Chapter 10 : Corporate Finance
Corporate finance is one of the most important aspects of maintaining and running a business. The purpose of any business is to stay in business and managing revenues, expenses, and profits properly will dictate the success or failure of the business. Companies perform better when their managers speak the language of business – the numbers. Learning to decode well-prepared financial reports, leaders will be much better equipped to understand the realities of a business’s position, what it has been doing correctly and where it faces challenges. Understanding finance also helps managers make better decisions inside their departments and outside of them, as well.
This subject is relevant to my aspirations because corporate finance is something that every business owner must deal with and understand. A manager who does not understand or is not conversational in the numbers cannot be an effective leader. Financially intelligent executives know how to question the number crunchers when the figures don’t look right, which is even more important in the wake of recent financial scandals managers can be held personally responsible for what the accounting department reports out.
“Financial Intelligence” by Karen Berman, Joe Knight, and John Case and “How to Read a Financial Report” by John Tracy explain why financial intelligence matters and provides a basic overview of high level accounting terms and principles used by US companies. Employees in the accounting department would find these books elementary. These books are relevant to my aspirations because I have a marketing and technical background and have been newly appointed to a position managing a profit and loss statement. Based on my assessments, I need to improve my financial literacy and ability to actively manage the finances of my business unit.
Financial Intelligence begins by explaining that finance is as much of an art as a science. Much of what determines how certain cost and revenue allocations are accounted for is subjective and based on the guidance and interpretation of rules by senior finance executives. In the same vein there are some types of physical goods where the depreciation time period is flexible.
Both books then go into some detail defining common terms of corporate finance. They start with a high level overview of the three common reports; income statement, balance sheet, and cash flow statement. Profitability (also called P&L) over time is reported on the income statement. Income statements take the total revenues and then steps through a series of deductions relating to company expenses.
· Gross profit is profit after cost of goods sold (COGS) or cost of service (COS) is deducted from total revenue
· Operating profit is subtracts operating expenses from gross profit. Operating profit is also called earnings before interest, taxes, depreciation, and amortization (EBITA).
· Net profit is what remains when interested and taxes are subtracted from operating profit. Net profit is also referred to net income.
Three ways to increase net profit are increasing sales of more profitable items, lower costs, or reduce the workforce.
The balance sheet reflects a company’s assets and liabilities; in other works what it owns and what it owes. Accounting tries to match and realize revenue in line with expenses. This is where terms such as accounts receivable (what a company is owed), accounts payable (what a company owes), depreciation, amortization, and expense accrual are found. Balance sheets must balance – an income statement affects the balance sheet. Each sale appears on the income statement as either cash or accounts receivable, while some expenses show up in accounts payable. The balance sheet answers these important questions:
• “Is the company solvent?” – More assets than liabilities means equity is positive.
· “Can the company pay its bills?” – Short-term assets should always cover short term liabilities.
· “Has owners’ equity been growing over time?” – Comparing several years’ worth of balance sheets will indicate a firm’s progress.
Cash flow statement reveals how a company uses its cash. The income statement and the statement of cash flows tell you different things. You must earn a profit and turn that profit into cash in a timely manner to realize its maximum value. “Free cash flow” is what remains after you subtract what you need to run the business; it’s an important indicator of a firm’s financial well-being. Income statements can be manipulated based on how expenses are calculated and timed, cash flow statements cannot.
Footnotes and ratios are important tools. Footnotes are important because they hold clues on how to interpret the numbers in financial statements usually related to the income statement and balance sheet. Ratios offer a methodology to compare performance of different companies in the same industry. Some common ratios are
• Return on Assets/Equity (ROA / ROE); calculates operating and net profit margins as a percent of total revenue
• Operating leverage refers to the relationship between a firms variable and fixed costs
• Financial leverage or debt-to-equity ratio indicates how much debt finances a company’s assets
• Liquidity compares short term assets to liabilities due within a year and tells how well a firm can meet their obligations.
• Days sales outstanding (DSO) measures the average time it takes to receive payment from customers.
• Return on sales indicates net income divided by sales revenue
• Price to earnings (P/E) divides the stock price by the earnings per share (EPS). EPS is net income divided by the number of outstanding stock shares.
From an international perspective “The Handbook of International Trade and Finance” by Anders Grath provides additional insights when dealing with multi-national business transactions. He provides insights into the different risk international business can present and some solutions to protect both parties (sellers and buyers). This book summary is relevent to my aspirations because all companies are doing business globally today - if not selling globally their supply chains are most likely global. Understanding the risks of international finance will help me keep my company out of precarious situations.
The International Trade Commission (ICC) establishes rules for member organizations in over 130 countries. It sets the procedures and policies for financing and delivery and defines terms and conditions found in trade contracts.
The risks that companies face can be broken down in several categories:
• Product, production and transport risks. These risks typically affect the buyer more than the seller, concerning the performance and delivery of a products throughout the maintenance or warranty period
• Commercial risks. A seller assumes the risk of being paid by the buyer from another country.
• Adverse business risks. What is customary or typical business practice in some countries is considered bribery and corruption in others. Companies from the United States must adhere to US law no matter what the local laws or customs are in the country they are doing business in.
• Political risks. Governments can impose challenges though their actions. Implementing higher trade tariffs, environmental clauses, disputes between governments; e.g Brazil recently turning to Russia for fighter jets because of NSA spying on Brazilians, could render a business deal unprofitable or void.
• Currency risks. Currency fluctuations can eliminate any profits that were built into a sale.
• Financial risks. A catch all category, basically stating the more prolonged a transaction is the greater risk of something going wrong.
We also learn about different methods companies can use to exchange money across borders. Some ways favor the seller more than the buyer and vice versa. There are four methods of payment that are most common:
• Bank Transfers. After a seller ships the product to a buyer, they generate an invoice at which time the buyer instructs its bank to transfer the funds to the sellers account.
• Check Payment. Similar to the method above with the exception that the buyer will issue a corporate or bank check to the seller.
• Documentary collection. In this situation banks are the intermediaries between the buyer and seller. The bank will present the buyer proof of shipment and the buyer pays upon receiving the documents, not necessarily the goods.
• Letter of Credit. In this situation the buyer asks a bank to issue a letter of credit to the seller. Again, the bank pays based on documents not goods. This method is more expensive, it also lowers the risk to both parties. The buyer can be assured the seller has fulfilled the contract and the bank is obligated to pay the seller.
The book also discusses topics such as Export Credit Insurance. Export Credit Insurance is issued by government sponsored export credit agencies who indemnify against political risk in longer term deals. We also learn about standard and structured trade financing for longer term deals such as infrastructure projects in developing nations. Overall I learned this is a very complex field and very specific expertise and specialization is needed. If an organization does not have in house expertise the help of an external consultant is mandatory to ensure international deals can remain profitable.
“Security Analysis” by Benjamin Graham and David Dodd outlines the fundamental highlights of securities analysis and how this differs from market analysis. Mr. Graham is considered the father of modern security analysis and the founder of value investing. Much has changed on Wall Street since this book was first published however the principles are still sound.
This book summary is relevant to my aspirations because my long term goal is to have 25% of my income generated through passive investments. Two primary ways to achieve this goal are through investing in the financial markets and in real estate. In reading this I have realized that outside of the mutual funds in my 401K, my investment approach has been speculative and not very successful. Through mastering the material in the book and others like it, I will be better prepared to meet this goal. Honestly assesing myself, I am not a great investor. I realize that most securities investing I have done to date are more speculative (i.e. gambling) than investing. This work will help me not be taken advantage of by more savvy investors or financial experts.
Security analysis is a process to determine what companies are sound investments, keeping principle safe and delivering an acceptable return. On the other hand market analysis attempts to forecast the prices of securities or a market as a whole without referring to necessary facts about the individual companies. Intrinsic value is an important yet elusive concept. Intrinsic value is the value of a company justified by the facts – assets, earnings, dividends, and prospects. Security analysis has three functions:
1. The descriptive function presents the relevant facts in an intelligible fashion and compares various securities.
2. The selective function judges whether an investor should buy, sell, hold onto or exchange a security.
3. The critical function monitors corporate policies, management and company structure on an ongoing basis.
Instead of thinking of investments as just stocks and bonds, securities can be classified more accurately as fixed-value securities, variable-value senior securities, and common stocks. Each of these has their own criteria for intelligent investing.
When evaluating fixed value securities such as bonds make sure the company has the ability to pay the bond debt. Can the company meet its obligations under worse case scenarios? Look for a company to be a dominant player in its industry and has sufficient earnings to cover bond interest by a large margin. Preferred stocks and income bonds should have greater safety margins built in.
There are privileges that make variable-value senior securities attractive, this does not necessarily mean safer. Those that do not meet investment grade safety requirements are in the same category as common stocks. Three privileges are convertible issues, participation issues, and subscription-warrant issues. Consider the amount of profit sharing benefits per dollar invested and the duration of those privileges.
Common stocks are the most often used investment vehicle today. Stocks are unstable; however an investor can diversify their portfolio to offset some risk. Three crucial factors in evaluating a stock’s price are:
· Dividends - Look at the dividends paid and the history of dividend payment even during stressful times.
· Earnings – Study the income statement. Current earnings can be manipulated so look for nonrecurring charges and profits to prop up earnings. Also look at earnings history over a 5-10 year period.
· Asset Value – Inspect the business’s balance sheet. Pay attention to the liquidation value of the company which is current assets minus liabilities. Also watch for any large debts that would mature in the near future and create financing problems.
Even though types securities described above might not meet requirements that would classify them as investment grade, a knowledgeable investor still has the opportunity to profit if the security is undervalued. It is a recommended practice that any investor periodically checks price and calculated value of a company to make sure conditions have not changed.
Exercises and practice routines
Exercise # 1. Reading financial reports
Objective: Build skills in understanding how to read and understand financial reports.
The team should take 10 minutes to read through the same financial report of a public company. After reading discuss with the group the financial strengths and weaknesses of the company. Is this company a good investment based on its current stock price?
This subject is relevant to my aspirations because corporate finance is something that every business owner must deal with and understand. A manager who does not understand or is not conversational in the numbers cannot be an effective leader. Financially intelligent executives know how to question the number crunchers when the figures don’t look right, which is even more important in the wake of recent financial scandals managers can be held personally responsible for what the accounting department reports out.
“Financial Intelligence” by Karen Berman, Joe Knight, and John Case and “How to Read a Financial Report” by John Tracy explain why financial intelligence matters and provides a basic overview of high level accounting terms and principles used by US companies. Employees in the accounting department would find these books elementary. These books are relevant to my aspirations because I have a marketing and technical background and have been newly appointed to a position managing a profit and loss statement. Based on my assessments, I need to improve my financial literacy and ability to actively manage the finances of my business unit.
Financial Intelligence begins by explaining that finance is as much of an art as a science. Much of what determines how certain cost and revenue allocations are accounted for is subjective and based on the guidance and interpretation of rules by senior finance executives. In the same vein there are some types of physical goods where the depreciation time period is flexible.
Both books then go into some detail defining common terms of corporate finance. They start with a high level overview of the three common reports; income statement, balance sheet, and cash flow statement. Profitability (also called P&L) over time is reported on the income statement. Income statements take the total revenues and then steps through a series of deductions relating to company expenses.
· Gross profit is profit after cost of goods sold (COGS) or cost of service (COS) is deducted from total revenue
· Operating profit is subtracts operating expenses from gross profit. Operating profit is also called earnings before interest, taxes, depreciation, and amortization (EBITA).
· Net profit is what remains when interested and taxes are subtracted from operating profit. Net profit is also referred to net income.
Three ways to increase net profit are increasing sales of more profitable items, lower costs, or reduce the workforce.
The balance sheet reflects a company’s assets and liabilities; in other works what it owns and what it owes. Accounting tries to match and realize revenue in line with expenses. This is where terms such as accounts receivable (what a company is owed), accounts payable (what a company owes), depreciation, amortization, and expense accrual are found. Balance sheets must balance – an income statement affects the balance sheet. Each sale appears on the income statement as either cash or accounts receivable, while some expenses show up in accounts payable. The balance sheet answers these important questions:
• “Is the company solvent?” – More assets than liabilities means equity is positive.
· “Can the company pay its bills?” – Short-term assets should always cover short term liabilities.
· “Has owners’ equity been growing over time?” – Comparing several years’ worth of balance sheets will indicate a firm’s progress.
Cash flow statement reveals how a company uses its cash. The income statement and the statement of cash flows tell you different things. You must earn a profit and turn that profit into cash in a timely manner to realize its maximum value. “Free cash flow” is what remains after you subtract what you need to run the business; it’s an important indicator of a firm’s financial well-being. Income statements can be manipulated based on how expenses are calculated and timed, cash flow statements cannot.
Footnotes and ratios are important tools. Footnotes are important because they hold clues on how to interpret the numbers in financial statements usually related to the income statement and balance sheet. Ratios offer a methodology to compare performance of different companies in the same industry. Some common ratios are
• Return on Assets/Equity (ROA / ROE); calculates operating and net profit margins as a percent of total revenue
• Operating leverage refers to the relationship between a firms variable and fixed costs
• Financial leverage or debt-to-equity ratio indicates how much debt finances a company’s assets
• Liquidity compares short term assets to liabilities due within a year and tells how well a firm can meet their obligations.
• Days sales outstanding (DSO) measures the average time it takes to receive payment from customers.
• Return on sales indicates net income divided by sales revenue
• Price to earnings (P/E) divides the stock price by the earnings per share (EPS). EPS is net income divided by the number of outstanding stock shares.
From an international perspective “The Handbook of International Trade and Finance” by Anders Grath provides additional insights when dealing with multi-national business transactions. He provides insights into the different risk international business can present and some solutions to protect both parties (sellers and buyers). This book summary is relevent to my aspirations because all companies are doing business globally today - if not selling globally their supply chains are most likely global. Understanding the risks of international finance will help me keep my company out of precarious situations.
The International Trade Commission (ICC) establishes rules for member organizations in over 130 countries. It sets the procedures and policies for financing and delivery and defines terms and conditions found in trade contracts.
The risks that companies face can be broken down in several categories:
• Product, production and transport risks. These risks typically affect the buyer more than the seller, concerning the performance and delivery of a products throughout the maintenance or warranty period
• Commercial risks. A seller assumes the risk of being paid by the buyer from another country.
• Adverse business risks. What is customary or typical business practice in some countries is considered bribery and corruption in others. Companies from the United States must adhere to US law no matter what the local laws or customs are in the country they are doing business in.
• Political risks. Governments can impose challenges though their actions. Implementing higher trade tariffs, environmental clauses, disputes between governments; e.g Brazil recently turning to Russia for fighter jets because of NSA spying on Brazilians, could render a business deal unprofitable or void.
• Currency risks. Currency fluctuations can eliminate any profits that were built into a sale.
• Financial risks. A catch all category, basically stating the more prolonged a transaction is the greater risk of something going wrong.
We also learn about different methods companies can use to exchange money across borders. Some ways favor the seller more than the buyer and vice versa. There are four methods of payment that are most common:
• Bank Transfers. After a seller ships the product to a buyer, they generate an invoice at which time the buyer instructs its bank to transfer the funds to the sellers account.
• Check Payment. Similar to the method above with the exception that the buyer will issue a corporate or bank check to the seller.
• Documentary collection. In this situation banks are the intermediaries between the buyer and seller. The bank will present the buyer proof of shipment and the buyer pays upon receiving the documents, not necessarily the goods.
• Letter of Credit. In this situation the buyer asks a bank to issue a letter of credit to the seller. Again, the bank pays based on documents not goods. This method is more expensive, it also lowers the risk to both parties. The buyer can be assured the seller has fulfilled the contract and the bank is obligated to pay the seller.
The book also discusses topics such as Export Credit Insurance. Export Credit Insurance is issued by government sponsored export credit agencies who indemnify against political risk in longer term deals. We also learn about standard and structured trade financing for longer term deals such as infrastructure projects in developing nations. Overall I learned this is a very complex field and very specific expertise and specialization is needed. If an organization does not have in house expertise the help of an external consultant is mandatory to ensure international deals can remain profitable.
“Security Analysis” by Benjamin Graham and David Dodd outlines the fundamental highlights of securities analysis and how this differs from market analysis. Mr. Graham is considered the father of modern security analysis and the founder of value investing. Much has changed on Wall Street since this book was first published however the principles are still sound.
This book summary is relevant to my aspirations because my long term goal is to have 25% of my income generated through passive investments. Two primary ways to achieve this goal are through investing in the financial markets and in real estate. In reading this I have realized that outside of the mutual funds in my 401K, my investment approach has been speculative and not very successful. Through mastering the material in the book and others like it, I will be better prepared to meet this goal. Honestly assesing myself, I am not a great investor. I realize that most securities investing I have done to date are more speculative (i.e. gambling) than investing. This work will help me not be taken advantage of by more savvy investors or financial experts.
Security analysis is a process to determine what companies are sound investments, keeping principle safe and delivering an acceptable return. On the other hand market analysis attempts to forecast the prices of securities or a market as a whole without referring to necessary facts about the individual companies. Intrinsic value is an important yet elusive concept. Intrinsic value is the value of a company justified by the facts – assets, earnings, dividends, and prospects. Security analysis has three functions:
1. The descriptive function presents the relevant facts in an intelligible fashion and compares various securities.
2. The selective function judges whether an investor should buy, sell, hold onto or exchange a security.
3. The critical function monitors corporate policies, management and company structure on an ongoing basis.
Instead of thinking of investments as just stocks and bonds, securities can be classified more accurately as fixed-value securities, variable-value senior securities, and common stocks. Each of these has their own criteria for intelligent investing.
When evaluating fixed value securities such as bonds make sure the company has the ability to pay the bond debt. Can the company meet its obligations under worse case scenarios? Look for a company to be a dominant player in its industry and has sufficient earnings to cover bond interest by a large margin. Preferred stocks and income bonds should have greater safety margins built in.
There are privileges that make variable-value senior securities attractive, this does not necessarily mean safer. Those that do not meet investment grade safety requirements are in the same category as common stocks. Three privileges are convertible issues, participation issues, and subscription-warrant issues. Consider the amount of profit sharing benefits per dollar invested and the duration of those privileges.
Common stocks are the most often used investment vehicle today. Stocks are unstable; however an investor can diversify their portfolio to offset some risk. Three crucial factors in evaluating a stock’s price are:
· Dividends - Look at the dividends paid and the history of dividend payment even during stressful times.
· Earnings – Study the income statement. Current earnings can be manipulated so look for nonrecurring charges and profits to prop up earnings. Also look at earnings history over a 5-10 year period.
· Asset Value – Inspect the business’s balance sheet. Pay attention to the liquidation value of the company which is current assets minus liabilities. Also watch for any large debts that would mature in the near future and create financing problems.
Even though types securities described above might not meet requirements that would classify them as investment grade, a knowledgeable investor still has the opportunity to profit if the security is undervalued. It is a recommended practice that any investor periodically checks price and calculated value of a company to make sure conditions have not changed.
Exercises and practice routines
Exercise # 1. Reading financial reports
Objective: Build skills in understanding how to read and understand financial reports.
The team should take 10 minutes to read through the same financial report of a public company. After reading discuss with the group the financial strengths and weaknesses of the company. Is this company a good investment based on its current stock price?
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Bibliography
Berman, Karen, Joe Knight, and John Case. “Financial intelligence: a manager's guide to knowing what the numbers really mean”. Harvard Business Press, 2013.
Tracy, John A. “How to read a financial report: wringing vital signs out of the numbers.” John Wiley & Sons, 2004.
Grath, Anders. “The handbook of international trade and finance: the complete guide to risk management, international payments and currency management, bonds and guarantees, credit insurance and trade finance”. Kogan Page Publishers, 2011.
Graham, Benjamin, David Le Fevre Dodd, and Sidney Cottle. “Security analysis.” New York: McGraw-Hill, 1934.
Berman, Karen, Joe Knight, and John Case. “Financial intelligence: a manager's guide to knowing what the numbers really mean”. Harvard Business Press, 2013.
Tracy, John A. “How to read a financial report: wringing vital signs out of the numbers.” John Wiley & Sons, 2004.
Grath, Anders. “The handbook of international trade and finance: the complete guide to risk management, international payments and currency management, bonds and guarantees, credit insurance and trade finance”. Kogan Page Publishers, 2011.
Graham, Benjamin, David Le Fevre Dodd, and Sidney Cottle. “Security analysis.” New York: McGraw-Hill, 1934.