This book intends to help students and others learn how to successfully manage the finances of small to medium size firms. The underlying assumption of this book is that successful financial managers need to master the construction and analysis of financial statements and present value models. Learning how to construct and analyze financial statements and present value models is the focus of this book that is divided into five parts.
Part I provides an introduction to management. Chapter 1 describes the firm management process—a process that includes identifying the firm’s mission statement and strategic (long term) goals and tactical (short term) objectives; identifying the firm’s strengths, weaknesses, opportunities, and threats; identifying and evaluating alternative strategies; and finally implementing and evaluating the preferred strategy. Chapter 1 notes that the management process has wide application including managing the financial resources of the small to medium size firm.
The firm’s opportunities and threats are most often nested in factors outside the firm’s control. For example, different ways to organize the firm (Chapter 2) and the tax environment facing the firm (Chapter 3) are factors external to the firm. They are important to discuss, though, because the firm can adopt different responses to the legal and tax environment in which it operates.
Part II focuses on the internal financial strengths and weaknesses of the firm and its ability to respond to external opportunities and threats. Chapter 4 focuses on the construction, analysis, and interpretation of coordinated financial statements (CFS). CFS are the primary tools for answering the question: what are the financial strengths and weaknesses of the firm?
An important consideration, especially when the focus is on small to medium-sized firms, is how to construct financial statements when the firm has incomplete records. While the data used in the financial management process and the construction of financial statements are most often assumed to be obtainable and accurate, the reality may be quite different. Small to medium-sized firms often lack the financial records required to conduct the analyses described in Part II of this book. Acquiring and sometimes guesstimating the missing data is almost an art form—a process that forms the nexus between theory and practice.
An important lesson to be learned about financial statements—even when we can construct them accurately—is that financial statements alone do not reveal completely the financial strengths and weaknesses of the firm. This more complete view of the firm’s strengths and weaknesses requires ratios be constructed using data included in the firm’s CFS (Chapter 5). Ratios constructed using the firm’s CFS can be compared with similar firms, and significant deviations from the norm can be noted and given further attention. Ratios describing the firm’s financial well-being can be described by the acronym SPELL: (S)olvency, (P)rofitability, (E)fficiency, (L)iquidity, and (L)everage.
Chapter 6 notes that the firm’s CFS is a system. An important characteristic of an open system is that its parts are connected internally with endogenous variables and externally to factors outside of the firm with exogenous variables. Therefore, an activity outside of the firm described by an exogenous variable can change conditions inside of the firm described by endogenous variables. Because CFS are a system, we can analyze the firm’s opportunities and threats presented by forces outside the firm. For example, we can ask: what if an exogenous variable changes, then how will the financial condition of the firm be affected? Or we may ask: if the firm has a financial goal, then how much must an exogenous variable change for the firm to reach its goal. Finally, we may ask: if one part of the system changes, what corresponding changes will result? One way to think of the CFS system is to compare it to a balloon: a squeeze somewhere in the balloon will produce a bulge somewhere else.
Throughout this book, we use data from a hypothetical (but not atypical) firm, HiQuality Nursery (HQN) to help make the analysis realistic. However, the financial analysis experience becomes authentic when students and others construct financial statements for actual firms, and analyze them to discover their strengths, weaknesses, opportunities, and threats. Often, these firms are ones in which the analyst has a personal interest.
Part III of this book introduces present value (PV) models. PV models compare a challenging investment(s) to a defending investment(s) by converting future dollars to their value in the present. A key principle that should guide the construction of PV models is to compare challenging and defending investments using homogeneous measures—the subject of Chapter 7. Chapter 8 describes the different kinds of PV models and the questions each model is designed to answer. Chapters 9, 10, and 11 remind those solving PV problems that comparisons between challenger(s) and defenders(s) must use homogeneous measures. Chapter 9 describes how to compare investments with different sizes. Chapter 10 describes how to compare investments with different terms. Chapter 11 describes how to introduce taxes into PV models to produce consistent comparisons.
Part IV describes more details about the properties of PV models. Chapter 12 provides the theoretical basis for PV models by comparing their construction to the process of producing earnings measures derived from accrual income statements. Chapter 13 builds PV model templates that can be used to solve practical PV problems. Besides illustrating how to solve practical PV problems, it describes how to forecast exogenous variables. Chapter 14 provides PV model properties to describe an investment’s liquidity.
We live in and make capital budgeting decisions in a world of risk and uncertainty. So how do we make choices when we can’t be sure what the outcomes will be? Formal insurance programs are one way of addressing the risk firms face. However, there are other risk responses the firm can employ. Learning about risk and applying this knowledge to the purchase of insurance and adopting other risk management alternatives is the focus of Chapter 15. Some of the concepts covered in Chapter 14 are essential statistical tools needed to plan and make important decisions in a risky and uncertain world.
Armed with a knowledge of PV model building principles and tools, the analyst is prepared to construct PV models for specific investments. Specific investments, while similar, may have some distinct characteristics, depending on the type of investment activity under examination.
Part V considers six different investment strategies. Chapter 16 considers taking out and repaying loans, emphasizing that loan analysis is essentially a present value problem. Chapter 17 considers purchasing, using, or selling land. An important feature of land purchases and sales is transaction costs, which are included in the land models. Chapter 18 recognizes that the control and use of investments can be acquired through leases as well as through purchases. So, in this chapter, models are constructed that can be used to find the present values of leases. Chapter 19 reviews financial investments, a separate class of investments, especially relevant for personal financial management decisions.
Chapter 20 prepares students to observe financial opportunities and threats using the term structure of interest rates, an important financial tool. Finally, Chapter 21 reminds readers that “money can’t buy love” nor most other relational goods. Thus, Chapter 22 enlarges the management process to include relational goods as well as commodities.
To solve many of the problems in this text we employ Excel spreadsheets that are now generally available and which have become the “industry standard” for solving financial management problems. Excel spreadsheets enable the analyst to solve complicated financial problems and examine the robustness of a solution under different possible scenarios. Although students are expected to come to this class with Excel experience, we include in this book an Appendix that provides a brief review of Excel methods employed in this text.
Finally, throughout this text we identify key paragraphs for understanding the material in particular chapters. These key paragraphs are highlighted and identified with a magnifying glass icon to suggest that the reader pay them particular attention.