues 352

Analytical Support 354

Chapter 11

Valuation and Business Performance 357

Definitions of Value 358

Economic Value 358 Market Value 359 Book Value 360 Liquidation Value 360 Breakup Value 361 Reproduction Value 361 Collateral Value 361 Assessed Value 362 Appraised Value 362 Going Concern Value 362 Shareholder Value 363

Value to the Investor 363

Bond Values 363 Preferred Stock Values 368 Common Stock Values 372

Specialized Valuation Issues 378

Rights and Warrants 378 Options 379

Business Valuation 380

Valuing the Equity 381 Valuing the Total Company 382 Using Shortcuts in Valuing an Ongoing Business 387

Key Issues 388

Analytical Support 389

Chapter 12

Managing for Shareholder Value 391

Shareholder Value Creation in Perspective 392

Evolution of Value-Based Methodologies 396

A Review of Key Measures 398 Economic Profit and CFROI 402

Creating Value in Restructuring and Combinations 411

Restructuring and Value 411

P R E F A C E

This volume is an adaptation for the professional market of the most recent 10th

(“millennium”) edition of Dr Helfert’s best-selling Techniques of Financial Analysis, which, with more than half a million copies in print over the past 38

years, has given the student, analyst, and business executive a concise, practical,usable, and up-to-date overview of key financial/economic analysis tools Thepresentation format has always been carefully designed to help the reader under-stand the linkage between management decisions and their impact on the financialperformance and the economic value of a business This book helps the reader tointerpret financial reports, develop basic financial projections, evaluate businessinvestment decisions, assess the implications of financing choices, derive thevalue of a business or a security, and understand the role of analysis in achievingthe goal of shareholder value creation Every technique and measure is describedand demonstrated in the context of important underlying financial and economicconcepts, but without delving into theoretical abstraction

A Unique Systems Approach to Financial Management

The concept that any business is essentially an integrated system of cash flowsdriven by management decisions provides the book’s foundation All analyticaltools and related financial/economic concepts are discussed within this systemscontext, which reflects the three basic types of decisions made continuously bythe management of any ongoing business: investment, operating, and financing.The materials are also structured around the viewpoints of the major parties inter-ested in the analysis and performance of a business: managers, owners, and cred-itors The book begins by providing a perspective on the recent speculativeexcesses in the new economy’s “dotcom” revolution, with the argument that basiceconomics and financial analysis have never changed, but only were ignored attimes Next, the key concept of the business system and all of its relationships tofinancial analysis and statements is presented in detail, from which the discussionproceeds to explain the various techniques and concepts in a logical flow Closure

is provided by returning to the systems concept in the final chapters on valuationand managing for shareholder value Within this structure, however, practicalityalways remains paramount Any issues and concepts going beyond what is essen-tial are left to the more specialized textbooks and articles identified in the refer-ences The systems approach is also reflected in the commercially available

Financial Genome business analysis and planning software and its accompanying

interactive templates

xvii

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xviii Preface

The Audience

Ever since the first edition appeared in 1963, the book has consistently maintained

a unique appeal both for students (graduate and undergraduate) and practitionersbecause of its clarity and commonsense presentation Straddling the educationaland professional markets, the book requires little if any background in finance andaccounting and provides an accessible, self-contained overview of the essentialfinancial management concepts and tools Countless students have found the book

an understandable and useful guide for their studies and kept the book for readyreference in their careers, while large numbers of professionals—whether finan-cial practitioners or nonfinancial managers—recognized the practicality and ap-plicability of the book’s approach to their needs and decision-making

Originally an outgrowth of the compact technical briefing materials used inthe MBA program at the Harvard Business School, which supplement practicalcase study discussion with essential background, the book has been regularly up-dated and modified approximately every four years The tenth “millennium” edi-tion reflects not only the latest practice in the use of the various financialtechniques, but also the experience gained over nine editions from the widespreaduse the book has enjoyed in university finance courses, both graduate and under-graduate, and from hundreds of executive development seminars and in-companyprograms in the United States, Canada, Latin America, and overseas, includingthose conducted by the author in numerous Fortune 100 client companies Fre-quently translated into nine foreign languages over the years, the book has tran-scended the confines of American business practice on which it is built, becausethe way in which the analytical methods are described makes them almost uni-versally applicable

What’s New in this Book

The 10th edition of Techniques of Financial Analysis, on which this volume is

based, has been refined and updated while preserving the logical, integrated flow

of the materials After setting the stage in Chapter 1, the coverage begins with anoverview of the “business system” and the key financial analysis tools, all the way

to the development of business valuation and the newly developed materials onmanaging for shareholder value The discussion of the analysis of business in-vestments and business valuation have been expanded into two chapters each, toprovide additional insights, practical examples, and greater linkage to shareholdervalue creation The various graphics supporting the text, several of them new ad-ditions, were tested for their effectiveness in numerous executive developmentprograms over the past 12 years Also, where appropriate, specific references tospreadsheet analysis have been included and examples are presented in this read-ily accessible format to ease the mechanical aspects of analysis

An entirely new feature is the optional availability of the advanced,

knowl-edge-based financial analysis software package, Financial Genome, created by

Modernsoft, Inc This professional application enables the user to develop cial statements, the whole range of key financial measures, and integrated finan-cial projections and plans, as well as ad hoc financial analyses The patentedknowledge-based technology enables the user to readily perform these tasks fromspreadsheet data or data bases with assured internal consistency, without having

finan-to worry about cell locations and formulas Knowledge of financial terms, tionships, and statement structures is built in, but can be accessed and displayed

rela-at will for enhanced understanding The software is also accompanied by a series

of interactive templates and displays relating to many of the key exhibits of thisbook, especially the core diagram of the business system The templates are de-signed to enhance the learning experience by graphically illustrating the impact ofchanges in assumptions and conditions Many templates are also designed for

general use, such as break-even and present value analysis Financial Genome is

described in detail in Appendix I Interested readers can download the softwarefor trial, as well as the “TFA Templates,” from Modernsoft, Inc’s web site:www.modernsoft.com

As before, chapters 2 through 6 of the book form an integrated set, builtaround the conceptual overview of the business system, its decisional context, andits relationship to financial statements and analytical tools as presented in Chap-ter 2 The coverage of analytical methods begins in Chapter 3 with funds flowanalysis, moves on to financial performance analysis, covers financial projections,and culminates in a discussion of the financial dynamics useful in modeling fi-nancial conditions and growth capabilities

Chapters 7 through 11 deal with more specialized topics such as businessinvestment analysis, the cost of capital, financing choices, and valuation of secu-rities and businesses, while the final Chapter 12 returns to the systems context in

an expanded discussion of the conceptual and analytical aspects of managing forshareholder value The informational Appendix III was updated to include key on-line references

The process of revision and current adaptation has not, however, affectedthe book’s primary focus on the doable and practical—in effect an “executivebriefing” concept—and on building the reader’s basic ability to grasp financial re-lationships and issues As before, the book presupposes only that the user hassome familiarity with basic accounting concepts

Acknowledgments

I would again like to express my appreciation to my former colleagues at the vard Business School for the opportunity to develop the original concept of thebook My thanks also go to my business associates and to my colleagues at uni-versities and in executive development programs here and abroad, too numerous

Har-to mention individually, for their continued extensive use of the book and for themany expressions of interest and constructive suggestions that have supported thebook’s evolution

xx Preface

My special thanks go to my colleagues at Modernsoft, Inc., Edgar P Canty,

Dr William J Clancey, John W Wu, and Lee Hecht for their enthusiasm and pertise in adapting the major concepts of the book and its approach in our devel-

ex-opment of the Financial Genome software and its accompanying educational

templates Their insights and suggestions were most valuable during the recent vision of this book, and their unwavering dedication to creating this unique pro-fessional financial analysis and planning software has been exemplary

re-I would also like to state my sincere appreciation to the McGraw-Hill lishing team who made this edition a reality; Jeffrey Krames, Publisher, andStephen Isaacs, sponsoring editor, have both consistently and generously guidedthe book through its various stages

pub-Finally, I continue to be most gratified by the positive responses from somany individual users, past and current, who have found the book helpful in theirstudies and an ongoing supportive resource in their professions

I N T R O D U C T I O N

When an analyst, business executive, or student is dealing with a financial issue,

or wishes to understand the financial implications and economic trade-offs volved in decisions about business investment, operations, or financing, a widevariety of analytical techniques—and sometimes rules of thumb—is available togenerate quantitative answers Selecting the appropriate tools from these choices

in-is clearly an important part of the analytical task Yet, experience has shown againand again that first developing a proper perspective for the problem or issue is just

as important as the choice of the tools themselves

Therefore, this book not only presents the key financial tools generallyused, but also explains the broader context of how and where they’re applied toobtain meaningful answers To this end, the second chapter provides an integratedconceptual backdrop both for the financial/economic dimensions of systematicbusiness management and for understanding the nature of financial statements,data, and processes underlying financial analysis techniques All subjects areviewed in the context of creating shareholder value—a fundamental concept that

is revisited in the final chapter on managing for shareholder value

While the tools and techniques covered in this book are discussed anddemonstrated in detail, the user must not be tempted to view them as ends inthemselves It’s simply not enough to master the techniques alone! Financial/economic analysis is both an analytical and a judgmental process which helps an-swer questions that have been carefully framed in a managerial context Theprocess is at its best when the analyst’s efforts are focused primarily on structur-ing the issue and its context, and only secondarily on data manipulation We can’tstress enough that the basic purpose of financial analysis is to help those respon-sible for results to make sound business decisions within a relevant cash flowframework

Apart from providing specific numerical answers, “solutions” to financialproblems and issues depend significantly on the points of view of the various par-ties involved, on the relative importance of the issue, and on the nature and relia-bility of the information available In each situation, the objective of the analysismust be clearly understood before pencil is put to paper or computer keys aretouched—otherwise, the process becomes wasteful “number crunching,” even ifthe workload itself is eased by analytical software

Management has been defined as “the art of asking significant questions.”The same applies to financial analysis, which should be targeted toward findingmeaningful answers to these significant questions—whether or not the results arefully quantifiable In fact, the qualitative judgments involved in finding answers

to financial/economic issues can often count just as heavily as the quantitative

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