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: Management
The chapters in Part I introduce 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.
We live in and make financial decisions in a world of risk and uncertainty. So how do we make choices when we can’t be certain 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 4. Some of the concepts covered in Chapter 4 are essential statistical tools needed to plan and make important decisions in a risky and uncertain world.
Part II: Strengths, Weaknesses, Opportunities, and Threats
Chapters in Part II focus on the internal financial strengths and weaknesses of the firm and its ability to respond to external opportunities and threats. Chapter 5 focuses on the construction, analysis, and interpretation of coordinated financial statements (CFS). CFS are the primary tools for answering the question: what is the financial condition of the firm and what are its financial strengths and weaknesses?
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 completely reveal the financial strengths and weaknesses of the firm. A more complete view of the firm’s strengths and weaknesses requires ratios be constructed using data included in the firm’s CFS (Chapter 6). 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 7 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, a change in one or more of the firm’s exogenous variables can change conditions inside the firm described by its 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 there is a change in the firm’s exogenous variables? Then, how will the financial condition of the firm change? 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 will be the corresponding change? One way to think of the CFS system and what if and how much analysis 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 those practicing financial management skills construct financial statements for actual firms, including ones in which the analyst has a personal interest.
Part III: Present Value Models
Chapters in Part III of this book introduce present value (PV) models. Chapter 8 provides the theoretical basis for PV models by demonstrating that PV models are multi-period extensions of a single period accrual income statement (AIS). To aid those preparing PV models, this chapter also introduces a generalized Excel template that can be used to solve practical PV problems. While PV models have the common feature of converting a challenger’s future cash flow to its equivalent in the present, Chapter 9 introduces several different kinds of PV models distinguished by the questions they answer. Chapter 10 introduces one important distinction between PV models, whether the investment is an incremental change to an existing firm versus a stand-alone investment. Chapter 11, the last chapter in Part III of this book, describes forecasting methods useful for obtaining future cash flow estimates to populate PV models. Included in chapter 11 is a brief introduction to statistical regression methods, essential for forecasting.
Part IV: Homogeneous Measures
Chapters in part IV provide more detailed guidelines for constructing PV models. Chapter 12 compares a challenging investment to a defending one by converting a challenger’s future cash flow to its equivalent in the present by exchanging cash flow between periods at the defender’s internal rate of return. Chapters 13, 14, and 15 remind those solving PV problems that comparisons between challenger(s) and defenders(s) must use homogeneous measures. Chapter 13 describes how to compare investments with different sizes. Chapter 14 describes how to compare investments with different terms. Chapter 15 describes how to introduce taxes into PV models to produce consistent comparisons between challengers and defenders. Finally, chapter 16 introduces homogeneous currency and liquidity requirements when comparing challenging and defending investments.
Part V: Present Value Model Applications
Armed with a knowledge of PV model building principles and tools, the analyst is prepared to construct PV models for specific investments. Chapters in Part V note that specific investments, while similar, may have some distinct characteristics, depending on the type of investment activity under examination. Chapter 17 considers taking out and repaying loans, emphasizing that loan analysis is essentially a present value problem. Chapter 18 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 19 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 20 reviews financial investments, a separate class of investments, especially relevant for personal financial management decisions. Chapter 21 prepares students to observe financial opportunities and threats using the term structure of interest rates, an important financial tool. Finally, Chapter 22 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. Chapter 7 includes an appendix to explain the HQN Coordinated Financial Statement Excel template. Chapter 8 includes an appendix to explain the Green & White Services PV Excel template. Chapter 11 includes an appendix showing how to manage Excel add-ons to access the Data Analysis option.
Finally, throughout this text we identify paragraphs that summarize key concepts explained in the preceding material. These key paragraphs are shaded to suggest that the reader pay them particular attention.