4/11/2016 Finance:IntroductorySection

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Finance:IntroductorySection
WelcometoFinance

YouareabouttobeginHarvardBusinessSchool'sinteractiveFinancecourse,whichwillintroduceyoutotheprinciplesof
finance.Successfulcompletionofthisintroductorysectionwillprepareyouforfurtherstudyoffinancialmanagement,
financialmarkets,andfinancialinstrumentsandtheapplicationofthesedisciplinesinorganizationsthroughouttheworld.

UsingtheTutorial

ThestructureoftheHarvardBusinessSchoolFinancetutorialanditsnavigationaltoolsareeasytomaster.Ifyouare
readingthistext,youmusthaveclickedonthenavigationitemlabeledUsingtheTutorialontheleft.

PleaseclickontheHelpiconintheupperrightcornerofthetutorialtoviewaclickableanimationonhowtousethis
tutorial.Youwillbeabletoreferbacktotheseinstructionsthroughoutthetutorial.

WhatisFinance?

Allcorporations,whetherlargeorsmall,neworold,confrontfundamentaldecisionsabouthowtodeploycapitalthatis,
whattoinvestinandhowtoraisefundsneededforinvestment.Thesechoicesarecentraltothedisciplineofcorporate
financialmanagement.Fundamentally,thestudyofcorporatefinancecoverstheprinciples,analyticaltools,and
institutionalknowledgeamanagerneedstomakegoodinvestmentandfinancingdecisions.Inaddition,however,awell
runcorporationneedsafinancialinfrastructuresystemsformonitoringcashandcashflow,forcreatingoperatingand
financialbudgets,formeasuringandreportingitsfinancialandoperatingperformance,formanagingitscurrentand
expectedtaxliabilities,andsoforth.Definedbroadly,thefieldoffinancecoversallthesetopics,andmanyrelatedonesas
well,suchasthemarketsinwhichfinancialcontractsarepricedandtraded,andtheinstitutionsthatuse,support,and
regulatethem.Thistutorialcannotcoverallthematerialaqualifiedmanagerneedstoknowrather,itsgoalistogetyou
startedandprepareyouforfurtherstudy.

TutorialOverview

Eachmoduleinthistutorialwillintroducenewfinancialconceptsandtools.Thesewilloftenbeillustratedinthecontext
ofasimple,stylizedcompany,calledtheGoldenStateCanningCompany.Tocementyourunderstandingofthematerial,
youwillbeaskedtocompletevariousexercisesasyouproceedthrougheachmodule.Alongtheway,youwillalsogettosee
andusesomerealworldcorporatedata.Forexample,you'llusefinancialinformationfromtheJ.M.SmuckerCompanyto
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helpyouevaluateaprojectproposedforGoldenStateCanning.Eachmoduleendswithacapsulesummaryofthematerial
justcovered.

Ifyouarealreadyfamiliarwithbasicfinanceconceptsandtools,youmaywishtotakethepretestbeforebeginningthe
tutorial.Ifyouarenotveryfamiliarwithfinance,simplyskipthepretesttosavetime.Ifyoutakethepretestandanswer
75%ofthequestionscorrectly,youarealreadyreasonablywellpreparedforfurtherstudyandneednotcontinuewiththe
tutorial.However,youshouldfeelfreetoexplorethetutorialanyway,focusingonareasinwhichyouwanttorefreshyour
knowledge.Ifyouanswerlessthan75%correctly,startatthebeginningofthetutorialandgothroughthematerialinthe
orderinwhichitispresented.Whenyouarefinished,youshouldtakeFinalExam1totestyourself.Ifyouanswer75%of
thesequestionscorrectly,youarefinished!Otherwise,youshouldgobackandreviewpartsofthetutorialthatgaveyou
difficultyandthentakeFinalExam2.

Thetutorialconsistsoffourmodulesfocusedonanalyzingacompany'spast,current,andfutureperformance,mostlyusing
itsfinancialstatements.ThesemodulesincludeanIntroduction,RatioAnalysis,theCashCycleandGrowth,andFinancial
Forecasting.ThenextmodulecoversTimeValueofMoneyasitrelatestoGoldenStateCanning.

PretestIntroduction

WelcometothepreassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledgeofsome
basicfinancialprinciples.

Allquestionsmustbeansweredforyourexamtobescored.

Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
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PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.

Yourresultswillbedisplayedimmediatelyuponcompletionoftheexam.

Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.

GoodLuck!

Introduction

Inthissectionyouwillusecommonanalyticaltoolstoassessacompany'sfinancialconditionandperformance.Inother
words,howisthecompanydoing?Whatsortofshapeisitin?Youwillbeintroducedtofinancialratioanalysis,commonsize
financialstatements,thecashcycle,sourcesandusesanalysis,sustainablegrowth,andthepreparationofforecastsandpro
formafinancialstatements.

FinancialStatements

Learningtoanalyzebusinessesrequireslearningtoworkwithfinancialstatementsmuchasaportraitartistmustlearnto
draw,oraphysicianmustlearnanatomy.Financialstatementsdonotgiveacompleteoranidealrenderingofabusiness,
buttheyareubiquitousandconvenient.

Theyshareacommonformacrossmanydifferenttypesofbusinesses.
Theyexpresseverythingincommonunits.
Theyprovideasystematicwayoflinkingthepast,present,and(expected)futureperformance.

Perhapsmostimportant,theyarefundamentallyquantitative,acharacteristicsometimesbemoanedforthelimitationsit
implies,butonethatconveystheboonofmathematicalmanipulability.Imaginehowdifficultitwouldbetoevaluatea
businessifwecouldrepresentitonlypictorially,orinwords,butnotwithnumbers.

Thistutorialpresumesyouarefamiliarwithbasicfinancialaccounting.Inparticular,itmakesextensiveuseofcorporate
incomestatementsandbalancesheets.Ifyouhavenotalreadydoneso,pleasecompletetheHBSFinancialAccounting
Tutorialforacomprehensiveintroductiontofinancialaccountingandbasicfinancialstatements.

GoldenStateCanning

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Thischapterillustratesfinancialstatementanalysiswithasimplebusiness.Togetstarted,pleaseadopttheperspectiveof
aprospectiveownerandmanagerofthebusiness,asfollows.

DownloadFinancialStatementshere.

RatioAnalysis

ThefirststepinanalyzingGoldenState'spotentialistoexamineitsrecentperformanceandcurrentfinancialcondition.
Financeprofessionalsuseamyriadofdifferentfinancialratiostoassessfinancialhealthsomany,infact,thatithelpsto
groupthemintocategories.Herearesixbasiccategories:

Growth
Profitability
Liquidity
Leverage
Efficiency
Risk

Beawarethatnoteveryoneusesthesamecategories,anddifferentanalystsmaydefineagivenratiodifferently.

Definition

Mostfinancialratiosconsistofasimplecomparisonbetweenitemsofinterestfromabalancesheetand/orincome
statementthatyieldinsightintoconditionorperformance.

Forexample,lookingatGoldenState'sbalancesheetwecancompareitsequitytoitsassetsandcomputetheequityto
assetratioin2007.

Growth

Youarelookingforabusinesswithgrowthpossibilities.Moregenerally,investorsandmanagerswanttheirbusinessesto
producemorecash,tobecomemorevaluable.Inshort,theyarelookingforgrowth.Weusuallymeasuregrowthasarateof
changeovertimeinaspecificitemofinterest,suchassales,assets,profits,orcashflow.

OneoftheattractionsofGoldenStateisthepossibilityofgrowingthebusiness.Hasitbeengrowinglately?Howfast?
Howconsistently?Historicgrowthratesmaybeanindicatoroffuturegrowthpotential.

CompoundAverageGrowthRate
Inadditiontocomputingacompany'syeartoyeargrowthrates,wemaybeinterestedinaveragegrowthratesovera
longerperiod.Onewaytomeasurethisistocomputeacompoundaveragegrowthrate(CAGR).TheCAGRisthesingle
constantgrowthratethat,whencompoundedoverafinitenumberofyears,producestheobservedendpointfromthe
observedstartingvalue.

Sales
ComputeGoldenState'syeartoyeargrowthratesforsales,aswellastheCAGRforGoldenState'ssalesfrom2004to
2007.

OperatingProfit
YoudecidetoinvestigateGoldenState'sgrowthfurtherbycomputingthegrowthinitsoperatingprofit.Operating
profitisoftenreferredtoasearningsbeforeinterestandtaxes(EBIT).

Profitability

Inadditiontoknowingwhetheracompanyisgrowing,wewanttoknowifitisprofitable.Wecouldsimplylookatgross
profit,operatingprofit,andnetincome,toseeifeachispositiveornegative.Butthat'snotenough.Ithelpstocompare
profitstosomething.Forexample,howmuchsaleswererequiredtogenerateagivenprofit?Howlargeanassetbasewas
required?Ifwecompareoperatingprofittosales,wegettheoperatingmargin.Comparingoperatingprofittoassetsis

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onewaytomeasurepretaxreturnonassets.

ProfitMargins
Weobservedpositive,ifunimpressivesalesgrowthforGoldenState.Operatingprofitgrewfasterbutwasunevenover
time.TogetaclearerpictureofGoldenState'sprofitability,let'slookatitsprofitmargins.Wecanthinkofprofit
marginsinahierarchyinwhicheachsuccessivemargintakesanadditionalfactorintoaccount.

ReturnonEquity
Since,ifyoudecidetobuyGoldenState,youwillbeinvestingmostofyoursavings,youareinterestedinhowmuch
profitthecompanywillproduce,comparedtoyourinvestment.Thereturnonbeginningequity(ROBE)compares
netincomeduringagivenyeartoowner'sequityatthebeginningoftheyear.ROBEisapopularmeasureoffinancial
performanceamonginvestorsandmanagersandwillbediscussedingreaterdetailinfuturechapters.Anothercommon
variantofthisratioisROE,whichcomparesnetincomeduringtheyeartoendofyearowner'sequity.

Efficiency

Manyfinancialratiosareintendedtohelpassesstheefficiencyofacompany'soperations.Someanalystscallthis
category"ActivityRatios".Forexamplewemaywanttomeasurehowwellabusinessemploysitsplantandequipment,its
inventory,itscreditfromsuppliers,andsoforth.Orwemaywanttoknowhowquicklyitsreceivablesarecollectedorhow
longsomeproductsstayininventorybeforeasale.

AssetTurnover
Now,computeaverageassetturnoverfortheremainingthreeyears,toseeifthereisatrend.

Inventory
Foramanufacturingcompanyoraretailer,wewouldliketoknowhowlongittakesthecompanytoproduceandsellits
goods.Thelongerittakes,themorefinancingwillberequired.Acommonratiocomparesthecostofgoodssoldto
inventory.Notethatonceagain,thiscombinesanitemfromtheincomestatement(COGS)toonefromthebalance
sheet(inventory)sowehavetostipulatebeginning,ending,oraverageinventory.DividingCOGSbyendinginventory
gives(ending)inventoryturnover.Let'scomputethisforGoldenStatefor2007.

Anothercommonformulationofaninventoryratioisdaysininventory.Itusesthesamebasicinformation,but
expressestheamountofinventoryheldintermsofthenumberofdaysofCOGSitrepresents.Tocomputedaysin
inventory,weexpressinventoryasafractionofCOGS(thisissimplythereciprocalofinventoryturnover)andthen
applythatfractionto365daysperyear.

Allelseequal,wepreferalowernumberofdaysininventory,whichcorrespondstoahigherinventoryturnover.Higher
turnoverindicatesaneedforlessinventoryandcorrespondinglylowercapitalrequirementstofinancetheinventory.
Butindustriesvarywidely,andsometimesacompanymaybewillingtocarrymoreinventoryifitfurtherssomeother
goal.Forexample,itmaybepossibletochargehigherpricesorreachmoreorbettercustomersbycarryingmore
inventory.

Let'sexamineGoldenState'sDaysinInventoryforthewholeperiod20042007.GoldenState'sdaysininventoryrose
steadilyfrom2004to2006andfellslightlyin2007.However,theseasonalnatureofGoldenState'sbusinessshould
makeuscarefulaboutinterpretingthisresult.

SeasonalityandCyclicality
Likemanybusinesses,GoldenState'scanningoperationsareseasonal:thecompanyiscanningmoreproduceatcertain
timesoftheyearthanothers.Seasonalpatternsaregenerallypredictabletheyfollowthecalendar.GoldenState's
seasonalpeakisdrivenbythegrowingseason.Forothercompanies,suchasretailers,theseasonalpeakmaybedriven
byconsumers'buyinghabitsforexample,purchasinggiftsforholidaysorsuntanlotioninthesummer.

Liquidity

Foranasset,liquiditydenotes"closenesstocash,"ortheeasewithwhichtheassetcanbeconvertedtocashwithoutaloss
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ofvalue.Foranentirecompany,liquidityisassociatedwiththecompany'sabilitytomeetknownneartermcash
obligationsand/ortocopewithunexpectedneedsforcash.

Liquidityratiosprovideanindicationofacompany'sabilitytopayor"liquidate"shorttermobligations,generally,those
fallingduewithinoneyear.Illiquiditymayhaveseriousconsequencesifitresultsindefaultondebtobligationsorifit
impairsfutureaccesstocredit.Ontheotherhand,excessiveliquiditymayreflectpoorassetutilization.

CurrentRatio
Themostcommonmeasureofliquidityisthecurrentratio.Thecurrentratiosimplycomparescurrentassetstocurrent
liabilities.Currentassetsincludecash,marketablesecurities,andworkingcapitalitemsthatwillturnintocashwithin
oneyear.Currentliabilitiesincludeamountsowedtosuppliers,employees,lenders,andthegovernmentwithinayear.
Alowcurrentratiomaybeanearlywarningoffutureliquidityproblemsasneartermobligationscomedueingreater
amountsthanarecoveredbycontemporaneousliquidassets.

Let'sexamineGoldenState'sliquiditybycalculatingitscurrentratioduring20032007.

QuickRatio
Anothermeasureofliquidityissimplytheamountofcashonhand.WecaneasilyseethatGoldenState'scashdropped
steadilyfrom2004to2006.

Howtightwerethingsin2007?Togetanidea,let'scomputethecompany'squickratiofor2007.Thequickratioislike
thecurrentratio,exceptthatinventoriesareexcludedfromcurrentassets.Why?Becauseinventoryisgenerally
consideredlessliquidthanreceivables(anditiscertainlylessliquidthancash).

Leverage

Financialleverage(sometimescalled"gearing")iscreatedwhenacompanyborrowsmoneytofunditsoperations.Debt
createsfixedfinancialcharges,namelyinterestandprincipalpayments,thatmakeacompany'snetearningsandcashflow
morevolatile.

DebtRatio
Oneofthemostcommonleverageratioscomparesdebttocapital,alsocommonlycalledthedebtratio.Thisisan
indication,forGoldenState,oftheextenttowhichMr.Cotahasutilizeddebttofinancethecompany'soperations.In
otherwords,whatfractionofGoldenState'scapitalisdebtasopposedtoequity?Beawarethat"debtratio"isaname
appliedtoavarietyofdifferentlydefinedratiositisimportanttochecktheparticulardefinitionbeingusedbya
givenanalyst.Forthemoment,wewillcomputeGoldenState'sdebtratioasinterestbearingdebtdividedbyinterest
bearingdebtplusequity.

TimesInterestEarned
Thetimesinterestearnedratio(alsoknownasthe"interestcoverageratio")isanothermeasureofleverage.It
examinestheextenttowhichacompany'searningscoveritsinterestpayments.Sometimesthisratioiscomputedusing
cashflowinsteadofoperatingprofitinthenumerator.

Risk
Thefutureperformanceofabusinessisuncertainitcouldbebetterorworse,dependingonwhathappensintheworld.
Wecanthinkofthisuncertaintyasrisk,andnotethatitvariesacrossbusinessesandindustries,sowewouldliketo
measureit.

Riskisdifficulttomeasureusingdatasolelyfromfinancialstatements,anditwillbestudiedingreaterdetailinafuture
chapter.Fornow,notethatnoneoftheratiosmentionedsofarmeasuresriskdirectly(thoughleverageisassociatedwith
financialrisk).Sohowcanweassessit?Onepossibilityistoscanhistoricaloperatingresultstogetanideaofthevolatility
ofsalesorprofit,forexample.ButwehavealreadyseenintheGoldenStateexamplethatsuchvariabilitycouldarisein
manyways,notallofwhichhavetodowithrisk.

FixedtoVariableCosts
Oneindicatorofoperatingriskistheratiooffixedcoststovariablecostsinacompany'soperations.Variablecostsvary

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directlywithsales,whilefixedcostsremainconstantregardlessofhigherorlowersales.Publishedfinancialstatements
seldomprovideunambiguousseparationsorallocationsofvariableandfixedcosts,thoughmanycompaniesperform
suchallocationsinternally,preciselyasameansofunderstandingrisk.Allelseequal,ahigherproportionoffixedcosts
denoteshigheroperatingrisk.Atthesametime,itdenotesthepotentialforeconomiesofscalethepossibilityof
growingsaleswithoutincreasingfixedcosts,whichtranslatesintohigheroperatingmargins(thisisknownas"operating
leverage").

Let'scompareGoldenState'sratiooffixedtovariablecosts.

Whatisthe2007ratio?

CommonsizeFinancialStatements

Youhavealreadycoveredthemaincategoriesoffinancialratios.Commonsizefinancialstatementsprovideaquickand
comprehensivelookatsomeofthem,andaconsistentmeansofcomparisonforsome.

Acommonsizefinancialstatementissimplyonethathasbeenscaledbyasingleparameter,suchassalesorassets,sothat
eachitemisexpressedinrelativeorpercentageterms,ratherthaninunitsofcurrency.Suchstatementsmakeiteasyto
spottrendsovertimethatarenotduetogrowth.Andtheyfacilitatecomparisonsofdifferentcompaniesinrelativeterms,
regardlessofdifferencesinsize.

Whilemanyoftheratiosintroducedabovecomenaturallyoutofacommonsizeincomestatementorbalancesheet(e.g.,
thegrossmargin,operatingmargin,debtratios,etc.),othersdonot,becausetheyconsistofitemsfromboththebalance
sheetandincomestatement(forexample,assetturnover).

BalanceSheet
Commonsizebalancesheetstypicallyexpressallitemsasapercentoftotalassets.

CompletethemissingitemsinGoldenState's2007commonsizebalancesheet.

IncomeStatement
Commonsizeincomestatementsgenerallyexpressallitemsasapercentofnetsales,enablingustostudyGoldenState's
costandprofitstructures.

CompletethemissingitemsinGoldenState's2007commonsizeincomestatement.

Trends
BylookingatGoldenState'scommonsizefinancialstatementsovertheyearswecanspotpotentiallyimportanttrends:

Interpretation
Theprecedingsectioncoveredonlyasmallfractionofthemanydifferentratiosthatyoumayencounterintherealworldof
financialanalysis.Differentanalystsandmanagerscomputedifferentratios.Moreconfusingly,eachmaydefineagiven
ratiodifferentlyfromsomeoneelse.Howshouldyoudecidewhichvariationofaparticularratiotolookat?Itdepends,of
course,onwhatyouaretryingtolearnaboutacompany.Italsodependsonpersonalpreferences,availabledata,and
availablebenchmarks.

Thecomputationoffinancialratiosisfairlymechanical,asyouhaveseen.Interpretingthem,however,isseldomso
straightforward.Mosthavelittleornointrinsicmeaning.Thatis,eventhoughtheyaddressimportanttopics,suchas
growthandprofitability,andtheyareinherentlycomparisonsofsay,operatingprofittosalestheymustbesubjected
tostillfurthercomparisonstobemeaningful.Soifwefind,forexample,thatGoldenState'soperatingmarginis8%,how
doweknowwhethertobeimpressedordisappointed?

Thissectionprovidessomeguidance.Financialratiosareusuallyinterpretedaccordingtooneoranotheroffourbasic
comparisons:changesovertime,peercompanies,prespecifiedbudgetsortargets,andrulesofthumb.

TimeTrend
Oneofthemostinformativewaystointerpretacompany'sratiosistocomparethemtothesamecompany'spast
performance.YouhavealreadyperformedthissortofcomparisonformanyofGoldenState'sratios.

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IndustryComparison
ThoughwecanseeGoldenState'sprofitmarginsriseandfallovertime,wehavenoexternalbenchmarktohelpus
decidewhethertheyareimpressiveordisappointing.Onesetofusefulbenchmarksisothercompaniesinthesame
business,perhapsevendirectcompetitors,whosefinancialstatementsmaybeavailableforcomparison.Sometimes
suchcomparisonsaredonecompanybycompany.

Budgets
RulesofThumb
Finally,someanalystsdeveloprulesofthumbtohelptheminterpretratios.Forexample,onemightsaythatthecurrent
ratioshouldbegreaterthan1.0asaruleofthumb.Attheirbest,rulesofthumbreflectacapableanalyst'syearsof
experience.Attheirworst,theyaresubjectivenotionsthatshouldbechallengedoratleastsupplementedwithother
data.

GoldenStateCanning
ThefollowingvideoreviewssomeofwhatwehavelearnedaboutGoldenStatethroughourstudyofitsfinancialratios
andhighlightssometopicsforfurtherstudyandinvestigation.

ListofCommonRatios

Thissectionpresentsacompendiumofcommonratios.Youshouldnotexpecttomemorizealltheratiosandtheir
formulas,atleastnotnow.Instead,aPDFfilecontainingtheformulasoftheratiospresentedinthischaptercanbe
downloadedbyclickinghere.

Growth
Growthratioscouldbecomputedforalmostanyitemonthebalancesheetorincomestatement.However,analysts
usuallyfocusongrowthinsales,operatingprofit,netincome,theworkingcapitalaccounts,fixedassets,andtotalassets.
Wecanlookatyeartoyeargrowthratesorataveragerates.Anaveragemaybecompounded(aswecomputedthe
CAGR)above,ornot.Acompoundedaverageissometimesreferredtoasa"geometricmean"whileanoncompounded
averageofyeartoyearratesisan"arithmeticmean."

Profitability
Thisisalistofcommonmeasuresofprofitability.

Efficiency
Thereisanabundanceofefficiencyratios.Asampleofcommononesfollows.

Liquidity
Thissectionprovidesformulasanddefinitionsforsomeliquidityratios.

Leverage
Youcancomputethefollowingmeasuresofleverage.

Risk
Youcancomputethreemeasuresofrisk.

Qualifications

Someofthelimitationsofratioanalysisandcommonsizefinancialstatementsare:
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Ratiosbasedsolelyonfinancialstatementsoverlookothercrucialdeterminantsofperformanceandfinancial
conditions.Forexample,marketshareisanimportantmeasureofperformancethatcannotbecomputedsolely
fromfinancialstatements
Itmaybedifficulttoidentifytrulysimilarcompaniesforexternalcomparisons
Accountingmethodsmaydifferacrossotherwisesimilarcompanies,e.g.,forcompaniesindifferentcountries
Agivencompanymaychangeaccountingmethodsovertime
Ratiosmaybedistortedbynonoperatingactivitiesandtransactions,byextraordinaryevents,anddiscontinued
operations.
Ratiosmaybedistortedbyseasonalityandcyclicality
Mostratiosarecomputedusingbookvaluesratherthanmarketvalues,whichmaybesubstantiallydifferent.For
example,adebttoassetsmeasureofleveragethatseemshighwhencomputedintermsofbookvaluesmightbe
quitereasonableifacompany'sfixedassetsareworthsubstantiallymorethantheirbookvalues.

Review

Youshouldnowhaveageneralunderstandingofratioanalysisanditspurposetomanagersandinvestors.Inparticular,
youlearned:

Howtocomputeratiosinthesixcategoriesofgrowth,profitability,efficiency,liquidity,leverage,andrisk
Howtocreatecommonsizefinancialstatements
Howcommonratiosarechosenandinterpreted
Someofthelimitationsofratioanalysis.

CashCycleandGrowth

Evenaprofitablecompanywillexperiencefinancialproblemsifitrunsoutofcash.Thisisespeciallytrueforcompanies
thataregrowingquickly.Rapidgrowthcreatesaneedforfinancingthat,ifnotprudentlymet,canprecipitateacrisisor,ata
minimum,retardgrowth.Oneofthekeystomanaginggrowthfromafinancialperspectiveisthecashcycle.

Thischapterintroducesthecashcycleandsomeanalyticaltoolsthathelpmanagersunderstandandmanageit.Theseinclude
sourceandusesanalysis,andinternalandsustainablegrowthrates.

CashCycle

Thecashcycleissometimescalledtheoperatingornetworkingcapital(NWC)cycle.Itisarepresentationofthe
movementofcashthroughacycleofoperations.Forexample,theoperatingcycleofawholesalerbeginswiththepurchase
ofgoodsfromasupplier,whichisheldasinventoryuntilacustomerpurchasesthegoods,andeventuallypaysthe
wholesaler,whointurnpaysthesupplier.Theorderinwhichtheseeventsoccur,andthelengthoftimebetweenthem,
drivethenaturalflowofcashinandoutofthebusiness.Thisoperatingcycleinvolvesdifferentsteps,dependingonthe
businessbeingexamined.Thatis,theoperatingcycleforamanufacturerwillbedifferentfromthatofawholesaleror
retailer,oraservicecompany.Accordingly,thecashcyclesforeachwilldifferaswell.

Tosomeextentthecharacteristicsofthecashcyclearedeterminedbyfundamentalpropertiesofagivenbusiness,suchas
GoldenState'sseasonalcanningbusiness.Butmanagerialchoicesaffectthecashcycleaswellforexample,howmuch
creditthecompanychoosestoextendtoitscustomerswilllengthenorshortenthecycle.

CashversusProfit
Notethatthecashcyclefocusesoncashflowratherthanprofit.Whatisthedifference?Profitisdefinedbyaccounting
principlesandrulesthatarenotdesignedtotrackcashflowandconsequentlydonotcorrespondtoit.

Whydoesitmatterthatwetrackandmanagecashflowinadditiontoprofit?Withoutcashflow,evenaprofitable
companywillgooutofbusiness.Withit,evenanunprofitableonemayoperateforalongtime.

InflowsandOutflows
Thinkofthecashcycleasreflectingarecurringsetofactivities.Acompanybuysgoods,sellsthem,collectscash,anduses
thecashtobuymoregoods,sellsthem,andsoforth.Everycompanyhasacashcycle.

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Illustration
Youmightsupposethatforahealthybusiness,theinflowsandoutflowsthatcomprisethecashcyclewillbalanceeach
otherout,sothereisnothingtoworryabout.Indeed,inthelongrunwewouldexpectaprofitablebusinesstohave
greaterinflowsthanoutflows,andhencestilllesstoworryabout.Butformostbusinesses,theoutflowshappenbefore
theinflows.GoldenStatehastobuythepeachesandcansbeforeitcansellthemtoacustomer.Thisfundamentalfact
createsafinancingneed.Let'sexamineGoldenState'scashcycle.

KnowingthatGoldenState'scashconversioncycleissomecertainnumberofdaysishelpful,butit'snotenough.When
Mr.Cotagoestohisbankforaloantocoverhisfinancingneed,hehastoborrowanamountofmoney,notanumberof
days.Howlargealoanisimpliedbyacashconversioncycleof,say15days?Itdependsonthescaleofoperations.Fora
largecanningoperation,15daysisalargerloanthanforasmalleroperation.

Growth
Thesimplefactthatoutflowsprecedeinflowscreatesaneedforfinancingofthebasicworkingcapitalaccounts.
Sometimesthisneedforfinancingissimplyreferredtoasaneedforworkingcapital.GoldenStatewillhavetofind
lendersorshareholderswillingtocontributecapitaltomeetthisneed(retainedearningsarefundscontributedby
shareholders).Howmuchcapitaldependsonhowlargeoperationsare:wesawthatlargeroperationsrequiremore
capital.RecallthatGoldenStatewantstogrowitwantstobecomelargerandlarger.Growthwillrequireevenmore
capital.Thehigherthegrowth,themorecapitalisrequired.Ineffect,agrowingfirmisusingcashcollectedfrom
yesterday'ssalestofundtomorrow'spurchases.Thiscausesashortfallbecauseagrowingfirmisbiggertomorrowthanit
wasyesterday.

Extensions
Sofar,wehaveonlyconsideredtheworkingcapitalaccounts.Amorecompletelookatthecashcyclewouldincludeother
sourcesandusesofcashaswell.

CashConversionCycle
Wementionedthecashconversioncycle(CCC)aboveinthecontextoftheworkingcapitalcycle.Let'scomputeitnow
forGoldenStateusingsomeofthekeyratiosweexaminedinanearlierchapter.TheCCCcombinesthreeratios:daysin
inventory,collectionperiodandpayablesperiod.Forsimplicity,assumethatcreditpurchasesareequaltoCOGSinyour
calculationofdayspayable.

Seasonality
Wesawinthepreviousmodulethatseasonalpatternsinabusinessaffectitsfinancialappearance.Suchseasonal
patternsobviouslyaffecttheoperatingcycleand,inturn,thecashcycle.

SourcesandUses

Anotherwayofmonitoringacompany'sfundingneedsandpatternsistoprepareastatementofSourcesandUsesof
funds.Accountantshavespecializedformatsforsuchstatements,whichyouhavealreadystudiedelsewhere.Auseful
shortcutforpreparingasourcesandusesanalysisissimplytotakebalancesheetsfromtwodifferentdatesandsubtract
onefromtheother.Theamountbywhicheachlineinthebalancesheethaschangedfromonedatetotheotheristhen
categorizedaseitherasourceorauseoffunds.Becausebalancesheetsbalance,itwillalwaysbethecase(withinrounding
error)thatsourcesequaluses.

Let'sconstructGoldenState'ssourcesandusesstatementusingthebalancesheetsprovidedbyMr.Cota.Inparticular,we
areinterestedinwhathappenedtothecompanywhileitwasrunbythehiredmanager.Solet'scompareyearend2004to
2006.Thiswillshowuswhathappenedduringthemanager'stwoyearstint.Thediagrambelow,forexample,showsthat
AccountsReceivabledeclinedfrom2006to2007by$4.2thousand.Thischangerepresentsasourceoffunds.

Construction
Twostepsarenecessarytocreateastatementofsourcesanduses:

1.Computethechangesbetweentwobalancesheets.Oftenthesewillbefromoneyearendtothenext,
butwecouldchooseanyperiodofinterest.ForGoldenStatewearelookingnowatatwoyearperiod.
2.Thentheobservedchangesneedtobeclassifiedaseithersourcesoruses.

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NowweneedtocategorizeeachchangeinGoldenState'sbalancesheetaseitherasourceorause.

Examples
Sourcesoffundscomefromreducinganassetorincreasingaliability.

Usesoffundscomefromincreasinganassetordecreasingaliability.

GoldenState
Testyourknowledgebyconstructingasourcesandusesstatementfor20062007,andthencompareittothe2004
2006statement.Thiswillhighlightsomedifferencesbetweenthecompany'sperformanceunderthemanagerversus
Mr.Cota.

Growth

Aswehaveseen,growthamplifiesthenaturalneedforfinancingimpliedbyacashcycleinwhichoutflowsprecede
inflows.ThiswillbetrueforGoldenStateaswell,shouldyoudecidetoacquireitandsucceedingrowingit.Increasingthe
company'ssaleswillrequirepurchasingmoreproduceandcans,andthismustbedonebeforetheoutputcanbesold.
Aftertheoutputissold,creditmustbeextendedtocustomers.Moreover,inthelongrun,withsustainedgrowth,Golden
Statewillneedadditionalfundstoexpandcapacity.Infact,thecompany'sgrowthrateinthefuturemightbeconstrained
byitsabilitytoobtainadequatefinancing.HowfastcanGoldenStategrow?Thisdependsinpart,ofcourse,onthemarket
forcannedproduceandcompetitiveconditions.Butwewillfocushereonthefinancingproblem.

InternalGrowthRate
Acompany'sinternalgrowthrateistherateatwhichitcangrowwithoutanynewexternalfunding(frombanksor
shareholdersforexample),andassumingitsoperatingratiosremainunchanged.Withoutexternalfunding,the
company'sonlysourceoffundsforgrowthisitsretainedearnings.Soitsinternalgrowthrateissimplytheratioofnew
retainedearningstobeginningofperiodassets.Newretainedearningswillequalnetincomeminusdividends,
sometimescomputedasnetincometimestheretentionrate.Theretentionrateissimplythefractionofnetincomenot
paidoutasdividends

SustainableGrowthRate
Anothermeasureofacompany'scapacityforfinancinggrowthisitssustainablegrowthrate.Thisistherateat
whichacompanycangrowif(1)itdoesnotissueanynewexternalequityand(2)itkeepsitsoperatingandfinancing
ratiosconstant.Thesustainablegrowthrateisgenerallyhigherthantheinternalgrowthrateforafirmwithleverage.
Theinternalgrowthrateiscomputedassumingnonewexternalfinancingofanykind.Bycontrast,thesustainable
growthrateiscomputedassumingnonewexternalequityinotherwords,thesustainablegrowthrateassumesnew
externalborrowinginamountsnecessarytokeepthedebtratioconstant.Thisnewborrowingsupportsmoregrowth,
whichiswhythesustainablegrowthrateishigherthantheinternalgrowthrate.

Howisthesustainablegrowthratecalculated?Itequalstheretentionratetimesthereturnonbeginningequity.

Whyisthesustainablegrowthratetiedtothereturnonequity?Toseewhy,assumenodividends,sotheretentionrate
is100%.Now,sinceoperatingandfinancingratiosarepresumedconstant,theonlywaytogrowthebalancesheetis
withnewfinancing.Newfinancingistiedtonewearnings,whichinturndeterminehowmuchnewborrowingmustbe
donetokeepleverageconstant.Salesmayonlygrowasfastasassets,givenconstantoperatingratios.Inthisway,growth
isconstrainedbytherateatwhichequitycanbeaugmentedbyearnings.Inotherwords,sustainablegrowthmustequal
thereturnonequity.

DuPontFormula
Theinternalandsustainablegrowthrates(theretentionratetimesROBAandROBE,respectively)areuseful
benchmarks.Theybothindicatethatthemoreprofitableacompanyisthefasteritcangrow,allelseequal.Theso
called"DuPontformula"isarestatementofROBEintermsofotherratios.

Qualifications
Theinternalandsustainablegrowthratesareusefulbenchmarks,butnothardconstraints.Canacompanygrowfaster
thanitssustainablegrowthrate?Certainly.How?WehavealreadyseenviatheDuPontformulathatachangeinratios

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(e.g.profitability,efficiency,orleverage)translatesintoachangeinROBEandhence,sustainablegrowth.Evenmore
fundamentally,acompanywishingtogrowfastcouldsimplyissuenewexternalequityi.e.,sellmorestocktoinvestors.
Manyhighgrowthcompaniesdoexactlythat.

Nothingsofarhasshownusthataparticulargrowthrateisoptimal.Itistruethatraisingleverageorsellingshares,for
example,permitshighergrowth.Butrepeatedincreasesinleveragecouldalsoleadtobankruptcy.Andrepeated
issuancesofnewsharesmaydiluteownership.Howfasttogrowacompanyandhowtofinancethegrowtharecomplex
managerialproblems.

Review

Thedominantthemeinthischapteristheimportanceofmanagingcash,whichmustbeunderstoodinthecontextofa
company'soperatingcycle.

Youdiscoveredtheimportanceofthecashcycleanditsrelationshiptotheoperatingcycle,particularlytheworkingcapital
accounts.Andyousawtheinterrelationshipoftheworkingcapitalaccountsinthecashcycle.

Youlearnedhowtocreateastatementofsourceandusestoanalyzethefundingofacompanyoveragivenperiod.

Youlearnedhowtocomputeinternalandsustainablegrowthratesforacompany,andtherelationshipbetweeneachof
theseandbasicfinancialratioscoveredinthepreviouschapter.

FinancialForecasting

Inprevioussectionswestudiedacompany'sperformanceandfinancialconditionbyanalyzingitspastandpresentfinancial
statements.Inthissectionwewilllookforwardratherthanbackwardandconstructprojectedfinancialstatementstogain
insightintoacompany'slikelyfutureperformanceandfinancialcondition.

Projectedfinancialstatementsareoftencalledproformastatements.Theycanhelpaddressmanyquestionsamanager
mightbeinterestedin,suchas:whatwillourfinancingrequirementsbeifwegrowsalesat10%nextyear?Ifwegrowat
10%foreachofthenextfiveyears?Whatwillhappentoearningspershareifweincreaseleverage?Willarecessioncauseus
toviolateacovenantonourbankloan?Andsoforth.

BasicIngredients

Financialforecastsandproformafinancialstatementsarebasedonafewkeyinputsthatwillcertainlyvaryfromcaseto
case,butarealwayspresent.

Abusinessforecastmaybesimpleorelaborate.Forexample,thegistofaforecastmightbesimplya10%growthinsales.
Oritmightinvolveprojectingmarketsize,penetration,acertainproductprice,competitors'reactions,andhence,market
share.Theforecastshouldbeconsistentwiththebusinessstrategyarticulatedbytopmanagement.

Givenastrategyandkeyelementsofabusinessforecast,therearepoliciestobesetinsupportofit,suchashowtomanage
workingcapitalaccounts,howmuchtospendonmarketingandpromotions,onR&D,etc.Managerssetthesepoliciesand
theproformafinancialstatementsshouldincorporatethem.

Economicfactorssuchasinflationrates,interestrates,andexchangerateswillaffectthecompany'sforecasts.

Proformasrelyonaccountingrelationshipssuchastheequivalenceofofassetsandliabilitiesplusequity,andthelink
betweenprofitandretainedearnings.

TheProcess

Onceformulated,forecastsshouldbescrutinizedandtested.Thisprocessmaybeformalandrigorousorsomewhatless
formal,dependingonhowtheforecastistobeused.Testsforreasonablenesstakemanyforms,suchascomparisonsto
pastperformance,tocompetitors,tomacroeconomicindicatorsorotherexternalbenchmarks.Ultimately,ithelpstobe
skepticalanddemandclearsupport.Forexample:

Bias,ErrorandUncertainty

Evengoodforecastsarefallibleinthesensethattheymaynotcometrue.Injudgingaforecast,itisimportantto
distinguishbetweenerrorandbias.Errorsaresimplymistakes,butoveralongperiodandmanyforecasts,wewould

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expectthatthemistakeswilltendtoevenoutsometimesthingsgobetterthanexpectedandsometimesworse.In
contrast,biasesaresystematictendenciestounderoroverestimate,andassuchtheydon'tcanceloutevenoveralong
period.Somebiasesariseunintentionally,perhapsthroughsimpleoptimismorpessimism.Othersmaybedeliberately
builtintoaforecast,forexample,toreflecta"bestcase"or"worstcase"scenario,ortoensureconservatism.Mostanalysts
willtrytogetridofunintentionalbiasesthoroughtestingandvettingofforecasts.Deliberatebiasesshouldbeexplained
andsupported.

ProFormas

Proformabalancesheetsareprojectionsofacompany'sassets,liabilities,andequity.Proformaincomestatements
containprojectionsofrevenues,costs,andprofit.Inalmostallrespects,proformafinancialstatementsarejustlikeany
regularstatements,exceptthattheyhaven'thappenedyetandmightneverhappen.Althoughhypothetical,theystillfollow
alltheusualaccountingrules:balancesheetsmustbalanceretainedearningsmustequalthepriorbalanceplusnet
incomeminusdividendsnetfixedassetsmustequalthebeginningbalancepluscapitalexpendituresminusdepreciation
andsoforth.

Tobeinformative,proformafinancialstatementsshouldbepreparedwithaclearmission.WhatamItryingtofigure
out?Forexample,acommongoalistoestimatetheamountofexternalfundingrequiredbyproposedbusinessplans.This
canbeexpressedinasimpleequation.

Theproformajustdescribedwillnottellushowtoraisetherequiredadditionalfunding.Shouldweuselongtermdebtor
shorttermdebt?Shouldweraiseequitybysellingadditionalstock?Toanswersuchquestions,wemightdevisestillmore
proformas.Tohelpusdecide,wecouldprepareproformasreflectingthedifferentpossibilitiesandthenanalyzeand
comparekeyratios,suchasleverageandcoverage,forexample.

PercentofSalesForecasting
Oneofthesimplestapproachestopreparingproformasis"percentofsales"forecasting,socalledbecauseitprojects
manyincomestatementandbalancesheetaccountsasapercentofsales.Initspurestform,itsimplyscalesall
projectionsupordownwithprojectedsales.Ifsalesareexpectedtogrow10%,thensodoeseverythingelse.

Let'sprepareandinterpretproformastatementsforGoldenStatein2008.We'lluseamodifiedversionofpercentof
salesforecasting,inwhichmany,butnotall,itemsaretiedtosalesgrowth.

First,weconsultMr.CotaandfindoutthatheexpectsGoldenState'srevenuetoincreaseby6%from2007to2008.
Nowwewillconstructproformafinancialstatementstoestimatehowmuchadditionalexternalfinancingwillbe
requiredtosupportthislevelofgrowth.

AccountsClassification
AkeystepincomputingGoldenState's2008proformastatementsistodeterminewhichaccountswethinkshould
varydirectlywithsales.Thepercentofsalesmethodclassifiesaccountsintotwocategories:

Exercise
FixedAccounts
First,let'sseehowaccountsthatdonotvarywithsalesareforecasted.Fornowwewillassumeinterestexpensesand
therevolvingcredittobefixedatlastyear'slevel.(Thereasonforthischoicewillbecomeapparentlater.Notethatfor
allaccountsthatvarywithsales,subtotalsandtotalsareinitiallyleftblankandwillbeaddedinsubsequentslides.)

HistoricalVariations
Foreachoftheaccountsthatvarywithsales,aforecastispreparedbasedoneachaccount'sexpectedrelationshipwith
sales.Thisrelationshipisofteninferredfromhistoricalfinancialstatements.Soourfirststepistoestimatethese
historicalrelationships.

ProjectingAccounts
Thefollowingtwoexamplesillustrateprojectinganaccountfortheincomestatementandbalancesheet,respectively,
usingpercentofsalesforecasting.

Let'sprojectGoldenState'scostsofgoodssold(COGS),thenextitemontheincomestatementbelowrevenue.
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Let'sexamineabalancesheetaccountnow.Wecanestimateaccountspayable,whichweexpecttovarywithsales.

Exercise
InterestExpense
Nowwecometoastandardprobleminproformapreparation.Wehaven'tmadeacarefulforecastforGoldenState's
2008interestexpenseyet,sincethisdependsonhowmuchitborrows,notonsales.Butwedon'tknowhowmuchthe
companywillborrowuntilweknowwhatitsexternalfundingneedis!Itisasthoughweneedtoalreadyknowthe
answerinordertocomputetheanswer.Fortunately,thereisasimpleprocedurewecanfollow.Inessence,wetakea
guessatinterestexpense,andthenseewhattheguessimpliesaboutfundingneeds.Thenwesupposethefunding
needismetwithdebt,andcalculateareasonableamountofinterestonallthedebt.Wecomparethat"reasonable
amount"toourinitialguess.Iftheyaren'tsame,wechangeourguessandgothroughtheprocessagain,repeating
untilthe"reasonableamount"ofinterestequalstheguessedatinterest.Let'swalkthroughtheprocessforGolden
State.

Exercise
ThemanagerMr.Cotahiredfor2005preparedsomeforecastsfor2005,usingtheactual2004financialstatements
asastartingpoint.Asanexercise,finishhisproformastatementsfor2005bycalculatinginterestexpensesand
revolvingcreditfor2005,andmakingsurethebalancesheetbalances.Assumean8percentinterestrateon
revolvingcreditandlongtermdebtaccounts.Remembertoiterateuntilyourinterestexpenseisconsistentwiththe
outstandingamountofdebtandtheexternalfundingneediszero.Reportbackwithyourfindings.

Seasonality
WenotedinprevioussectionsthatGoldenState'soperationsarehighlyseasonal.Bearinmindthattheproforma
balancesheetwejustpreparedisasofacertaindate,specifically,theendofthecalendaryear.Thenegativeexternal
fundingrequirementcorrespondstoDecember31,2008.ButweknowthatGoldenState'speakfinancingperiodis
earlier,atharvesttimeorjustafter,wheninventoryishigherandreceivableshavenotyetbeencollected.Weshould
expectthatexternalfundingrequirementsatthattimemightbequitedifferent,andmaybeevenpositive!Toaddress
thisreality,highlyseasonalbusinessesgenerallycomputequarterly,orevenmonthly,proformaforecaststomakesure
theyhaveadequatefundingattheirseasonalpeakwithoutviolatingloancovenants.

GoldenState'sExpansion
The2008proformastatementsassumed6%salesgrowth,basedonconversationswithMr.Cotaand,mostlikely,his
currentintentionsformanagingGoldenState.

However,youareinterestedinGoldenStateforitsgrowthpotential,andyouexpecttoformulatemoreambitious
growthplansifyouacquireit.

Let'swalkthroughtheprocessofcreatingsuchproformas.Thesearemorecomplexthantheonewejustlookedat,so
we'lldividetheprocessintothreesteps.

Step1
Thefirsttaskistopreparebusinessforecastsandoperatingpolicies.Keyfeaturesofanillustrativeplanforexpanding
GoldenStateare:

Normaloperationsduring2008,accordingtoMr.Cota'soperatingplan,whilepreparationsaremadetobegin
expandingin2009.
Useofthecoldstoragecapacitytoextendcanningoperationswellbeyondthecurrentseasonalpeak.
Developmentofnewproductsbasedondifferenttypesofproduceandgourmetand/orallnaturalrecipes,to
beintroducedasbrandedgoodsinlocalandregionaldistributionchannels.
Extensionofexistinglinesintoregionaldistributiontoboostsalesgrowth.
Useofthejarringlinebothtoincreaseannualoutputandtoproducenewlines.
Newactivitieswillrequireexpendituresforproductdevelopmentandmarketing,newoverhead,addedcapital
spending,additionalinventoryduebothtothenewlinesandtheextendedseason.

Theaccompanyingchartabovesummarizeskeyoperatingassumptionsassociatedwiththisexpansionstrategy.

Download
SixYearGolden
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StateProFormas

Step2
Thenextstepistoputtheoperatingforecastsintotheappropriatelinesinproformaincomestatementsandbalance
sheetsfortheperiod20092013.(For2008,wewillusetheproformaswealreadyprepared.)

Wehaveenoughinformationtocompletetheincomestatementsallthewaythrough"operatingprofit."

Onthebalancesheets,wehaveeverythingweneedfortheassetside.Wehaveallthecurrentliabilitiesexceptforthe
revolvingcredit,alongwithlongtermdebt.Inotherwords,wehaveonlyalittlemoretodotofinishthestatements.

Download
SixYearGolden
StateProFormas

Step3
DownloadSixYearGoldenStateProFormas

DownloadSixYearGoldenStateProFormas

DownloadSixYearGoldenStateProFormas

Werepeattheabovestepsfor2010andsoforth.

Uses
Let'shaveacloserlookatthesixyearforecastsforGoldenStatetoseewhattheycantellus.

Uncertainty
Allbusinessforecastsarecharacterizedbyuncertainty.Agoodanalystwillusehisorherknowledgeofthebusinessto
identifykeyuncertaintiesandtestkeyassumptions.Whatifsalesgrowby3%or10%ratherthan6%?Whatifthislevel
ofgrowthrequiresadditionalspendingonmarketing?

Threeapproachesarecommonlyusedtotestthereasonablenessofforecasts:sensitivityanalysis,scenarioanalysis,and
simulation.

SensitivityAnalysis
Sensitivityanalysisfocusesononevariableandcomputestheeffectontheplugfigure(orsomeotheritemof
interest)ofachangeinthatsinglevariable,assumingeverythingelsestaysconstant.

Let'sseewhathappensifGoldenState'ssalesweretogrowat3%,holdingallotherassumptionsconstant.

ScenarioAnalysis
Whilesensitivityanalysisstudieschangesinoneassumptionatatime,scenarioanalysiscombinesconcurrent
changesinmanyassumptions.Thecombinationsofassumptionsareintendedtocorrespondtoparticularscenarios,
choseneitherbecausetheyareparticularlylikelyorparticularlysalientinsomeotherway.

Forexample,supposeacompetingcanningcompanyopensanewfactoryinthevicinityofGoldenState'soperations.
ThisnewcompetitionalmostcertainlywouldaffectGoldenStateinmorethanoneway.Thescenariomightinclude
lowersalesvolume,theneedtolowersalesprices,competitionforlocalcrops,risingrawmaterialprices,etc.

Simulation
Finally,simulationsaresophisticatedstatisticalanalysesperformedbycomputerprogramsusingboththe
mathematicsofprobabilityandstatisticsandrawcomputingpower.Acommonversionofthissortofanalysisiscalled
MonteCarloSimulation.

Review
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Youshouldnowunderstandthebasicprinciplesunderlyingfinancialforecastsandbefamiliarwithsomesimple
techniques.Inparticular,youlearned:

Thatproformastatementsareprojectionsofacompany'sfuturefinancialstatements.Theywilldependonthe
forecastdateandtimeframe.
Financialforecastscombineseveralbasicingredients:abusinessforecast,managerialchoices,externalvariables,
andaccountingidentities.
Thesimplestproformasemploypercentofsalesforecasts,atechniquewherebymostaccountsvarydirectlywith
sales.Note,though,thatsimplicityisnotalwaysaparamountconsideration,andmanybusinessesemploymuch
moresophisticatedforecastingtechniques.
Howexternalfundingneedsmaybeestimatedusingproformafinancialstatementsusinganiterativealgorithm.
Howtotestassumptionsandoutputsforreasonableness.

TimeValueofMoneyandProjectValuation

Manycorporatedecisionsinvolveconsiderationsofvalue:howmuchisabusiness,abrand,aproject,orafacilityworth?
Evenmoretothepoint,howmuchisitworthcomparedtowhatitcosts?Acommonwaytoestimatevalueistomodelthe
businessorprojectasastreamofcashflowsexpectedtooccurovertime,andtocomputethepresentvalueofthestream.
Thisgeneralmethodiscalleddiscountedcashflow(DCF)analysisanditmaybeappliedtomanybusinesssituations.
ThischapterpresentstheprinciplesbehindDCFvaluationandthemathematicsofdiscounting.Futurechapterstreatthe
problemofhowtodevelopadiscountrateforuseinaDCFanalysisandhowtoapplythemethodologytovalueanentire
company.

Thischapteralsoexaminescommoninvestmentcriteria:netpresentvalue(NPV),internalrateofreturn(IRR),andpayback
period.Youwillseehoweachiscalculated,whateachisusedfor,andthestrengthsandweaknessesofeachasaninvestment
criterion.

Introduction

Thetimevalueofmoneyembodiesthepremisethatadollartodayisworthmorethanadollartomorrow.Adollarnot
consumedtodaymaybesavedandinvested.Consequently,adollarinvestedtodaywillbeworthadollarplusinterest
tomorrow.Thetimevalueofmoneyisexpressedbythefollowingequation:

CompoundingandDiscounting

Ifweknowpresentvaluewecanalwaysconvertittofuturevaluebyaprocesscalled"compounding".Compoundingisthe
mathematicalcomputationofhowmuchinterestwillbeearnedinthefirstyear,theninthesecondyear,including
interestoninterest,andsoforthforaslongastheinvestmentisoutstanding.Youhaveprobablyusedtheconceptof
compoundingtocalculatehowmuchyoursavingsaccountwillbeworthatsomefuturedatewhenyouwanttospendthe
accumulatedfunds.

Discountingissimplythereverseofcompounding.Whencompoundingyoubeginwithapresentvalueandturnitintoa
futurevaluebymultiplyingby(1+r)forasmanyyearsasnecessary.Whendiscounting,youbeginwithaknownfuture
valueandyoucomputeanequivalentpresentvalue,nowdividingby(1+r).Forexample,supposeyouaresavingmoney
topurchaseacar.Youwouldliketoknowhowmuchmoneyyouneedtoinvesttodayinanaccountpaying10percent
annualinterestifyouwanttobesuretohave$20thousanddollarsataspecificfuturedate.Let'sdothediscounting.

Exercise
Youdeposit$100at5%interestforthefirstyear,withtheinterestincreasingeachyearbyonepercentagepoint.What
isthevalueafterfiveyears?

Supposethatinsteadoftheannuallyescalatinginterestratesyouinvestedyour$100inanaccountthatpaidaconstant
7%annualinterestrate(theaverageoftheescalatingrates).Wouldyouhavemore,less,orthesameamountofmoney
attheendoffiveyears,comparedtothe$140.2fromthepreviousexercise?

Youwerehopingtohave$200afterinvestingforfiveyears,ratherthanthe$140.2showninthepreviousexercise.
Supposingyoucanfindaninvestmentthatpays8%annualinterestinsteadof7%,howmuchdoyouneedtoinvest
todaytoachieveyourgoal?

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PVofaCashFlowStream
Sofarwehavediscountedonlyonefuturecashflowfromfuturevaluetopresentvalue,butmanyinvestmentsinvolve
multiplecashflowsoccurringatdifferentpointsintime.Forexample,supposeyouownagovernmentbondthatwillpay
you$100todayandeachyearforthenextfouryears,atotaloffivepayments.Whatisthevalueofsuchabondtoday?It
cannotbe$500,thesumofthepayments,becauseyouwon'treceivethemalltoday.Instead,wecancomputethevalue
asthesumofthepresentvalueofeachofthefivepayments.Iftdenotesthepointintimeatwhicheachpaymentoccurs
andrdenotesthemarketinterestrateonfiveyeargovernmentbonds(let'sassumer=5%),thentheformalexpression
ofthisis:

Next,wewillapplythediscountingconceptandmathematicstovalueabusinessprojectthatGoldenStatemightwantto
undertake.

ValuingGoldenState'sJarringLineProject
MakingtheDecision
IncrementalCashFlows
Mr.Cotagivesussomecalculationsmadebythepreviousmanagershowingthenumberofjars(5,000perseason)that
thelinecanhandle,andtheexpectedwholesalepriceofajaroffruit,assumingnopriceincreases.Thesamesetof
calculationsshowstheCOGSforjarredfruit,andrevealsthatthegrossprofitmarginisthesame23%forjarred
fruitasitisforGoldenState'scanningoperations.Withthisinformation,wecancalculatetheannualincrementalgross
profitforthejarringline.

Wewillhavetopayadditionalcommissionstothesalesteamtopromoteandsellthejarredproduct.Incremental
commissionsof3%implyacostof$525peryear($17,500x0.03=$525),whichwewillsubtractfromincrementalgross
profit.

Theresultingannualincrementalcashflowis:

Theincrementaloperatingcashflowwejustcomputedcanbederivedinotherways,too.Anothercommonapproachis
toapplyataxrate(actually1minusthetaxrate)directlytothe$3,500wecomputedasincrementalgrossprofitless
commissions,andthenaddthetaxshieldassociatedwithincrementaldepreciation.

Thisisthesameresultwecalculatedabove.

Thedepreciationtaxshield,whichequalsthedepreciationchargetimesthetaxrate,issimplytheamountoftaxessaved
byvirtueofbeingabletodeductdepreciationfromourtaxableincome.

Yetanothercommonderivationoftheincrementaloperatingcashflowbeginswithtaxableincomeascomputed
previously:

Wesubtracttaxesfromthisamountasbefore(taxat36%=$540),whichgivesusincrementalnetincome.

Butnetincomedoesnotequalcashflow,becausesomeoftheexpensewechargedagainsttheprojectwasnoncash,
namelydepreciationof$2,000.Soweaddbackthenoncashdepreciationtothenetincome:

Notethatweobtainthesameannualincrementaloperatingcashflowestimateof$2,960fromallthreemethods.

NetWorkingCapital
Manybusinessprojects,suchasGoldenState'sjarringline,requireincrementalinvestmentsinworkingcapital.Thatis,
thecashcycleweexaminedinapreviouschapterisaffectedbychangesinaccountspayable,accountsreceivable,
inventory,andsoforththatcomeaboutasaresultofoperatingthejarringline.Ingeneral,wewillneedtoestimate
theseeffectsinordertocapturealloftheincrementalcashflowsassociatedwithaprojectlikethejarringline.

PuttingItAllTogether
WenowhavenearlyenoughinformationtocomputethepresentvalueofGoldenState'sjarringline,assumingwekeep
itandoperateit.

Therewillbean$800investmentininventory,followedbyincrementaloperatingcashflowsof$2,960everyyearfor
fiveyears.We'llassumethatthesecashflowsdon'tstartuntil2009,oneyearfromnow.

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InvestmentDecisionCriteria

We'vedonesomeanalysisoftheincrementalcashflowsassociatedwithGoldenState'sjarringline.Butwehavenotyet
usedthemtomakeabusinessdecisionabouttheline.Shouldwekeepitorsellit?Inthissectionwe'llexaminesome
commoncriteriausedtomakesuchdecisions,andmoregenerallytoevaluateproposedinvestments.Theyare:

Netpresentvalue
Paybackperiodanddiscountedpaybackperiod
Internalrateofreturn.

NetPresentValue
Nowweknowthepresentvalueofoperatingthejarringlineis$11,078.Towhatshouldthisfigurebecompared?It
shouldbecomparedtothevalueofthejarringlineifwedonotoperateit.Ifwedon'toperateit,itjustsitsthere,
producingnothing,soavalueof$0isonepossiblepointofcomparison.ButrecallthatMr.Cotasuggestedsellingthe
lineandtoldusitwouldfetch$10,000ifwesolditrightawayin2008.Thisisamoresensiblecomparisonthan$0.

Moregenerally,NPVisthedifferencebetweenhowmuchaprojectisworth(thePV)andhowmuchitcosts(the
investment).WhenNPVisgreaterthan0,theprojectisworthmorethanitcostsandconverselywhenNPVislessthan
0,theprojectcostsmorethanit'sworth.Accordingly,aproject'sNPVistheamountbywhichwealthorfirmvalue
increasesordecreasesifyouundertaketheproject.

Thislastobservationleadsnaturallytoapowerfulruleformakinginvestmentdecisions.Theruleis:

InvestinallprojectsforwhichNPVisgreaterthan0.

Thesearetheprojectsthatincreasewealth,becausetheyareworthmorethantheycost.Thisistheruleapersonwould
followtomaximizewealth,orthatafirmwouldfollowtomaximizeitsvalue.

ThegeneralformulaforNPVis:

TheNPVruleleadstosimpledecisioncriteria.Examineallprojectsand:

Inrealbusinesssituations,thecalculationsonwhichNPVrestsmaybeverycomplex,andinputsareestimatedwith
varyingdegreesofconfidence.Sometimespertinentconsiderationsareleftoutofthepresentvaluecalculations,simply
becausetheyaretoodifficulttoquantify.Consequently,somefirmsuseNPVasinimportant,butnotdecisiveor
exclusive,considerationintheirdecisionsaboutinvestmentopportunities.Andmanyfirmssupplementitwithother
calculationsandcriteria.Wewillpresenttwoofthem,paybackperiodandinternalrateofreturn.

PaybackPeriod

Thepaybackperiodisdefinedasthetimeittakestorecouptheoriginalinvestmentinaproject.Allelsebeingequal,
companiesprefershorterpaybackperiodsduetothetimevalueofmoneyand,perhaps,becauseofriskconsiderations.

Computingthepaybackperiodisusuallystraightforwardafterincrementalcashflowshavebeenestimated.Onesimply
computestheaccumulatedcashflowforeachyear,beginninginyearzeroandcomparestheaccumulatedcashflowto
theinitialinvestment.Thepaybackperiodisthepointintimeatwhichaccumulatedcashflowequalstheinitialoutlay.

Let'sfigureoutthepaybackperiodforGoldenState'sjarringlineproject.

ThepaybackperiodforGoldenState'sjarringprojectisapproximately3yearsand8months.

Themainadvantageofthepaybackperiodcalculationisitssimplicity.Unfortunately,itincludesnoformaltreatmentof
thetimevalueofmoney.Perhapsevenmoreseriously,itignoresallcashflowsbeyondthepaybackperiod.Soaproject
withaverylarge,butsomewhatdistant,payoffisnottreatedkindlybythiscalculation.

DiscountedPaybackPeriod
AvariationonpaybackperiodisDiscountedPaybackPeriod.Thedifferenceisthatinsteadofusingcumulativecash
flowtocalculatethepayback,oneusescumulativediscountedcashflow.Thisvariationconsidersthetimevalueof
money,butstillignorescashflowbeyondthepaybackhorizon.

Thediscountedpaybackperiodforthejarringprojectisapproximately4.5years.Asyouwouldexpect,itislonger
thanusingthenondiscountedcashflows.

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InternalRateofReturn

AnotherinvestmentcriterionisInternalRateofReturn(IRR).TheIRRisdefinedasthediscountrateatwhichthe
NPVofaninvestmentequalszero.TouseIRRasaninvestmentcriterion,onecomparesittothecostofcapital.Typically,
projectsforwhichIRRexceedsthecostofcapitalareprojectsforwhichNPV>0.

InGoldenState'sjarringproject,weusedadiscountrateof8%.Inreality,determiningtheappropriatediscountrate
reliesonanumberoffactors,suchasprevailinginterestratesandtheinherentriskinessoftheproject.Wewillconsider
howtoestimatecostsofcapitalinthenextchapter.

GoldenState'sJarringProject
UsingthediscountedincrementalcashflowsforGoldenState,wecandeterminetheIRRforthejarringproject.The
processofdetermininganIRRisiterative:applydifferentdiscountratestotheNPVcalculationuntil
NPV=0.

ExcelhasanIRRfunctiontoacceleratethisprocess.InsertthecostoftheprojectintoYear2008andapplytheIRR
functionacrosstherelevantincrementalcashflows.

WhenusingExcelorothermeansofcalculation,itiscriticaltoplacecashflowsinthecorrectperiods.

IRRandNPV
TherelationshipbetweentheNPVanddiscountratemaybeplottedonagraph.Inthecaseofthejarringlineproject,
thegraphlookslikethis:

Asthediscountrateincreases,theNPVfallsandthepointwhereitcrossesthediscountrateaxis(NPV=0)istheIRR.
Inmanycircumstances,theNPVandIRRmethodsleadtothesameconclusion.IfaninvestmenthasapositiveNPV,
itsIRRistypicallygreaterthanthecostofcapitalandviceversa.

Incaseswherethecashflowsdonotfollowatypicalpatternofoutflowfollowedbyseveralyearsofinflow,theIRR
approachcanyieldincorrectorambiguousresults.Morespecifically,incaseswherethesigns(plusorminus)ofthe
streamofcashflowschangemorethanonce,therewillbemorethanoneIRR.Byitsnature,theIRRalsoimplicitly
assumesthatinterimcashflowsthatiscashyoureceivebetweenthebeginningandtheendoftheprojectare
reinvestedforthelifeoftheprojectandyieldareturnequaltotheIRR.Thismaynotbetrueinpractice,andisnot
similarlyassumedbytheNPVcalculation.

Perpetuities

Aperpetuityisastreamofcashflowsthatoccuratregularintervalsandlastforever.Anexampleofatrueperpetuityis
theconsolbondissuedbytheBritishgovernment.Whatisthepresentvalueofaperpetuity?Tocalculateit,addupthe
presentvaluesofallthecashflowsatadiscountrateofr:

Thislookscumbersome,butfortunately,themathematicsofinfiniteseriesprovidesuswithasimpleformulaforthe
presentvalueofaperpetuitythatpaysus$1oneyearfromnow(att=1),andanotherdollareveryyearthereafterforever.

Theformulais:

Thisisaveryusefulformulaforsomebusinessesandinvestments,becauseagoingconcern,forexample,maygenerate
cashflowforaverylongtime,approximately"forever".Tousetheformulainsuchasetting,wemodifyitasfollows:

where"CF"istheamountofcashgeneratedeachyear,beginninginyearone,andristhediscountrate.

GrowingPerpetuities
Theformulaeaboveassumethecashflowremainsconstant.Thereisasimilarlysimpleformulaforthepresentvalueof
aperpetuitywherethecashflowsgrowataconstantrate,g,everyyear.Theformulais:

whereCFistheinitialcashflow,risthediscountrateandgistheconstantgrowthrateofthecashflows.Notethatwhen
g=0,thisformulareducestothesameonepresentedabove.

WewillrevisitperpetuitieswhenweperformthevaluationofGoldenStateasanentity.Fornow,itisimportanttonote
thatthegrowthrate,g,mustbelessthanthediscountrate,r.Fortunately,thisisnotanunreasonableconditionto
imposenocompany,indeednoeconomy,canproduceacashflowthatgrowsfasterthanthediscountrateforever.

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Review

Inthischapterwecoveredthetimevalueofmoneyandhowtoperformasimpleprojectvaluation.Youshouldhavean
understandingof:

Theconceptofthetimevalueofmoney.
Howtoperformdiscountingandcompoundingonasinglecashflowandcalculatethepresentvalueofastreamof
cashflows.
Theconceptofincrementalcashflows
Differentmethodsforcomputingincrementalcashflows.
NPVasaprimaryinvestmentdecisionmakingcriterion.
PaybackperiodandIRRasadditionalfinancialcharacteristicsofinvestmentproposals,andthelimitationsofeach
approach.
Howtocalculatethepresentvalueofperpetuities.

Conclusion

Congratulations!Youhavecompletedthiscourseonbasicfinancialanalysis.We'vecoveredmanytopics:financialratio
analysis,thecashcycle,sustainablegrowth,proformaforecasting,compoundinganddiscounting,andsimpleinvestment
decisioncriteria,amongothers.

Thereismoretolearnaboutthesetopics,andstillmoretopicswehavenotyetevenbegun.Nevertheless,youshouldbe
preparednowforfurtherstudyoffinanceand,inparticular,tobeginmorespecializedtopicssuchascapitalstructuretheory,
portfoliotheory,andbusinessvaluation.

Totestyourknowledgeofthematerialcoveredsofar,takethefinalexambyclickingonthetabtotheleft.Beforebeginning
theexam,however,youmaywishtotakesometimetogobackandreviewtopicsofyourchoosinganywhereinthecourse.
Takeasmuchtimeasyoulikethenwhenyou'reready,returntotheexam.

FinalExam1Introduction

WelcometothepostassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledgeofsome
basicfinancialprinciples.

Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
withyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforwardadvancearrow.
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.

Yourexamresultswillbedisplayedimmediatelyuponcompletionoftheexam.
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4/11/2016 Finance:IntroductorySection
Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.

Goodluck!

FinalExam2Introduction

WelcometothesecondpostassessmenttestfortheHBSFinancetutorial.Thistestwillallowyoutoassessyourknowledge
ofsomebasicfinancialprinciples.

Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoice
andclicktheSubmitbutton.Aftersubmittingyouranswer,youwillnotbeabletochangeit,somakesureyouaresatisfied
withyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforwardadvancearrow.
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthe
navigationalarrowsatanytime.Althoughyoucanskipaquestion,youmustnavigatebacktoitandansweritallquestions
mustbeansweredfortheexamtobescored.

IMPORTANT:Takethisexamonlyaftertakingthepreviousfinalassessmentexam.Thereareonlytwofinal
assessmentexams.Thus,ifyoudidnotreceiveapassingscoreonthefirst,itiscriticalthatyoureviewthe
coursematerialscarefullybeforetakingthisexam.

Yourresultswillbedisplayedimmediatelyuponcompletionoftheexam.

Aftercompletion,youcanreviewyouranswersatanytimebyreturningtotheexam.

Goodluck!

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