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191
RETURNS NEEDED
A Business as an Ongoing Investment Project 191
Cost of Capital 192
Short-Term and Long-Term Asset Investments 195
The Whole Business versus Singular Capital
Investments 196
Capital Investment Example 197
Flexibility of a Spreadsheet Model 206
Leasing versus Buying Long-Term Assets 206
A Word on Capital Budgeting 210
End Point 210
Chapter Appendix 211

CHAPTER 15”DISCOUNTING INVESTMENT
213
RETURNS EXPECTED
Time Value of Money and Cost of Capital 214
Back to the Future: Discounting Investment Returns 215

x
CONTENTS


Spreadsheets versus Equations 217
Discounted Cash Flow (DCF) 218
Net Present Value and Internal Rate of Return (IRR) 222
After-Tax Cost-of-Capital Rate 224
Regarding Cost-of-Capital Factors 226
End Point 227


PART 5
END TOPICS

231
CHAPTER 16”SERVICE BUSINESSES
Financial Statement Differences of Service
Businesses 232
Management Profit Report for a Service
Business 234
Sales Price and Volume Changes 237
What about Fixed Costs? 239
Trade-off Decisions 239
End Point 241

243
CHAPTER 17”MANAGEMENT CONTROL
Follow-through on Decisions 244
Management Control Information 244
Internal Accounting Controls 247
Independent Audits and Internal Auditing 249
Fraud 250
Management Control Reporting Guidelines 252
Sales Mix Analysis and Allocation of Fixed Costs 262
Budgeting Overview 270
End Point 273

CHAPTER 18”MANUFACTURING
275
ACCOUNTING
Product Makers versus Product Resellers 275
Manufacturing Business Example 276
Misclassification of Manufacturing Costs 280
Idle Production Capacity 283
Manufacturing Inefficiencies 285
xi
CONTENTS


Excessive Production 287
End Point 289

291
APPENDIX A GLOSSARY FOR MANAGERS


313
APPENDIX B TOPICAL GUIDE TO FIGURES


315
INDEX




xii
P R E FA C E




T
This book is for business managers, as well as for bankers,
consultants, lawyers, and other professionals who need a
solid and practical understanding of how business makes
profit, cash flow from profit, the assets and capital needed to
support profit-making operations, and the cost of capital.
Business managers and professionals don™t have time to
wade through a 600-page tome; they need a practical guide
that gets to the point directly with clear and convincing
examples.
In broad terms this book explains the tools of the trade for
analyzing business financial information. Financial state-
ments are one primary source of such information. There-
fore financial statements are the best framework to explain
and demonstrate how managers analyze financial informa-
tion for making decisions and keeping control. Surprisingly,
most books of this ilk do not use the financial statements
framework. My book offers many advantages in this re-
spect.
This book explains and clearly demonstrates the indispen-
sable analysis techniques that street-smart business managers
use to:
• Make profit.
• Control the capital invested in assets used in making profit


xiii
P R E FA C E


and in deciding on the sources of capital for asset invest-
ments.
• Generate cash flow from profit.
The threefold orientation of this book fits hand in glove
with the three basic financial statements of every business:
the profit report (income statement), the financial condition
report (balance sheet), and the cash flow report (statement of
cash flows). These three “financials” are the center of gravity
for all businesses.
This book puts heavy emphasis on cash flow. Business
managers should never ignore the cash flow consequences of
their decisions. Higher profit may mean lower cash flow;
managers must clearly understand why, as well as the cash
flow timing from their profit.
The book begins with a four-chapter introduction to finan-
cial statements. Externally reported financial statements are
prepared according to generally accepted accounting princi-
ples (GAAP). GAAP provide the bedrock rules for measuring
profit. Business managers obviously need to know how much
profit the business is earning.
But, to carry out their decision-making and control func-
tions, managers need more information than is reported in
the external profit report of the business. GAAP are the point
of departure for preparing the more informative financial
statements and other internal accounting reports needed by
business managers.
The “failing” of GAAP is not that these accounting rules are
wrong for measuring profit, nor are they wrong for presenting
the financial condition of a business”not at all. It™s just that
GAAP do not deal with presenting financial information to
managers. In fact, much of this management information is
very confidential and would never be included in an external
financial report open to public view.
Let me strongly suggest that you personalize every example
in the book. Take the example as your own business; imagine
that you are the owner or the top-level manager of the busi-
ness, and that you will reap the gains of every decision or suf-
fer the consequences, as the case may be.
If you would like a copy of my Excel workbook file of all
the figures in the book contact me at my e-mail address:
tracyj@colorado.edu.

xiv
P R E FA C E


As usual, the editors at John Wiley were superb. Likewise,
the eagle-eyed copy editors at North Market Street Graphics
polished my prose to a much smoother finish. I would like to
mention that John Wiley & Sons has been my publisher for
more than 25 years, and I™m very proud of our long relation-
ship.
John A. Tracy
Boulder, Colorado
March, 2002




xv
1
PA R T




Financial
Reporting
Outside
and Inside
a Business
1
CHAPTER




Getting Down
to Business



E
Every business has three primary financial tasks that deter-
mine the success or failure of the enterprise and by which its
managers are judged:
• Making profit”avoiding loss and achieving profit goals by
making sales or earning other income and by controlling
expenses
• Cash flow”generating cash from profit and securing cash
from other sources and putting the cash inflow to good use
• Financial health”deciding on the financial structure for
the entity and controlling its financial condition and sol-
vency


To continue in existence for any period of time, a
business has to make profit, generate cash flow,
and stay solvent.
Accomplishing these financial objectives depends on doing
all the other management functions well. Business managers
earn their keep by developing new products and services,
expanding markets, improving productivity, anticipating
changes, adapting to new technology, clarifying the business
model, thinking out clear strategies, hiring and motivating
people, making tough choices, solving problems, and arbitrat-
ing conflicts of interests between different constituencies (e.g.,

3
FINANCIAL REPORTING


customers who want lower prices versus employees who want
higher wages). Managers should act ethically, comply with a
myriad of laws, be responsible members of society, and not
harm our natural environment”all the while making profit,
generating cash flow, and avoiding insolvency.


ACCOUNTING INSIDE AND OUT
Ask people to describe accounting and the most
common answer you™ll get is that accounting involves a lot of
record keeping and bookkeeping. Which is true. The account-
ing system of a business is designed to capture and record all
its transactions, operations, activities, and other develop-
ments that have financial consequences. An accounting sys-
tem generates many documents, forms, and reports. Even a
small business has hundreds of accounts, which are needed to
keep track of its sales and expenses, its assets and liabilities,
Y
and of course its cash flows. Accounting systems today are
FL
computer-based. The accounts of a business are kept on the
hard disks of computers, which should be backed up fre-
quently, of course.
AM


The primary purpose of an accounting system is to accu-
mulate a complete, accurate, and up-to-date base of data and
information needed to perform essential functions for a busi-
TE




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