Finance and accounting for nonfinancial managers finkler pdf

FINANCE

& ACCOUNTING for Nonnancial Managers

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Fourth Edition Steven A. Finkler, Ph.D., CPA

Finance & Accounting for Nonfinancial Managers

4th Edition Steven A. Finkler, Ph.D, CPA

Editorial Staff

Production ................ Christopher Zwirek, Ann Hartmann, Linda Kalteux Cover Design ............................................ Kathie Luzod Index .................................................. Deanna Leach

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service and that the author is not offering such advice in this publication. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

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No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH’s copyright: (1) the gathering, compilation, and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials.

In loving memory of my parents v About the Author

Steven A. Finkler, Ph.D., CPA, is Professor Emeritus of Accounting and Financial Management at the Robert F. Wagner Graduate School, New York University. At the Wagner School he directed the Finance Specialization for over twenty years. He holds a bachelor’s degree with joint majors in accounting and finance (summa cum laude) and a master’s degree in Accounting (with highest honors) from the Wharton School. His master’s degree in Economics and Ph.D. in Business Administration

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are from Stanford University. Before joining NYU, he was on the faculty of the Wharton School.

An award-winning teacher and author, he has written nineteen other books on budgeting, cost accounting, and financial management, and over two hundred articles on financial management. He has consulted for numerous organizations around the United States and abroad. He worked for several years as a CPA with Ernst & Young.

vii Contents

Preface xiii List of Excel Templates xvii Chapter One—An Introduction to Financial Management ........ 1

What Is Financial Management?............................ 1 The Goals of Financial Management ........................ 2 Key Terms ............................................. 6 Questions for Review .................................... 7 Chapter Two—Excel Basics ................................. 9 Spreadsheets ........................................... 9 What Are the Reasons We Use Electronic Spreadsheets.......... 9 Getting Started with Excel ................................ 11 Alternative Ways to Do Computations....................... 14 Setting up the Spreadsheet ................................ 17 Automatic Computation Updates .......................... 23 Copying Cells .......................................... 26 Summary ............................................. 27 Key Terms ............................................. 27 Questions for Review .................................... 28 Additional Resources .................................... 28 Chapter Three—Accounting Concepts ........................ 29 Basics ................................................ 29 Assets ................................................ 30 Liabilities ............................................. 31 Owners’ Equity......................................... 31 The Accounting Equation................................. 31 Key Terms ............................................. 32 Questions for Review .................................... 32 Chapter Four—An Introduction to the Key Financial Statements . . . 33 The Balance Sheet....................................... 33 The Income Statement ................................... 35 The Statement of Cash Flows .............................. 36

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Cash Versus Accrual Accounting ........................... 37 Key Terms ............................................. 39 Questions for Review .................................... 39 Chapter Five—Where Does the Organization’s Money Come From? Capital Structure........................................ 41 Proprietorships and Partnerships........................... 41

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Not-for-Profit Organizations .............................. 41 For-Profit Corporations .................................. 42 Getting Capital ......................................... 46 Key Terms ............................................. 48 Questions for Review .................................... 49 Chapter Six—Strategic Planning and Budgeting ................ 51 Definition and Role of Budgets............................. 51 Strategic Plan .......................................... 51 Long-Range Plan........................................ 52 Annual Budgets ........................................ 53 Budget Preparation...................................... 54 Flexible Budgeting ...................................... 60 The Cash Budget........................................ 61 Zero-Based Budgeting ................................... 62 Key Terms ............................................. 63 Questions for Review .................................... 64 Chapter Seven—Business Plans ............................. 65 Why Develop a Business Plan?............................. 65 Questions that Drive a Business Plan ........................ 65 The Planning Process .................................... 66 The Elements of a Business Plan............................ 67 How a Business Plan Is Read .............................. 75 A Successful Business Plan................................ 76 Key Terms ............................................. 76 Questions for Review .................................... 77 Chapter Eight—Cost Accounting ............................ 79 Average vs. Marginal Costs ............................... 79 Cost vs. Expense: The Inventory Process ..................... 81 Period Costs vs. Product Costs............................. 82 Cost Systems: Process, Job-Order, and Standard Costs .......... 83 Cost Allocation......................................... 84 Key Terms ............................................. 89 Questions for Review .................................... 90 Chapter Nine—Leverage ................................... 91

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Financial Leverage ...................................... 91 Operating Leverage ..................................... 93 Key Terms ............................................. 96 Questions for Review .................................... 97 Chapter Ten—Dealing with Uncertainty ...................... 99 The Expected Value Technique............................. 99 Network Cost Budgeting ................................. 103 Key Terms ............................................. 108 Questions for Review .................................... 109 Chapter Eleven—Capital Budgeting .......................... 111 Investment Opportunities................................. 111 Data Generation ........................................ 112 The Payback Method .................................... 112 The Time Value of Money................................. 114 The Net Present Value (NPV) Method ....................... 121 The Internal Rate of Return Method (IRR) .................... 124 Project Ranking......................................... 125 Summary ............................................. 126 Key Terms ............................................. 126 Questions for Review .................................... 127 Chapter Twelve—Earned Value Management .................. 129 Quantifying Planned Value (PV) and Earned Value (EV)......... 130 The Method............................................ 134 Limitation of EVM ...................................... 136 Benefits of EVM ........................................ 136 Key Terms ............................................. 137 Questions for Review .................................... 137 Chapter Thirteen—Depreciation: Having Your Cake and Eating It Too! .................................................. 139 Amortization........................................... 139 Asset Valuation for Depreciation ........................... 140 Straight-Line vs. Accelerated Depreciation ................... 143 Comparison of the Depreciation Methods .................... 143 Modified Accelerated Cost Recovery System (MACRS) ......... 146 Depreciation and Deferred Taxes: Accounting Magic ........... 146 Key Terms ............................................. 147 Questions for Review .................................... 148 Chapter Fourteen—Long-Term Financing...................... 149 Long-Term Notes ....................................... 149 Mortgages............................................. 149 Bonds ................................................ 152 Leases ................................................ 155

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Key Terms ............................................. 158 Questions for Review .................................... 159 Chapter Fifteen—Working Capital Management and Banking Relationships .......................................... 161 Working Capital Management ............................. 161 Short-Term Resources.................................... 161

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Short-Term Obligations................................... 169 Banking Relationships ................................... 173 Key Terms ............................................. 175 Questions for Review .................................... 176 Chapter Sixteen—Inventory Costing: The Accountant’s World of Make Believe .......................................... 179 The Inventory Equation .................................. 179 Periodic vs. Perpetual Inventory Methods .................... 179 The Problem of Inflation.................................. 181 Cash-Flow Assumptions.................................. 182 Comparisons of the LIFO and FIFO Cost-Flow Assumptions ..... 183 LIFO and IFRS ......................................... 185 Key Terms ............................................. 186 Questions for Review .................................... 186 Chapter Seventeen—Variance Analysis: Using Budgets for Control 187 Understanding Why Variances Occurred..................... 187 Static Budgets .......................................... 189 Flexible Budgeting ...................................... 191 Key Terms ............................................. 194 Questions for Review .................................... 194 APPENDIX—Computing Variances......................... 195 Chapter Eighteen—Fraud................................... 197 What is Fraud? ......................................... 197 Business Fraud ......................................... 198 Why Does Fraud Happen? ................................ 199 Preventing Fraud by Focusing on Ethics ..................... 200 Preventing Fraud through Legislation ....................... 201 Using Control Systems to Prevent Fraud ..................... 203 Key Terms............................................. 207 Questions for Review .................................... 208 Chapter Nineteen—The Role of the Outside Auditor ............ 209 Generally Accepted Accounting Principles (GAAP) ............ 209 International Financial Reporting Standards (IFRS)............. 214 The Audit ............................................. 217

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Key Terms............................................. 221 Questions for Review .................................... 222 Chapter Twenty—Recording and Reporting Financial Information . 223 Double Entry and the Accounting Equation .................. 223 Debits and Credits ...................................... 224 Ledgers ............................................... 227 Chart of Accounts....................................... 228 Key Terms ............................................. 229 Questions for Review .................................... 229 APPENDIX—Recording and Reporting Financial Information .... 231 Chapter Twenty-One—Valuation of Assets, Liabilities and Stockholders’ Equity .................................... 247 Asset Valuation......................................... 247 Valuation of Liabilities ................................... 254 Valuation of Stockholders’ Equity .......................... 255 Key Terms ............................................. 255 Questions for Review .................................... 256 Chapter Twenty-Two—A Closer Look at Financial Statements..... 257 The Balance Sheet ....................................... 257 The Income Statement ................................... 261 The Statement of Cash Flows .............................. 263 Key Terms............................................. 267 Questions for Review .................................... 267 Chapter Twenty-Three—Notes to the Financial Statements ....... 269 Significant Accounting Policies ............................ 269 Other Notes............................................ 271 Summary ............................................. 273 Key Terms ............................................. 274 Questions for Review .................................... 274 Chapter Twenty-Four—Ratio Analysis ........................ 275 Benchmarks for Comparison .............................. 275 Common Size Ratios..................................... 280 Liquidity Ratios ........................................ 283 Efficiency Ratios ........................................ 285 Solvency Ratios......................................... 287 Profitability Ratios ...................................... 289 Key Terms ............................................. 293 Questions for Review .................................... 293 Chapter Twenty-Five—A Primer on Taxes ..................... 295 How Much Do You Need to Know?......................... 295 Personal vs. Corporate Taxes .............................. 295 The Tax Rate and the Tax Base ............................. 298

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Progressive, Proportional, and Regressive Tax Rates............ 298 Marginal, Average, and Effective Tax Rates ................... 299 Calculating Federal Income Tax ............................ 302 Other Concerns for Corporations ........................... 303 Conclusion ............................................ 304 Key Terms ............................................. 304

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Questions for Review .................................... 304 Chapter Twenty-Six—Summary and Conclusion................ 305 Glossary ................................................. 307 Annotated List of Web Sites Related to Finance and Accounting......... 321 Index.................................................... 325

xiii Preface

This book is an introduction to the world of financial management. However, its intent is not to make the reader a financial manager. Rather, it is an attempt to familiarize the nonfinancial manager with what accounting and finance are all about. This book concentrates on providing a working vocabulary for communication, so that the reader can develop an ability to ask the right questions and interpret the jargon-laden answers. Any accountant can bury any nonaccountant in debits and credits. But, once you understand a few basics, you can fight back and demand information that is both useful and usefully explained.

In addition to vocabulary, this book describes a variety of methods, processes, and tools of accounting and finance. They are not described in sufficient detail for the reader to fire the treasurer or controller and take over the job (how many of you really want to do that?). Instead, there is sufficient detail so that the reader can say, “So that’s what LIFO-FIFO is all about. I always wondered why we changed our inventory system,” or perhaps, “Hey, we never thought about those advantages of leasing rather than buying; maybe we should give leasing a closer look!”

There’s no escaping the fact that all managers are affected by the financial decisions that every firm makes. This book clarifies in the reader’s mind what questions are important to the firm’s financial management and why.

Who are the nonfinancial managers this book is aimed at? They are all managers except for the accountants and other financial experts in the firm. This includes all the engineers, marketing and sales personnel, and production people who have moved up within their firm to the point at which they need more financial lingo to

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follow what’s going on in their communications with the financial officers. It includes those in law and human resources, and others throughout all areas of the firm, who have shifted career paths or who have simply grown with the firm and been promoted to more responsible positions. Sometimes managers need this book simply because the growth of their firm has been so fast that the financial complexity has increased at a more rapid rate then they have been able to keep up with.

Most of the readers of this book will not have attended business school. However, many business school graduates will pick this book up as a refresher. Frequently, business school graduates who majored in fields such as management, marketing, and industrial organization have commented years later that they would have paid far more attention to their accounting and finance course work had they realized how valuable that background is to those in responsible positions in industry.

Essentially, this book is for any manager or future manager who comes into contact with elements of the financial process and feels a need for a better understanding of what’s going on. The structure of this book is such that the reader can sit down and read it in whole or in part. Although it is not a novel, the

xiv Preface

material is presented in a prose that should eliminate the need for intensive studying to understand the main points. A once-through reading should provide the reader with a substantial gain in knowledge. As specific financial questions come before the reader at times in the future, the book will serve as a good reference to brush up in a particular area.

The widespread acceptance of the first three editions of this book has been gratifying. When first published, it was selected as the book of the month by Fortune Book Club. Since then it has been featured by a number of other book clubs, and over 175,000 copies have been sold. It has been included in business CD collections, and is the basis for an on-line interactive course in accounting and finance. It has been adopted by a number of colleges and universities that wanted a less technical book for their non-accounting majors. It has been the basis for a number of executive programs as well. I am most proud of the wide number of individuals who have used it on their own, and then written to thank me because they found it so useful.

Included with this edition are Microsoft Excel templates that will allow you to immediately apply many of the concepts and techniques discussed throughout the book. Also included in an extensive annotated list of Web sites related to accounting and finance that would be useful for nonfinancial managers.

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This fourth edition has changed substantially from the prior edition. In addition to many general updates to make the book more current, this new edition includes new and expanded chapters, discussion of international accounting standards that may soon have a major impact on accounting in the United States, and a major restructuring of the order in which the material in the book is presented.

Chapter 2, new to this edition, provides a basic Excel tutorial. Many nonfinancial managers are held back in their advancement because they are not proficient in Excel. If you know how to use Excel, please skip this chapter. But if you are not currently an Excel user, you will be pleased to see how quickly and easily you can pick up the essentials.

Several of the new chapters in this edition are focused on tools and techniques. Chapter 10 focuses on Uncertainty, providing several tools to aid in making effective decisions when there is uncertainty about the future. Chapter 12 discusses the Earned Value Management technique, designed to help keep projects running on time and on budget. Chapter 17 is devoted to Variance Analysis. The chapter relies heavily on flexible budget concepts to help managers deal better with situations where actual outcomes differ from budgeted expectations.

Several discussions have been added to address some of the major financial events of recent years. In light of a rash of recent financial scandals, Chapter 18 has been refocused from accountability and internal control to a primary focus on fraud and fraud prevention. Chapter 21 now contains a discussion of mark-tomarket accounting, which some believe was a major factor leading to the subprime mortgage crisis of 2008 and the subsequent Great Recession.

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Chapter 14 on Leases has been substantially expanded to include information about other types of long-term financing including long-term notes, mortgages, and bonds.

As of the writing of this book, there is a movement toward requiring the use of International Financial Reporting Standards (IFRS) in the United States. A convergence committee is working on bringing U.S. generally accepted accounting principles and IFRS together. It is possible that some U.S. companies may begin using some version of IFRS as early as 2014. At this point there is no way to know what the final standards will look like if adopted in the U.S., but the reader will get a sneak peak at IFRS in a number of places throughout the book.

Some of the other new topics included in this edition include discussion of the cash versus accrual bases of accounting, cost allocation including Activity Based Costing, and the eXtensible Business Reporting Language (XBRL).

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Perhaps the most dramatic change in this edition is that there has been a major restructuring of the order in which the chapters are presented. For those of you new to the book, hopefully you will just find that there is a nice flow of information from chapter to chapter. Those of you who have used earlier editions may find the restructuring somewhat jarring at first. Earlier editions of the book were written in the traditional order that accounting is generally taught. However, that order best meets the needs of future CPAs, who are primarily concerned with financial reporting to individuals outside of the firm. The new chapter order considers the needs of a nonfinancial manager, providing an emphasis on first planning, then on implementing plans, and then finally on reporting results.

Instructors using this book in a classroom setting will be pleased to see the addition of Questions for Review at the end of each chapter. The solutions to these homework questions and a set of power point class notes are available on the Instructor’s Guide CD.

I would like to thank Professors Viswanathan and Alford of National University, and Professors Lange and Florence of Regis University who reviewed the book and provided helpful comments for the revisions for this new edition. My thanks go to Stewart Karlinsky for his valuable contributions to the tax sections of this book. I am also grateful for the assistance of my editor Kurt Diefenbach and also Lynn Kopon of the CCH editorial staff. I would especially like to thank Christopher Zwirek who did an outstanding job in the production of this book.

Any comments or question concerning this book may be addressed to me at steven.finkler@nyu.edu.

Steven A. Finkler, Ph.D., CPA Professor Emeritus of Accounting and Financial Management The Wagner School, New York University

xvii List of Excel Templates

To ease your way into the application of the material in this book. a set of computer templates has been prepared. In each chapter where the material for a template is discussed, there is a box referring the reader to the template.

Template 1. Balance Sheet (Simple Example) —Chapter 4 Template 2. Income Statement (Simple Example)—Chapter 4 Template 3. Statement of Retained Earnings—Chapter 4

Template 4. Income and Retained Earnings Statement (Simple Example)—Chapter 4

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Template 5. Cash Flow Statement (Simple Example) —Chapter 4 Template 6. Operating Budget—Chapter 6 Template 7. Flexible Budget—Chapter 6 Template 8. Monthly Cash Budget—Chapter 6 Template 9. Present Value—Chapter 11 Template 10. Future Value—Chapter 11 Template 11. Net Present Value—Chapter 11 Template 12. Internal Rate of Return—Chapter 11

Template 13. Calculating Straight-Line and Accelerated Depreciation—Chapter 13

Template 14. Accounts Receivable Aging Schedule —Chapter 15 Template 15. Economic Order Quantity (EOQ)—Chapter 15 Template 16. Credit Terms (Calculate Implicit Interest Rates)—Chapter 15 Template 17. Computing Variances—Chapter 17 Template 18. Journal/Ledger Worksheet—Chapter 20

Template 19. Income Statement and Balance Sheet Derived from Template 18— Chapter 20

Template 20. Balance Sheet (Statement of Financial Position) —Chapter 22 Template 21. Income Statement and Analysis of Retained Earnings—Chapter 22 Template 22. Statement of Cash Flows—Chapter 22 Template 23. Common Size Ratios—Balance Sheet—Chapter 24 Template 24. Common Size Ratios—Income Statement—Chapter 24 Template 25. Liquidity Ratios—Chapter 24 Template 26. Efficiency Ratios—Chapter 24

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Template 27. Solvency Ratios —Chapter 24 Template 28. Profitability Ratios—Chapter 24 Template 29. Calculation of Federal Income Tax—Chapter 25

1 Chapter 1 An Introduction to Financial Management WHAT IS FINANCIAL MANAGEMENT?

Financial management is the part of management which focuses on the organization’s finances. Within financial management there are two primary disciplines: accounting and finance. See Figure 1-1. Accounting is a system for providing financial information. It is generally broken down into two principal elements: financial accounting and managerial accounting. Finance is the area of

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financial management that supervises the acquisition and disposition of the firm’s resources, especially cash.

The financial accounting aspect of accounting is a formalized system designed to record the financial history of the firm. The financial accountant is simply a historian who uses dollar signs. An integral part of the financial accountant’s job is to report the firm’s history from time to time to interested individuals, usually through the firm’s annual and quarterly financial reports.

The managerial accountant looks forward whereas the financial accountant looks backward. Instead of reporting on what has happened, the managerial accountant provides financial information that might be used for making improved decisions regarding the future. In many small firms the same individual is responsible for providing both financial and managerial accounting information.

FIGURE 1-1 Financial Management

Finance is responsible for the organization’s money. It focuses on borrowing funds and investing the cash resources of the firm. However, the finance function also involves providing financial analyses to improve decisions that will affect on the wealth of the organization and its owners. The managerial accountant provides the information for use in the analyses performed by the finance officer.

THE GOALS OF FINANCIAL MANAGEMENT

At first thought, one might simply say that the goal of financial management is to aid in the maximization of wealth, or more simply, maximization of the firm’s profits. Profits are, after all, literally, the bottom line for for-profit organizations. That’s true, but as all managers know, the corporate environment has many other goals— maximization of sales, maximization of market share, maximization of the growth rate of sales, and maximization of the market price of the firm’s stock, for example. For not-for-profit organizations maximization of profits may not be a goal at all, although at least some profit is usually necessary to ensure the financial well-being of even not-for-profit organizations.

On a more personal level, managers are concerned with maximization of salary and perks. Such maximization is often tied in with the maximization of return on investments (ROI), return on equity (ROE) or return on assets (ROA). (See Chapter 24 for a discussion of these terms.) The list of goals within the organization is relatively endless, and our intention is to narrow the range rather than broaden it.

From the perspective of financial management there are two over-riding goals: profitability and viability. See Figure 1-2. The firm wants to be profitable, and it

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wants to continue in business. It is possible to be profitable and yet fail to continue in business. Both goals require some clarification and additional discussion.

FIGURE 1-2 Organizational Goals Profitability

In maximizing profits there is always a trade-off with risk. See Figure 1-3. The greater the risk we must incur, the greater the anticipated profit or return on our money we demand. Certainly, given two equally risky projects, we would generally choose to undertake the one with a greater anticipated return. More often than not, however, our situation revolves around whether the return on a specific investment is great enough to justify the risk involved.

Consider keeping funds in a passbook account insured by the Federal Deposit Insurance Corporation (FDIC). The return on a bank savings account is low, but so is the risk. Alternatively, you could put your money in a nonbank money market fund where the return might be higher. However, the FDIC would not insure the investment. The risk is clearly greater. Or you could put your money into the stock market. In general, do we expect our stocks to do better or worse than a money market fund? Well, the risks inherent in the stock market are significantly higher than in a money market fund. If the expected return weren’t higher, would anyone invest in the stock market?

FIGURE 1-3 Profitability Trade-Off

That doesn’t mean that everyone will choose to accept the same level of risk. Some people keep all their money in FDIC insured bank accounts, and others choose the

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most speculative of stocks. Some firms will be more willing to accept a high risk in order to achieve a high potential profit than other firms. The key here is that in numerous business decisions the firm is faced with a trade-off— risk vs. return. Throughout this book, when decisions are considered, the question that will arise is, ‘‘Are the extra expected profits worth taking the risk?’’ It is, I hope, a question that you will be somewhat more comfortable answering before you’ve reached the end of this book.

Viability

Viability refers to the ability to continue to provide goods and services, and to not go out of business. Firms have no desire to go bankrupt, so it is no surprise that one of the crucial goals of financial management is ensuring financial viability. This goal is often measured in terms of liquidity and solvency. See Figure 1-4.

FIGURE 1-4 Viability

Liquidity is simply a measure of the amount of resources a firm has that are cash or are convertible to cash in the near term, to meet the obligations the firm has that are coming due in the near term. Accountants use the phrases ‘‘nearterm,’’ ‘‘short- term,’’ and ‘‘current’’ interchangeably. Generally the near-term means one year or less. Thus a firm is liquid if it has enough near-term resources to meet its near-term obligations as they become due for payment.

Solvency is simply the same concept from a long-term perspective. Long-term simply means more than one year. Does the firm have enough cash generation potential over the next three, five, and ten years to meet the major cash needs that will occur over those periods? A firm must plan for adequate solvency well in advance because the potentially large amounts of cash involved may take a long period of planning to generate. The roots of liquidity crises that put firms out of

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business often are buried in inadequate long-term solvency planning in earlier years.

So a good strategy is maximization of your firm’s liquidity and solvency, right? No, wrong. Managers have a complex problem with respect to liquidity. Every dollar kept in a liquid form (such as cash, Treasury bills (T-bills), or money market funds) is a dollar that could have been invested by the firm in some longer-term, higher yielding project or investment. There is a trade-off in the area of viability and profitability. The more profitable the manager attempts to make the firm by keeping it fully invested, the lower the liquidity and the greater the possibility of a liquidity crisis and even bankruptcy. The more liquid the firm is kept, the lower the profits. Essentially this is just a special case of the trade-off between risk and return discussed earlier.

We mentioned that profitability and viability are not synonymous. A firm can be profitable every year of its existence, yet go bankrupt anyway. How can this happen? Frequently it is the result of rapid growth and poor financial planning. Consider a firm whose sales are so good that inventory is constantly being substantially expanded. Such expansion requires cash payments to suppliers well in advance of ultimate cash collection from customers.

Consider the hypothetical firm, Expanding Growth Company, that starts the year with $40,000 in cash, $80,000 of receivables, and 10,000 units of inventory. Receivables are amounts that Expanding Growth’s customers owe it for goods and services that they bought, but have not paid for yet. Its inventory units are sold for $10 each and they have a cost of $8, yielding a profit of $2 on each unit sold. During January it collects all of its receivables from the beginning of the year (no bad debts!), thus increasing available cash to $120,000. January sales are 10,000 units, up 2,000 from the 8,000 units sold last December.

Due to increased sales, Expanding Growth decides to expand inventory to 12,000 units. Of the $120,000 available, it spends $96,000 on replacement and expansion of inventory (12,000 units acquired @ $8). No cash is collected yet for sales made in January. This leaves a January month-end cash balance of $24,000.

$ 40,000 Cash, January 1 + 80,000 Collections during January $120,000 Cash Available – 96,000 Purchase of Inventory (12,000 units @ $8) $ 24,000 Cash Balance, January 31

During February all $100,000 of receivables from January’s sales (10,000 units @ $10) are collected, increasing the available cash to $124,000. In February the

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entire 12,000 units on hand are sold and are replaced in stock with an expanded total inventory of 15,000 units.

$ 24,000 Cash Balance, January 31 +100,000 Collections during February $124,000 Cash Available –120,000 Purchase of Inventory (15,000 units @ $8) $ 4,000 Cash Balance, February 28

Everyone at Expanding Growth is overjoyed. They are making $2 on each unit sold. They are collecting 100 percent of their sales on a timely basis. There appears to be unlimited growth potential for increasing sales and profits. The reader may suspect that we are going to pull the rug out from under Expanding Growth by having sales drop or customers stop paying. Not at all.

In March, Expanding Growth collects $120,000 from its February sales. This is added to the $4,000 cash balance from the end of February, for an available cash balance of $124,000 in March. During March, all 15,000 units in inventory are sold and inventory is replaced and expanded to 20,000 units. Times have never been better, except for one problem. Expanding Growth has only $124,000, but the bill for its March purchases is $160,000 (i.e., 20,000 units @ $8). It is $36,000 short in terms of cash needed to meet current needs. Depending on the attitudes of its supplier and its banker, Expanding Growth may be bankrupt.

$ 4,000 Cash Balance, February 28 +120,000 Collections during March $124,000 Cash Available –160,000 Purchase of Inventory (20,000 units @ $8) $(36,000) Cash Balance, March 31

Two key factors make this kind of scenario common. The first is that growth implies outlay of substantial amounts of cash for the increased inventory levels needed to handle a growing sales volume. The second is that growth is often accompanied by an expansion of plant and equipment, again well in advance of the ultimate receipt of cash from customers.

Do growing companies have to go bankrupt? Obviously not. But they do need to plan their liquidity and solvency along with their growth. The key is to focus on the long-term plans for cash. It is often said that banks prefer to lend to those who don’t need the money. Certainly banks don’t like to lend to firms like Expanding Growth, who are desperate for the money. A more sensible approach for Expanding Growth than going to a bank in March would be to lay out a longterm plan for how much it expects to grow and what the cash needs are for that amount of growth. The money

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can then be obtained from the issuing of bonds and additional shares of stock (see Chapter 5), or orderly bank financing can be anticipated and approved well in advance.

Apparently, even in a profitable environment cash flow projections are a real concern. Liquidity and solvency are crucial to the firm’s viability. Throughout the book, therefore, we will constantly return to this issue as well as that of profitability. In fact, the reader will become aware that a substantial amount of emphasis in financial accounting is placed on providing the user of financial information with indications of the firm’s liquidity and solvency.

KEY TERMS Financial management—management of the finances of the firm in order to maximize the wealth of the organization and its owners. Accounting—the provision of financial information. a. Financial accounting—provision of retrospective information regarding the financial position of the firm and the results of its operations. b. Managerial accounting—provision of prospective information for making improved managerial decisions. Finance—provision of analyses concerning the acquisition and disposition of the firm’s resources. Goals of Financial Management

a. Profitability—A trade-off always exists between maximization of expected profits and the acceptable level of risk. Undertaking greater risk should only be done if there are greater anticipated returns.

b. Viability—A trade-off always exists between viability and profitability. Greater liquidity results in more safety, but lower profits.

QUESTIONS FOR REVIEW 1. What is the difference between accounting and finance?

2. What is the difference between financial accounting and managerial accounting? 3. What are the primary goals of financial management? 4. Explain the relationship between financial risk and financial return. 5. Explain the need for financial managers to balance liquidity and solvency.

9 Chapter 2 Excel Basics

Throughout this book you will find references to Excel templates that you can use to perform techniques demonstrated in the book on your own. In order to do that, you

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will need a basic ability to use Excel. If you are already an Excel user, it is suggested that you skip this chapter. However, if you have not used Excel or a similar electronic spreadsheet program (such as the one provided in Google Documents or Open Office), then this chapter is designed to quickly provide you with the basics you need. It will not make you an expert in Excel, but will give you all the rudiments that you need to read spreadsheets prepared by others, to work on the templates provided with this book, and do basic computations on your own.

SPREADSHEETS

A spreadsheet is a document with a grid of columns and rows. Before the widespread use of computers, financial managers used paper that was pre-lined with columns and rows for their computations. Spreadsheets have been used for hundreds of years.

In the late 1970s a Harvard Business School student, Daniel Bricklin, decided that it would be easier to do repetitive computations on a personal computer. Together with Bob Frankston of MIT, he co-invented a software program called VisiCalc. VisiCalc was a major breakthrough in personal computers, pushing them beyond their use as smart typewriters. In the early 1980s Lotus 1-2-3 added charting and database functions to the idea of an electronic spreadsheet. Lotus quickly became the dominant electronic spreadsheet. In the mid-1980s Excel was created. Excel was one of the first spreadsheets to use a mouse and pull down menus making it easier to use. When Microsoft released the Windows operating system in the late 1980s Excel was one of its primary programs, and Excel has held a dominant market position ever since.

WHAT ARE THE REASONS WE USE ELECTRONIC SPREADSHEETS?

Most computers used in business situations will have Microsoft Office software. Microsoft Office is a suite of software programs. The suite includes Microsoft Word, a word processing program, Microsoft Powerpoint, a program for making presentations, Microsoft Access, a program for working with databases, Microsoft Outlook, an e-mail program, and Microsoft Excel, an electronic spreadsheet program.

Electronic spreadsheets such as Excel are computer software programs that are used for computations and creating charts. Much of what is done using Excel could be done manually. However, the computer does computations faster and with fewer errors as compared to those done by hand or by calculator. Probably the main benefit of electronic spreadsheets is the ease with which you can rerun an analysis using a different set of assumptions. One number can be changed, and the results of

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the analysis can be automatically and quickly updated taking that change into account. This allows managers to do a lot of ‘‘what if’’ analyses, evaluating a projection under a wide range of assumptions.

Unlike a calculator, where you can only see one piece of data at a time, with a spreadsheet program you can look at the computer monitor and see a good section of your work all at once. This is helpful for organizing your approach to solving problems. It also allows you to see both the values and formulas used to derive them, making it much easier to locate and correct errors. Electronic spreadsheets can be saved and reused in the future, allowing you to save a lot of time because you don’t have to recreate things from scratch. Often from one year to the next, just a few numbers have to be updated in the saved Excel file.

Once data have been analyzed in a spreadsheet such as Excel, charts or graphs can easily be created, showing the results in a way that may make them easier to comprehend. This chapter will not discuss preparation of charts, but once you have the essentials from this chapter, you will be able to go on and learn how to use charts either using the help function within Excel, or using the free on-line tutorial suggested at the end of this chapter.

Another advantage of electronic spreadsheets is the ability to link and/or share analyses. Once a computer file has been saved, it can be shared with colleagues (e.g., by e-mail or on a thumb drive). This allows them to modify your analysis without having to recreate it. Also, files can be linked, so that an analysis can draw on data in another file without having to reenter all of the information.

Although we generally think about electronic spreadsheets as being computer- based, spreadsheet software programs such as Excel are now available for download onto smart phones and other personal digital assistants (PDAs).

GETTING STARTED WITH EXCEL

In Exhibit 2-1 we see an example of an Excel spreadsheet. When you open the software program, your computer screen will look something like this. Although there are quite a few icons and menu choices on the top of the screen, the most important part for a novice to focus on now is the grid, or the columns and rows.

EXHIBIT 2-1 Excel Spreadsheet

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Exhibit 2-2 zooms in on just a portion of the spreadsheet. The spreadsheet is sometimes referred to as a ‘‘worksheet.’’ This exhibit only shows columns A through E and rows 1 through 11. Arrows in this exhibit emphasize the rows and columns, which are the critical elements of the worksheet. If you were to scroll to the right, the columns keep going. After Column Z, the next column is AA, AB, etc. And if you were to scroll down there are thousands of rows. The intersection of a column and row is called a ‘‘cell’’ on the spreadsheet. Each cell can be referenced by its cell name, which is its column and row. For example, in Exhibit 2-3, the cell that is highlighted is referred to as Cell A1. So if someone told you to look at Cell A1 on the spreadsheet that they just e-mailed to you, you would open the computer file, and look at the contents of the cell in Column A and Row 1.

EXHIBIT 2-2 Columns and Rows

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EXHIBIT 2-3 Cell Names

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The most basic operation you can perform in Excel is to enter information. If possible, as you read this chapter have a computer that has the Excel software program nearby. Open the Excel program. Use your mouse to put your pointer over the Cell A1 box, and left click the mouse. When you left click, Cell A1 will be outlined in black (as in Exhibit 2-3) to let you know, just by glancing at the spreadsheet, which cell you are currently working on. Next, hit the number 5 key, on your keyboard, and then hit the Enter key. That’s it. You now know how to enter data in Excel. On your spreadsheet, in Cell A1 you should now see the number 5.

Of course, typing numbers is fine, but we are mostly concerned with doing math in Excel. All calculations in Excel start with an equals sign (=). We use the plus sign (+) sign for addition, the minus sign (–) for subtraction, the forward slash (/) for division, and an asterisk (*) for multiplication. The asterisk is used to avoid any confusion between a multiplication sign “×” and the letter “x.”

Suppose that we want to add together two numbers. Let’s say we want to add 5 and 5 together. We would put our cursor in a cell (move the mouse to the desired cell and then hit the left mouse button) and then type =5+5. Exhibit 2-4 shows what we would see when we type =5+5, before we hit the Enter key. Next, hit the Enter key and you should get the result we see in Exhibit 2-5. That is, as soon as you hit the Enter key, you should see 10 in Cell A1. So the result is 10. However, it is