McGraw hill financial analysis tools & techniques a guide for managers

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COMMENTS ABOUT ERICH A. HELFERT AND THIS BOOK

“Erich Helfert’s book is a bona fide treasury for executives, managers, and entrepreneurs

who need to understand financial management. I have used and recommended this great

work in both corporate and university programs for more than ten years. Erich Helfert pos￾sesses unique abilities to make clear the arcane that frequently enshrouds topics of finan￾cial management.”

Allen B. Barnes

Past Provost

IBM Advanced Business Institute

(formerly Director of Executive Education, UCLA)

“Erich Helfert’s book is a candidate for every consultant-to-management’s bookshelf. The

underlying agenda is financial management as it pertains to effective resource allocation de￾cisions. Framed in a dynamic model of the Business System, the beauty of Helfert’s presen￾tation lies in its treatment of subsystems that differentiate between investment, operations and

financing decisions, but which are also integrated into the overall managerial fabric.”

Stanley Press CMC

Book review September 2000

C2M Consulting to Management Journal

“Erich Helfert possesses a rare ability to make financial concepts understandable to individu￾als who lack a financial background. As a result we had Dr. Helfert conduct shareholder value

creation classes for all senior managers and create a shareholder value course for all other

salaried and hourly employees. The results of these efforts exceeded our high expectations.”

L. Pendleton Siegel

Chairman and Chief Executive Officer

Potlatch Corporation

“Erich Helfert has played an instrumental role in teaching HP managers of both financial

and non-financial backgrounds in our long-standing Functional Management Program. His

excellent financial overviews and simplified models effectively broaden our managers’

understanding and ownership of their fiscal responsibility to HP and our shareholders.”

Robert P. Wayman

Executive Vice President and

Chief Financial Officer

Hewlett-Packard Company

“Dr. Helfert’s book and his teachings go a long way toward removing the mystery from the

financial workings of an enterprise. His approach allows managers from all areas of the busi￾ness to understand how their decisions impact shareholder value.”

Stephen E. Frank

President and Chief Operating Officer

Southern California Edison

“Erich Helfert has contributed to the development of financial skills of TRW managers

through his case study preparation and presentations, his book Techniques of Financial

Analysis, and his instruction. He continues to be included as a highly rated faculty member

in TRW’s management development programs.”

Peter S. Hellman

Past President and Chief Operating Officer

TRW Inc.

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FINANCIAL

ANALYSIS: TOOLS

AND TECHNIQUES

A Guide for Managers

ERICH A. HELFERT, D.B.A.

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ABOUT THE AUTHOR

Erich A. Helfert is an internationally recognized management consultant in cor￾porate finance, strategic planning, and executive education in financial/economic

decision 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 Corpora￾tion, a major integrated paper and forest products company. Prior to his 20-year

corporate 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 major

companies.

A native of the Sudetenland, formerly Austria, he received his BS from the

University 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 writes

and 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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ix

CONTENTS

Preface xvii

Introduction xxi

Chapter 1

The Challenge of Financial/Economic Decision-making 1

Lessons for the Millennium 2

The New Economy 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 50

Key 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 78

Funds Management and Shareholder Value 89

Cash Management 89

Working Capital Management 90

Investment Management 91

Key Issues 91

Analytical Support 93

Chapter 4

Assessment of Business Performance 95

Ratio Analysis and Performance 95

Management’s Point of View 97

Operational Analysis 98

Resource Management 107

Profitability 112

Owners’ Point of View 115

Investment Return 116

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Contents xi

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

Financial Modeling 184

Sensitivity Analysis 186

Key Issues 187

Analytical Support 189

Chapter 6

Dynamics and Growth of the Business System 191

Leverage 192

Operating Leverage 193

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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

Key Issues 250

Analytical Support 252

Chapter 8

Analysis of Investment Decisions 255

Strategic Perspective 256

Decisional Framework 259

Problem Definition 260

Nature of the Investment 261

Future Costs and Benefits 262

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Contents xiii

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

Key Issues 293

Analytical Support 295

Chapter 9

Cost of Capital and Business Decisions 297

Decisional Context 298

Investment Decisions 298

Operating Decisions 299

Financing Decisions 300

Cost of Operating Funds 300

Cost of Long-term Debt 304

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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

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