The portable MBA in finance and accounting 4e by theodore grossman

A Case Study Points to Remember about Financial Statements Financial Statements: Who Uses Them and Why Financial Statement Format Guide to SEC Filings The Notes to the Financial Statemen

About the Contributors

Part I - Financial Accounting

Chapter 1 - Understanding Financial Statements

What Are Financial Statements? A Case Study

Points to Remember about Financial Statements

Financial Statements: Who Uses Them and Why

Financial Statement Format

Guide to SEC Filings

The Notes to the Financial Statements

Financial Accounting Standards

From GAAP to IFRS

Summary and Conclusions

Downloadable Resources for this chapter available at www.wiley.com/go/portablembainfinance

Internet Links

For Further Reading

Chapter 2 - Analyzing Financial Statements

How to Analyze Financial Statements

Using Financial Ratios

Combining Financial Ratios

The Z-Score

Summary and Conclusions

Downloadable Resources for this chapter available at www.wiley.com/go/portablembainfinance

Internet Links

Notes

For Further Reading

Chapter 3 - Analyzing Business Earnings

The Nature of Nonrecurring Items

The Process of Identifying Nonrecurring Items

Nonrecurring Items in the Income Statement

Nonrecurring Items in the Statement of Cash Flows

Interpreting Information in the Operating Activities Section

Nonrecurring Items in the Inventory Disclosures of LIFO Firms

Nonrecurring Items in the Income Tax Note

Nonrecurring Items in the Other Income and Expense Note

Nonrecurring Items in Management‟s Discussion and Analysis (MD&A)Nonrecurring Items in Other Selected Notes

Earnings Analysis and Other Comprehensive Income

Summarizing Nonrecurring Items and Determining Sustainable EarningsRole of the Sustainable Earnings Base

Application of the Sustainable Earnings Base Worksheet: Pfizer, Inc.The Pfizer Worksheet Analysis: Downloadable Tool 3.38

For Further Reading

Part II - Financial Management

Chapter 4 - Discounted Cash Flow

Time Value of Money

For Further Reading

Chapter 5 - Capital Structure

Risk and Return

Portfolio Risk

Capital Asset Pricing Model

Cost of Capital

Cost of Debt and Equity Capital

Weight of Debt and Equity Capital

Capital Structure Theory

Capital Structure in Practice

Chapter 6 - Planning Capital Expenditure

The Objective: Maximize Wealth

Computing NPV: Projecting Cash Flows

Initial Cash Outflow

Cash Flows in Later Years

Treatment of Net Working Capital

Depreciation

Windfall Profit and Windfall Tax

Taxable Income and Income Tax

Interest Expense

Putting the Pieces Together to Forecast Cash Flow

Guiding Principles for Forecasting Cash Flows

Computing NPV: The Time Value of Money

Discounting Cash Flows

Summing the Discounted Cash Flows to Arrive at NPV

Outsourcing and the Build/Buy Decision

The Discount Rate

Weighted Average Cost of Capital

The Effects of Leverage

Divisional versus Firm Cost of Capital

Other Decision Rules

Internal Rate of Return

Innovations in Capital Budgeting

Summary and Conclusions

Note

For Further Reading

Chapter 7 - Global Finance

Currency Exchange Rates: A Case of Individual InvestingCurrency Exchange Rates: A Case in China with Country RiskLocal Partner: Robinson Investment Case

Unknown Rental Cars Borrowing Case: January 1, 1985

Theory: Interest Rate Parity

Theory: Purchasing Power Parity

Futures and Options

Summary

For Further Reading

Part III - Business Entities

Chapter 8 - Choosing a Business Form

The Consulting Firm

The Software Entrepreneur

The Hotel Venture

The Purpose of This Chapter

Business Forms

Comparison Factors

Formation of Sole Proprietorships

Formation of Partnerships

Formation of Corporations

Formation of Limited Partnerships

Formation of Limited Liability Companies

Out-of-State Operation of Sole Proprietorships and Partnerships

Out-of-State Operation of Corporations, Limited Partnerships, and Limited Recognition of Sole Proprietorships as Legal Entities

Recognition of Partnerships as Legal Entities

Recognition of Corporations and Limited Liability Companies as Legal EntitiesRecognition of Limited Partnerships as Legal Entities

For Further Reading

Chapter 9 - Taxes and Business Decisions

Spin-Offs and Split-Ups

Sale of the Corporation

Conclusion

Problems

For Further Reading

Chapter 10 - The Integrity of Financial Reporting

Introduction

Restatements of Previously Published Financial Statements

Asleep at the Switch

The Remedies

It‟s Not Just the Private Sector

Summary and Conclusions

Downloadable Resources for this chapter available at

www.wiley.com/go/portablembainfinance

Notes

For Further Reading

Part IV - Management Accounting

Chapter 11 - Forecasts and Budgeting

The Concept of Budgeting

Fixed Budgets versus Flexible Budgets

The Profit Plan

The Budget Review Process

Recent Trends

Internet Link

Note

For Further Reading

Chapter 12 - Cost Structure Analysis, Profit Planning, and Value Creation

Estimating Cost Structure from Publicly Available InformationPitfalls

Profit Planning from an Internal Perspective

Pricing in CVP Analysis

Predatory Pricing

Dumping

Notes

Chapter 13 - Activity-Based Costing

Basics of Activity-Based Systems

Reflections

What an ABC Systems Is and Is Not

Lessons from Japan

Summary

Notes

Part V - Planning and Strategy

Chapter 14 - Business Planning

How This Chapter Fits in a Typical MBA Curriculum

Who Uses This Material in the Real World

The Story of Your Business

Types of Plans

From Glimmer to Action: The Process

The Story Model

The Business Plan

Conclusion

Other Resources

Internet Links

Notes

For Further Reading

Chapter 15 - Financial Management of Risks

What Went Wrong: Case Studies of Derivatives Debacles

Size of the Derivatives Market and Widespread Use

The Instruments

How to Choose the Appropriate Hedge

Summary and Final Recommendations

Notes

For Further Reading

Chapter 16 - Business Valuation

Three Approaches to Value

Different Types of Buyers

An Overview of the Business Valuation Process

The Fundamental Position of the Firm

Financial Statement Analysis

Adjustments to Earnings for Valuation Purposes

Income Approach: Discounted Cash Flow Method

Discount Rate for the Valuation Model

Market Approach: Publicly Traded Guideline Companies Method

Reconciliation of Valuation Methods

Adjustment for Illiquidity

Valuation Conclusion for Acme

Valuing Minority Interests

Business Valuation Standards

Value Engineering

Summary

Notes

For Further Reading

Chapter 17 - Profitable Growth by Acquisition

Definitions and Background

Recent Trends and the Performance Record of Mergers and AcquisitionsAnatomy of a Successful Acquirer: The Case of Cisco Systems Inc.Creating Value in Mergers and Acquisitions

Some Practical Considerations

Successful Postmerger Implementation

Summary and Conclusions

Notes

References

Chapter 18 - Outsourcing

Motivation to Outsource

Domestic versus Offshore Outsourcing

Issues with Using Offshore Providers

Risks and Challenges of Outsourcing

For Further Reading

Part VI - Advanced Topics

Note

For Further Reading

Chapter 20 - Information Technology and the Firm

For Further Reading

Chapter 21 - Careers in Finance

Overview: What Is the Marketplace for MBAs?

Career Opportunities in Finance

Your Career Plan/Your End Game

Aiming for Your Goals

Implementing Your Strategy

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List of Downloadable Materials

For access to the following list of downloadable materials for The Portable MBA in Finance and

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Syllabus

How Chapter Topics in This Book Track the Core MBA Curriculum

If one were to review the core curriculum for first-year students offered by most of the major MBA programs, one would find, in one form or another, the following courses:

• Financial Accounting

• Management Accounting

• Financial Management

• Business Law and Business Entities

• Planning and Strategy

While this book makes no attempt to cover the entire core curriculum, it does cover most, if not all,

of the accounting and finance topics, as well as several others The following table compares the chapter topics with the typical courses that would be in an MBA program

Preface

Since the third edition of this book was published in late 2001, much has happened to reshape the business world as we now know it Our financial system almost collapsed Stalwarts like Lehman Brothers and Merrill Lynch ceased to exist because they had assumed huge risk in financial

instruments that were vastly overvalued The mortgage market collapsed and along with it went a host

of financial companies and banks that had invested in subprime mortgage-backed securities Bernie Madoff went from obscurity to become a household name after allegedly bilking investors out of approximately $50 billion in the largest-ever Ponzi scheme The stock market lost 35% of its value Personal 401(k) retirement accounts were devastated, and people had to rethink their retirement plans Companies planning to use their stock to finance the purchase of acquisitions found that the value of their stock had plunged Credit became tight and financing difficult

As a result of the Enron scandal, corporate governance has become a hot topic, with potential liability for CEOs and CFOs and with much increased and highly expensive and cumbersome added requirements for internal control imposed by the 2002 Sarbanes-Oxley Act

• Understand financial statements

• Measure liquidity of a business

• Analyze business profitability

• Differentiate between regular income and extraordinary items

• Predict future bankruptcy for an enterprise

• Prepare a budget

• Do a break-even analysis

• Figure out return on investment

• Compute the cost of capital

• Put together a business plan

• Legitimately minimize income taxes payable by you or your business

• Decide what your obligations are as an officer or director of the company

• Determine the implications of outsourcing a product, a function, or a project either domestically or internationally

• Manage foreign currency exposure

• Evaluate a merger or acquisition target

• Serve as a director of a corporation

• Build a successful e-business

• Understand and use financial derivatives

• Use information technology for competitive advantage

• Value a business

These are some of the key topics explained in this book It is a book designed to help you learn the basics in finance and accounting, without incurring the considerable time and expense of a formal MBA program The book consists of valuable, practical how-to information, applicable to an entire range of businesses, from the smallest start-up to the largest corporations in the world Each chapter of the book has been written by an outstanding expert in the subject matter of that particular chapter

Some of these experts are full-time practitioners in the real world, and others are business school professors with substantial real-world experience who also serve as part-time management

consultants Most of these professors are on the faculty of Babson College, which is famous for its major contributions to the field of entrepreneurship, and which year after year is at the top of the

annual list of leading independent business schools compiled by U.S News & World Report and the

University of Maryland‟s University College, a leading Internet university with 100,000 students, including 3,000 MBA students

The first edition of this book was published in 1992, the second edition in 1997, and the third in

2001 All of the editions, hardback and paperback, have been highly successful, and have sold many, many copies In addition, the book has been translated into Chinese (Cantonese and Mandarin),

Indonesian, Portuguese, Russian, and Spanish We are delighted that so many readers in various countries have found this book useful Now, the entire book has been updated for the fourth edition New chapters have been added on the following subjects:

• Discounted Cash Flow

• Analyzing Financial Statements

Some of the chapters include additional online materials that will reinforce the materials contained

in the chapters Please go to www.wiley.com/go/portablembainfinance.com to access the online

materials that are designated for this book

This book can be read, and reread, with a great deal of profit Also, it can be kept handy on a nearby shelf so you can pull it down and look up answers to questions as they occur Further, this book will help you to work with finance and accounting professionals on their own turf and in their own jargon You will know what questions to ask, and you will better understand the answers you receive, without being confused or intimidated

Who can benefit from this book? Many different people, such as:

• Managers wishing to improve their business skills

• Engineers, attorneys, chemists, scientists, and other technical specialists preparing to take

on increased management responsibilities

• People already operating their own businesses, or thinking of doing so

• Businesspeople in nonfinancial positions who want to be better versed in financial matters

• BBA or MBA alumni who want a refresher in finance and accounting

• People in many walks of life who need to understand more about financial matters

Whether you are in one, some, or even none of these categories, you will find much of value in this book, and the book is reader-friendly Frankly, most finance and accounting books are technically complex, boringly detailed, or just plain dull This book emphasizes clarity to nonfinancial readers, using many helpful examples and a bright, interesting style of writing Learn, and enjoy!

THEODORE GROSSMAN JOHN LESLIE LIVINGSTONE

Acknowledgments

A book like this can result only from the contributions of many talented people We would like to thank the chapter authors who make up this book for their clear and informative explanations of the powerful concepts and tools of finance and accounting These people dedicate their lives to educating others in the complexities of their disciplines In this ever-changing world of technology, strategy, economic cycles, geopolitical events, and the Internet, while most of the underlying concepts remain fixed, the applications are ever changing, requiring the authors to constantly rededicate themselves to their professions We thank our editor, Michael Grossman, for his reviewing of the materials from the perspective of an MBA student

We dedicate this book to our wives, Ruthie Grossman and Trudy Livingstone, and to our children and grandchildren They provide the daily inspiration to diligently perform our work and to have undertaken this project

T G

J L L

About the Contributors

Richard T Bliss has been involved in corporate financial analysis since 1987 and is currently on the

finance faculty at Babson College He teaches at the undergraduate, MBA, and executive levels, specializing in the areas of corporate financial strategy and entrepreneurial finance Prior to coming to Babson, Dr Bliss was on the faculty at Indiana University, and he has also taught extensively in Central and Eastern Europe, including at the Warsaw School of Economics, Warsaw University, and the University of Ljubljana in Slovenia

With publications in the areas of corporate finance, emerging markets, entrepreneurship, and

banking, Dr Bliss has an active research agenda His work on the impact of bank mergers on CEO

compensation has been cited in Fortune magazine and numerous other business publications and was published in the Journal of Financial Economics

Dr Bliss holds a PhD in finance from Indiana University He also received his MBA in finance/real estate from Indiana University and graduated with honors from Rutgers University, earning a BS degree in engineering and a BA degree in economics

Ralph J Constantino is associate director of the MBA Center for Career Development, F.W Olin

Graduate School of Business, Babson College He has had over 30 years of senior-level professional experience in the financial services industry Prior to joining Babson, he served as the managing director for strategic marketing and product development for State Street Global Advisors, where he drove international initiatives in Hong Kong and Australia and played a leading role in the formation

of CitiStreet LLC, a joint venture between State Street and CitiCorp He was also the senior vice president and chief investment officer for the Schoolhouse Capital business unit that built solutions for the 529 college savings marketplace Before his tenure at State Street Corporation, he held senior-level positions with the Abu Dhabi Investment Authority, Chase Consulting Group, Mercer Meidenger Hanson, Equitable Capital Management Company, Smilen and Safian, and Citibank Aside from his corporate experience, Mr Constantino has also served as a member of the adjunct faculty at New York University, Loyola University, the American Institute of Banking, and Bentley University He is also a featured speaker at professional conferences in the United States, Europe, and Asia He has also

appeared on the Nightly Business Report and major print media He holds a BS degree in economics

and business administration from Wagner College as well as a master‟s degree in economics from Rutgers University

Michael A Crain, CPA/ABV, CFA, ASA, CFE, MBA, is a practitioner specializing mostly in

business valuation and forensic accounting in Fort Lauderdale, Florida He holds several certifications related to valuation: Chartered Financial Analyst awarded by the CFA Institute, Accredited Senior Appraiser in business valuation from the American Society of Appraisers, and Accredited in Business Valuation awarded by the American Institute of Certified Public Accountants (AICPA) Mr Crain is a past chairman of the AICPA business valuation committee, and he has been a member of the

committee that develops the examination given to CPAs who seek the AICPA‟s certification in

business valuation He teaches a business valuation course at Florida Atlantic University Mr Crain

has received several awards, including the AICPA Journal of Accountancy Lawler Award for best

article of the year, and has been inducted into the AICPA business valuation hall of fame His articles have been published in practitioner journals, and he has spoken to national audiences He is currently working on doctorate research at the Manchester Business School, University of Manchester, England

Dawna Travis Dewire is a member of the full-time faculty at Babson College in Massachusetts She

teaches courses in information systems design, database development, and process reengineering Ms

Dewire is the author of five books and has been the editor of The James Martin Report, the Year 2000 Practitioner, and the quarterly Journal of Information Systems Management Prior to joining Babson

College, she was on the full-time faculty at Bentley College Ms Dewire‟s professional experience includes positions with Information Resources, Inc., TRW United-Carr Division, Blue Cross/Blue Shield, and the State of New York Ms Dewire holds a BS in mathematics and an MS in computer science from the University at Albany-State University of New York and an MBA from Northeastern University

James A Elfter currently resides in East Seaham, a suburb of Newcastle, New South Wales,

Australia Jim has an MBA from the University of Maryland University College and an undergraduate degree from Governors State University in Illinois Since 2006, he has been working for the

University of Maryland‟s Graduate School of Management and Technology as a graduate faculty assistant Jim retired from General Motors after more than 30 years of service in various managerial capacities and international assignments He has lived and worked in Greece, Egypt, Yugoslavia, Brazil, Canada, and Australia, where he is enjoying semiretirement

Steven P Feinstein is an associate professor of finance at Babson College He has earned a PhD in

economics from Yale University and a BA degree in economics from Pomona College, and he also holds the Chartered Financial Analyst (CFA) designation His research and teaching specialties are in the fields of investments and capital markets In addition to his teaching and research, Professor Feinstein provides consulting services and expert testimony on a variety of financial topics, most frequently securities litigation Past and present clients include the United States Securities and

Exchange Commission, the National Association of Securities Dealers, the Internal Revenue Service, the attorney general of the State of Illinois, State Street Bank, and numerous law firms

Theodore Grossman is a member of the faculty of Babson College, where he teaches information

technology and accounting He lectures on various information technology topics such as Web

technologies, e-commerce, strategic information systems, managing information technology, and systems analysis and design He also performs extensive consulting for food and nonfood retailers and suppliers of technology products to the retail industry He is called on frequently to act as an expert witness in complex litigation in matters relating to technology and cyber law Prior to joining Babson College, he was the founder and CEO of a computer software company for the retail industry He holds a BS degree in engineering from the University of New Hampshire and an MS in management from Northeastern University Mr Grossman was a contributor to the second edition of this book and

is an editor of both the third and fourth editions

Robert F Halsey has a BA, MBA, and PhD from the University of Wisconsin-Madison During his

business career, Dr Halsey managed the commercial lending division of a large Midwestern bank and served as the chief financial officer of a privately held retailing and manufacturing company Prior to joining the faculty of Babson College, he taught at the University of Wisconsin-Madison, where he received the Douglas Clarke Memorial teaching award His teaching and research interests are in the area of financial reporting and include firm valuation, financial statement analysis, and disclosure

issues Dr Halsey is the author of Advanced Financial Accounting (forthcoming in 2009 by

Cambridge Business Publishers) and a co-author of Financial Accounting for MBAs, third edition (Cambridge Business Publishers), MBA Financial & Managerial Accounting (Cambridge Business Publishers), and Financial Statement Analysis, ninth edition (McGraw-Hill) He has published in

Advances in Quantitative Analysis of Finance and Accounting, the Journal of the American Taxation Association, and Issues in Accounting Education

William C Lawler is the leadership professor, strategy and accounting, F.W Olin Graduate School

of Business, Babson College He is also the director of the Consortium for Executive Development at Babson Executive Education His teaching and research focus on two areas: financial footprints of business unit strategy and the impact of new technologies on cost systems design Dr Lawler has written several papers and given numerous professional presentations His primary focus is on aiding operational managers in understanding the financial consequences of their decisions He has run seminars on this topic for such diverse groups as telecom managers in China, production managers in the Czech Republic, and R&D managers in the United States Dr Lawler consults with a number of companies, ranging from small biotechs to Fortune 100 technology companies, concerning the design and use of cost information systems for management decision support rather than external financial reporting His most recent publications in this area are a chapter, “Understanding the Financial

Footprint of Strategy,” in Strategy, Innovation, and Change (Oxford University Press, 2008), and chapters on activity-based costing and profit planning in the fourth edition of The Portable MBA in Finance and Accounting

Les Livingstone is the MBA Program Director in Economics, Finance and Accounting at the

University of Maryland University College, a leading Internet university with 100,000 students, including 3,000 MBA students (http://www.umuc.edu/index.shtml) He earned MBA and PhD

degrees at Stanford University and is a CPA (licensed in New York and Texas) Since 1991 he has directed his own consulting firm, specializing in damage estimation for large-scale commercial

litigation and in business valuation He has served as a consulting or testifying expert in many cases, and has testified in federal and state courts in Arizona, California, Florida, Georgia, Illinois,

Massachusetts, New York, Rhode Island, and Texas He has also testified before federal government agencies, including the Federal Trade Commission (FTC) Federal Energy Regulatory Commission (FERC), as well as the Public Utilities Commission of Texas Web site http://leslivingstone.com

Richard P Mandel is associate dean of the Undergraduate School and associate professor of law at

Babson College, where he teaches a variety of courses in business law and taxation on the

undergraduate, graduate, and executive education levels and has served as chair of the finance division and acting dean of the Undergraduate School He is also of counsel to the law firm of Bowditch and Dewey, of Worcester, Framingham, and Boston, Massachusetts, where he specializes in the

representation of growing businesses and their executives Mr Mandel has written a number of

articles regarding legal issues encountered by small businesses He holds an AB in government and meteorology from Cornell University and a JD from Harvard Law School

Tracee Petrillo is director, MBA Center for Career Development, and assistant dean, F W Olin

Graduate School of Business, Babson College She has over 15 years of corporate and higher

education experience Prior to receiving her MBA at Babson in 2000, she had been in operations management, business development, and corporate sales in the hospitality industry working for

organizations such as Disney, Doubletree, and Sheraton After her Babson MBA, she worked at Keane Consulting Group as an operations consultant She returned to Babson as program manager of the two-year MBA program in 2003 Subsequently she became the director of the office of program

management before becoming assistant dean of the graduate school During this time, she led the transition of the experiential learning function to the graduate school leading the corporate business development program for the experiential learning programs, and implemented new processes for both programs In addition to her Babson MBA, she holds a BA degree from Union College She is

proficient in Spanish and German, and has traveled extensively, including time living abroad in both Germany and Spain In Madrid, she studied at Sampere Language School

Michael J Riley is a professor at the University of Maryland University College, teaching MBAs He

is a board member of Church Mutual Insurance Company and chairs the audit committee of the

Architect of the Capitol, an agency of the U.S Congress Previously, Dr Riley earned his doctorate of business administration from Harvard University (1977), his MBA from the University of Southern California (1972), and his BS from the United States Naval Academy (1965) Dr Riley has served as CFO of the United States Postal Service, CFO of Lee Enterprises, CFO of United Airlines, and

treasurer of Michigan Bell Telephone Company During his tenure, the Postal Service posted the largest increase in profits of any organization in the world (1995) and remained consistently profitable during the remainder of his service He has consulted with companies, government agencies, and a major union He has taught at Harvard University, Boston University, the University of Connecticut, the University of Michigan, and George Mason University His articles have appeared in major

magazines and newspapers, including the Wall Street Journal Dr Riley began his career as a Navy

pilot, earning the Air Medal for service in Vietnam

Virginia Earll Soybel teaches financial accounting and financial statement analysis in both the

graduate and undergraduate programs at Babson College She earned her MBA and PhD at Columbia University and taught at the Amos Tuck School of Business at Dartmouth College before coming to Babson in 1995 Professor Soybel‟s research focuses on the effects of alternate reporting methods on corporate financial statements and ratios, the time series behavior of financial ratios, and the political

process of accounting standard-setting Her publications include articles in Strategic Management Journal and in the Journal of Accounting and Public Policy

Craig A Stephenson has been a member of the faculty at Babson College since 1997 He has

experience in the CFO organizations of Phillips Petroleum, Texas Instruments, and Dell He teaches in the undergraduate, graduate, and executive education programs, and he specializes in corporate

finance and financial strategy He has also been on the faculty at the University of Colorado, the University of Wisconsin, and MIT‟s Sloan School of Management Professor Stephenson received his PhD from the University of Arizona, his MBA from the University of Texas, and his BS from the University of Colorado He is also the recipient of an honorary degree from the Babson College graduating class of 2004, awarded to the undergraduate professor of the year He is a member of the Institute of Management Accountants, and is a certified management accountant

Andrew Zacharakis is the John H Muller Jr chair in entrepreneurship and the director of the Babson

College Entrepreneurship Research Conference, the leading academic conference on entrepreneurship worldwide He previously served as chair of the entrepreneurship department at Babson College from

2003 to 2005 and as acting director of the Arthur M Blank Center for Entrepreneurship at Babson College from 2003 to 2004 In addition, Dr Zacharakis was the president of the Academy of

Management, entrepreneurship division, an organization with 1,800 members, from 2004 to 2005 He

also served as an associate editor at the Journal of Small Business Management (2003-2006) His

primary research areas include the venture capital process and entrepreneurial growth strategies Dr

Zacharakis is the co-author of five books, The Portable MBA in Entrepreneurship, third edition; Business Plans That Work; How to Raise Capital; Entrepreneurship, The Engine of Growth; and a forthcoming textbook titled Entrepreneurship The editors of Journal of Small Business Management selected “Differing Perceptions of New Venture Failure” as the 1999 best article His dissertation The Venture Capital Investment Decision received the 1995 Certificate of Distinction from the Academy

of Management and Mr Edgar F Heizer, recognizing outstanding research in the field of new

enterprise development Dr Zacharakis has been interviewed in newspapers nationwide, including the

Boston Globe, the Wall Street Journal, and USA Today He has also appeared on the Bloomberg Small Business Report and been interviewed on National Public Radio He has taught seminars to leading

corporations, such as Boeing, Met Life, Lucent, and Intel He has also taught executives in countries worldwide, including Spain, Chile, Costa Rica, Mexico, Australia, China, Turkey, and Germany Dr Zacharakis received a BS (finance/marketing) from the University of Colorado, an MBA

(finance/international business) from Indiana University, and a PhD (strategy and

entrepreneurship/cognitive psychology) from the University of Colorado Professor Zacharakis

actively consults with entrepreneurs and small business startups His professional experience includes positions with The Cambridge Companies (investment banking/venture capital), IBM, and Leisure Technologies

Hal: How much money will you need to get started?

Gail: I estimate $80,000 for the beginning inventory, plus $36,000 for store signs, shelves, fixtures,

counters, and cash registers, plus $24,000 working capital to cover operating expenses for about two months That‟s a total of $140,000 for the start-up

Hal: Suppose the bank lends you $40,000 on a one-year note, at 15% interest, secured by a lien on the

inventory Let‟s put together projected financial statements from the figures you gave me Your beginning balance sheet would look like what you see on the computer screen:

Nutrimin

The left side shows Nutrimin‟s investment in assets It classifies the assets into “current” (which means turning into cash in a year or less) and “noncurrent” (not turning into cash within a year) The right side shows how the assets are to be financed: partly by the bank loan and partly by your equity as the owner

Gail: Now I see why it‟s called a “balance sheet.” The money invested in assets must equal the

financing available—it‟s like two sides of the same coin Also, I see why the assets and liabilities are classified as “current” and “noncurrent”—the bank wants to see if the assets turning into cash in a year

or less will provide enough cash to repay the one-year bank loan Well, in a year there should be cash

of $104,000 That‟s enough cash to pay off more than twice the $40,000 amount of the loan I guess that guarantees approval of my loan!

Hal: We‟re not quite there yet We need some more information First, tell me: How much do you

expect your operating expenses will be?

Gail: For year 1, I estimate as follows:

Hal: We also have to consider depreciation on the store equipment It probably has a useful life of 10

years So each year it depreciates 10% of its cost of $36,000 That is $3,600 a year for depreciation So operating expenses must be increased by $3,600 a year from $96,400 to $100,000 Now, moving on, how much do you think your sales will be this year?

Gail: I‟m confident that sales will be $720,000 or even a little better The wholesale cost of the items

sold will be $480,000, giving a markup of $240,000—which is 33 % on the projected sales of

$720,000

Hal: Excellent! Let‟s organize this information into a projected income statement We start with the

sales, and then deduct the cost of the items sold to arrive at the gross profit From the gross profit we deduct your operating expenses, giving us the income before taxes Finally we deduct the income tax expense in order to get the famous “bottom line,” which is the net income Here is the projected

income statement shown on my computer screen:

Nutrimin

Gail: I understand the general idea But what does “gross profit” mean?

Hal: It‟s the usual accounting term for sales less the amount that your suppliers charged you for the

goods that you sold to your customers In other words, it represents your markup from the wholesale cost you paid for goods to the price for which you sold those goods to your customers It is called

“gross profit” because your operating expenses have to be deducted from it In accounting, the word

gross means “before deductions.” For example, “gross sales” means sales before deducting goods

returned by customers Sales after deducting goods returned by customers are referred to as “net

sales.” In accounting, the word net means “after deductions.” So, “gross profit” means income before

deducting operating expenses By the same token, “net income” means income after deducting

operating expenses and income taxes Now, moving along, we are ready to figure out your projected balance sheet at the end of your first year in business But first, I need to ask you: How much cash do you plan to draw out of the business as your compensation?

Gail: My present job pays $76,000 a year I‟d like to keep the same standard of compensation in my

new business this coming year

Hal: Let‟s see how that works out after we‟ve completed the projected balance sheet at the end of year

1 Here it is on my computer screen:

Nutrimin

Gail, let‟s go over this balance sheet together It has changed, compared to the balance sheet as of January 1 On the “Liabilities and Equity” side of the balance sheet, the net income of $84,000 has increased capital to $184,000 (because earning income adds to the owner‟s capital), and deducting drawings of $76,000 has reduced capital to $108,000 (because drawings take capital out of the

business) On the “Assets” side, notice that the equipment now has a year of depreciation deducted, which writes it down from the original $36,000 to a net (there‟s that word “net” again) $32,400 after depreciation The equipment had an expected useful life of 10 years, now reduced to a remaining life

of nine years Last, but not least, notice that the cash has increased by only $11,600 from $24,000 at the beginning of the year to $35,600 at year-end This leads to a problem: The bank loan of $40,000 is due for repayment on December 31 But there is only $35,600 of cash available on December 31 How can the loan be paid off when there is not enough cash to do so?

Gail: I see the problem But I think it‟s bigger than just paying off the loan The business will also

need to keep about $25,000 cash on hand to cover two months‟ operating expenses and income taxes

So, with $40,000 to repay the loan, plus $25,000 for operating expenses, the cash requirements add up

to $65,000 But there is only $35,600 cash on hand This leaves a cash shortage of almost $30,000 ($65,000 less $35,600) Do you think that will force me to cut down my drawings by $30,000, from

$76,000 to $46,000? Here I am, opening my own business, and it looks as if I have to go back to what

I was earning five years ago!

Hal: That‟s one way to do it But here‟s another way that you might like better After your suppliers

get to know you, and do business with you for a few months, you can ask them to open credit accounts for Nutrimin If you get the customary 30-day credit terms, then your suppliers will be financing one month‟s inventory That amounts to one-twelfth of your $480,000 annual cost of goods sold, or

$40,000 This $40,000 will more than cover the cash shortage of $30,000

Gail: That‟s a perfect solution! Now, can we see how the balance sheet would look in this case?

Hal: Sure When you pay off the bank loan, it vanishes from the balance sheet It is replaced by

accounts payable of $40,000 Then the balance sheet looks like this:

Nutrimin

Now the cash position looks a lot better But it hasn‟t been entirely solved: there is still a gap between the accounts payable of $40,000 and the cash of $35,600 So, you will need to cut your drawings by about $5,000 in year 1 But that‟s still much better than the cut of $30,000 that had seemed necessary before In year 2, the bank loan will be gone, so the interest expense of $6,000 will be saved Then you can use $5,000 of this savings to restore your drawings back up to $76,000 again

Gail: That‟s good news I‟m beginning to see how useful projected financial statements are for

business planning Can we look at the revised projected balance sheet now?

As we see, cash is increased by $5,000 to $40,600—which is sufficient to pay the accounts payable of

$40,000 Drawings are decreased by $5,000 to $71,000, which provided the $5,000 increase in cash

Gail: Thanks That makes sense I really appreciate everything you‟ve taught me about financial

statements

Hal: I‟m happy to help But there is one more financial statement to discuss A full set of financial

statements consists of more than the balance sheet and the income statement It also includes a cash flow statement Here is the projected cash flow statement:

Nutrimin

Gail, do you have any questions about this cash flow statement?

Gail: Actually, it makes sense to me I realize that there are only two sources that a business can tap in

order to generate cash: internal (by earning income) and external (by obtaining cash from outside sources, such as bank loans) In our case the internal sources of cash are represented by the “Cash from Operations” section of the cash flow statement, and the external sources are represented by the

“Cash from Financing” section of the cash flow statement It happens that the “Cash from Financing”

is negative, because no additional outside financing is received for the year 20XX, but cash payments are incurred for drawings and for repayment of the bank loan I also understand that there are no “Uses

of Cash” because no extra equipment was acquired In addition, I can see that the total sources of cash less the total uses of cash must equal the net cash increase, which in turn is the cash at the end of the year less the cash at the beginning of the year But I am puzzled by the “Cash from Operations”

section of the cash flow statement I can understand that earning income produces cash However, why

do we add back depreciation to the net income in order to calculate cash from operations?

Hal: This can be confusing, so let me try to explain as clearly as I can Certainly net income increases

cash, but first an adjustment has to be made in order to convert net income to a cash basis

Depreciation was deducted as an expense in figuring net income So adding back depreciation to net

income just reverses the charge for depreciation expense We back it out because depreciation is not a

cash outflow Remember that depreciation represents just one year‟s use of the equipment The cash outflow for purchasing the equipment was incurred back when the equipment was first acquired, and amounted to $36,000 The equipment cost of $36,000 is spread out over the 10-year life of the

equipment at the rate of $3,600 per year, which we call depreciation expense So, it would be double counting to recognize the $36,000 cash outflow for the equipment when it was originally acquired, and then to recognize it again a second time when it shows up as depreciation expense We do not write a check to pay for depreciation each year, because it is not a cash outflow

Gail: Thanks Now I understand that depreciation is not a cash outflow But I don‟t see why we also

added back the increase in current liabilities to the net income in order to calculate cash from

operations Can you explain that to me?

Hal: Of course The increase in current liabilities is caused by an increase in accounts payable

Accounts payable is amounts owed to our suppliers for our purchases of goods for resale in our

business Purchasing goods for resale from our suppliers on credit is not a cash outflow The cash outflow occurs only when the goods are actually paid for by writing out checks to our suppliers That

is why we added back the increase in current liabilities to the net income in order to calculate cash from operations In the future, the increase in current liabilities will, in fact, be paid in cash But that will take place in the future, and is not a cash outflow in this year Going back to the cash flow

statement, notice that it ties in neatly with our balance sheet amount for cash It shows how the cash at the beginning of the year plus the net cash increase equals the cash at the end of the year

Gail: Now I get it Am I right that you are going to review my projections and then I‟ll hear from you

about my loan application?

Hal: Yes, I‟ll be back to you in a few days By the way, would you like a printout of the projected

financial statements to take with you?

Gail: Yes, please I really appreciate your putting them together and explaining them to me I picked

up some financial skills that will be very useful to me as an aspiring entrepreneur

1 The basic form of the balance sheet is Assets = Liabilities + Owner Equity

2 Assets are the expenditures made for items such as inventory and equipment that are needed to operate the business The liabilities and owner equity reflect the funds that financed the expenditures for the assets

3 Balance sheets show the financial position of a business at a given moment of time

4 Balance sheets change as transactions are recorded

5 Every transaction is an exchange, and both sides of each transaction are recorded For example, when a bank loan is made, there is an increase in cash, which is matched by an increase

in a liability entitled “Bank loan.” When a bank loan is repaid, there is a decrease in cash, which

is matched by a decrease in a liability entitled “Bank loan.” After every transaction, the balance sheet stays in balance

6 Income increases owner equity, and drawings decrease owner equity

7 The income statement shows how the income for the period was earned

8 The basic form of the income statement is:

a Sales - Cost of Goods Sold = Gross Income

b Gross Income - Expenses = Net Income

9 The income statement is simply a detailed explanation of the increase in owner equity represented by net income It shows how the owner equity increased from the beginning of the year to the end of the year on account of the net income

10 Net income contributes to cash from operations, after it has been adjusted to a cash basis

11 Not all expenses are cash outflows: for instance, depreciation

12 Changes in current assets (except cash) and current liabilities are not cash outflows or inflows, respectively, in the period under consideration They represent future, rather than present, cash flows

13 Cash can be generated internally by operations, or externally from outside sources such

as lenders (or equity investors)

14 The cash flow statement is simply a detailed explanation of how cash at the start developed into cash at the end by virtue of cash inflows, generated internally and externally, less cash outflows

Therefore, all three financial statements are interrelated, or, to use the technical term,

“articulated.” They are mutually consistent, and that is why they are referred to as a “set” of financial statements The three-piece set consists of a balance sheet, income statement, and cash flow statement

16 A set of financial statements can convey much valuable information about the enterprise

to anyone who knows how to analyze financial statements This information goes to the core of the organization‟s business strategy and the effectiveness of its management

While Gail was making her notes, Hal was carefully analyzing the Nutrimin projected financial statements in order to make his recommendation to the bank‟s loan committee about the Nutrimin loan application He paid special attention to the cash flow statement, keeping handy the bank‟s guidelines

on cash flow analysis, which included issues such as the following:

• Is cash from operations positive? Is it growing over time? Is it keeping pace with growth in sales? If not, why not?

• Are cash withdrawals by owners only a small portion of cash from operations? If cash withdrawals by owners are a large share of cash from operations, then the business is conceivably being milked of cash, and may not be able to finance its future growth

• Of the total sources of cash, how much is being internally generated by operations versus obtained from outside sources? Normally, it is wiser to rely more on internally generated cash for growth than on external financing

• Of the outside financing, how much is derived from equity investors and how much is borrowed money? Normally, it is preferable to rely more on equity than on debt financing

• What kinds of assets is the company acquiring with the cash being expended? Is it likely that that these asset expenditures will be profitable? How long will it take for these assets to repay their cost, and then to earn a reasonable return?

Hal reflected carefully on these issues, and then finalized his recommendation, which was to

approve the loan It turned out that the bank‟s loan committee accepted Hal‟s recommendation, and even went further They authorized Hal to tell Gail that—if she met all of her responsibilities in regard

to the loan throughout the year—the bank would renew the loan at the end of the year and even

increase the amount Hal called Gail with the good news Their conversation included the following dialogue:

Hal: In order to renew the loan, the bank will ask you for new projected financial statements for the

subsequent year Also, the loan agreement will want you to submit financial statements for the year just past—that is, not projected, but actual financial statements The bank will require that these actual financial statements have been reviewed by an independent CPA

Gail: Let me be sure I understand: Projected financial statements are forward-looking, whereas actual

financial statements are backward-looking Is that correct?

Hal: As you probably know, a CPA is a certified public accountant, a professional trained in finance

and accounting, and licensed by the state Independent means a CPA who is not an employee of yours,

or a relative It means someone in public practice in a CPA firm In other words, it is someone outside,

objective and unbiased Gail: And what does reviewed mean?

Hal: Good question CPAs offer three levels of service relating to financial statements:

1 An audit is a thorough in-depth examination of the financial statements and tests of the

supporting records The result is an audit report, which states whether the financial statements are free of material misstatements (whether caused by error or by fraud) A “clean” audit report provides assurance that the financial statements are free of material misstatements A “modified” report gives no such assurance, and is cause for concern Financial professionals always read the auditor‟s report first, before even looking at any financial statement, in order to see if the report is clean If it is not clean, there is no assurance that the financial statements are free of material misstatements The auditor is a watchdog, and this watchdog barks by issuing a modified audit report By law, all companies that have publicly traded securities must have their financial statements audited, as a protection to investors, creditors, and other financial statement users Private companies are not required by law to have audits But sometimes audits are required for private companies by agreement with particular investors or creditors An audit provides the highest level of assurance that a CPA can provide Audits are also the most expensive level of service There are less expensive and less thorough levels of service, such as the following

2 A review is a less extensive, and less expensive, level of financial statement inspection by

a CPA Since it is less extensive and less expensive, it provides a lower level of assurance that the financial statements are free of material misstatements

3 Finally, there is the lowest level of service, which is called a compilation, where the

outside CPA puts together the financial statements from the client company‟s books and records but does not examine them in much depth A compilation provides the least assurance and is the least expensive level of service

So the bank is asking you for the middle level of assurance when it requires a review by an independent CPA Banks usually require a review from borrowers that are smaller private businesses

2 Prospective equity investors and lenders, to decide whether to invest

3 Investment analysts, money managers, and stockbrokers to make buy/sell/hold recommendations to their clients

4 Rating agencies (such as Moody‟s Investors Service, Standard & Poor‟s, and Fitch Ratings), to assign credit ratings, or Dun & Bradstreet, to obtain business information reports

5 Major customers and suppliers, to evaluate the financial strength and staying power of the company as a dependable resource for their business

6 Labor unions, to gauge how much of a pay increase a company is able to afford in upcoming labor negotiations

7 The board of directors, to review the performance of management

8 Management, to assess its own performance

9 Corporate raiders, to seek hidden value in companies with underpriced stock

10 Competitors, to benchmark their own financial results

11 Potential competitors, to assess how profitable it may be to enter an industry

12 Government agencies responsible for taxing, regulating, or investigating the company

13 Politicians, lobbyists, issue groups, consumer advocates, environmentalists, think tanks, foundations, media reporters, and others who are supporting or opposing any particular issue

14 Actual or potential joint venture partners, franchisors or franchisees, and other business interests that have a reason to be informed about the company and its financial situation

This brief list shows how many people use and rely on financial statements for a large variety of business purposes It shows how important financial statements are in business

It also shows how essential it is to master the understanding, analysis, and use of financial

statements in order to be successful in the business world

Income Statement

Note what this income statement tells us:

• Revenue increased each year, by $4,485 in XXX2 and by $3,209 in XXX3 These increases are good news, but note that the amount of increase has dropped in year XXX3

• Total expenses have also increased each year, but by a smaller amount than revenue

• As a result, net income increased each year, by $3,295 in XXX2 and by $1,636 in XXX3 Again, this is good news, but note that the amount of increase has dropped in year XXX3

Cash Flow Statement

Note what this cash flow statement tells us:

• Cash from operations increased each year, by $4,704 in XXX2 and by $824 in XXX3 These increases are good news, but note that the amount of increase has dropped in year XXX3

• Cash from financing is negative each year The corporation has not increased its outside financing, but rather has reduced it—mainly by repurchasing its own stock

• Net cash invested increased each year, by $3,919 in XXX2 and by $736 in XXX3 Again, this is good news, because investment is needed to grow the company But note that the amount

of increase has dropped in year XXX3

• Cash from operations has been sufficient to provide for the company‟s investment needs, and even to reduce outside financing That shows a company with sufficient growth and

profitability to keep investing for further growth It generates sufficient cash from operations to cover all investment needs while also reducing outside financing

Balance Sheet

Note what this balance sheet tells us:

• This company grew its total assets by $13,525, from $38,625 to $52,150

• But total liabilities increased only by $595, from $10,187 to $10,782

• Therefore net assets grew by $13,525 less $595, which is $12,930

• This $12,930 is the same amount by which total equity increased from $28,438 to $41,368, because, as we know: Total Assets = Total Liabilities + Owner Equity

You may have observed that there are only two years of balance sheets but three years of income statements and cash flow statements This is because these public company financial statements were obtained from filings with the U.S Securities and Exchange Commission (SEC), and the SEC

requirements for corporate annual report filings are two years of balance sheets, plus three years of income statements and cash flow statements

These corporate financial statements contain numbers very much larger than those for Nutrimin But there is no difference in the general format of these two sets of financial statements

Guide to SEC Filings

The SEC requires all public companies in the United States to disclose certain financial information in filings with the SEC, which can be viewed online The main filings include:

• Form 8-K Disclosure of significant financial events—for example, resignation or

termination of auditor, a new borrowing of material amount, a material merger or acquisition, or

a material divestment

• Form 10-Q Quarterly financial statements

• Form 10-K Annual report for the fiscal year Typical Table of Contents:

Item 1 Brief Description of Company Business Item 1A Risk Factors

Item 1B Unresolved Staff Comments Item 2 Properties

Item 3 Legal Proceedings Item 4 Submission of Matters to a Vote of Security Holders Item 5 Market for Registrant‟s Common Equity, Related Stockholder Matters and Issuer, Purchases of Equity Securities

Item 6 Selected Financial Data Item 7 Management‟s Discussion and Analysis of Financial Condition and Results

of Operations (often abbreviated as MD&A)

Item 7A Quantitative and Qualitative Disclosures about Market Risk Item 8 Financial Statements and Supplementary Data

Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

Item 9A Controls and Procedures Item 9B Other Information Item 10 Directors and Executive Officers of the Registrant Item 11 Executive Compensation

Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Item 13 Certain Relationships and Related Transactions Item 14 Principal Accountant Fees and Services

Item 15 Exhibits and Financial Statement Schedules

The Notes to the Financial Statements

In addition to the three financial statements, there are the notes to the financial statements, which are regarded as an integral part of the three statements (See Exhibit 1.1.)

Financial Accounting Standards

It is no accident that financial statements have a standard format There are financial accounting standards that require uniformity in financial statement presentation, in order that financial statements can be compared:

• From period to period for the same organization

• From organization to organization for the same period

This comparability is essential because accounting is the language of business, so it is important that all businesses use the same language How is this uniformity established?

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated

organization in the private sector for establishing standards in financial accounting and reporting Those standards govern the preparation of financial reports, and are known as generally accepted accounting principles (GAAP) They are officially recognized as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (AICPA) (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979) The main purpose

of GAAP is to make financial statements uniform and comparable in form and content from

organization to organization and from period to period Such standards are essential to the efficient functioning of the economy, because investors, creditors, auditors, and others rely on credible,

transparent, and comparable financial information

function to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest

is necessary for the various financial accounting standards of different countries to be replaced with a single set of worldwide financial accounting standards That development is currently proceeding under the name of International Financial Reporting Standards (IFRS)

GAAP is a vast collection of rules that set out in detail how financial information must be compiled and disclosed in financial statements In brief, GAAP is rule-based In contrast, IFRS is much less detailed and much less specific It lays out broad general principles, and leaves the specific details to the discretion of users, so long as they keep within the broad general principles In brief, IFRS is principles-based rather than rules-based As a result, there are many disagreements and disputes between proponents of GAAP and proponents of IFRS However, while the resolutions of these disputes remain unclear, one thing seems absolutely certain: In a few years IFRS will replace U.S GAAP

financial statements:

Chapter 2: Analyzing Financial Statements

Chapter 3: Analyzing Business Earnings

Chapter 10: The Integrity of Financial Reporting

Downloadable Resources for this chapter available at

Here are short videos about each of the financial statements:

“What Is a Balance Sheet?”

For Further Reading

Horngren, Charles T., Gary L Sundem, John A Elliott, and Donna Philbrick, Introduction to

Financial Accounting, Charles T Horngren Series in Accounting (Upper Saddle River, NJ:

Prentice-Hall, 2005)

Ingram, Robert W., and Thomas L Albright, Financial Accounting: Information for Decisions

(Florence, KY: South-Western College Publishing, 2007)

Stickney, Clyde P., and Roman L Weil, Financial Accounting: An Introduction to Concepts, Methods and Uses (Florence, KY: South-Western College Publishing, 2006)

Weygandt, Jerry J., Donald E Kieso, and Paul D Kimmel, Accounting Principles, 7th ed., with

PepsiCo Annual Report (Hoboken, NJ: John Wiley & Sons, 2004)

We check the financial health of a company in much the same fashion, by analyzing the financial statements The vital signs are tested mostly by various financial ratios, which are calculated from the financial statements The financial vital signs can be classified into three main categories:

1 Short-term liquidity

2 Long-term solvency

3 Profitability

Next, we explain each of these three categories in turn

“No” means bankruptcy The importance and urgency of this question are the reasons why current assets (which are expected to turn into cash within a year) and current liabilities (which are expected

to be paid in cash within a year) are shown separately on the balance sheet Net current assets (current

assets less current liabilities) are known as working capital Most businesses cannot operate without

positive working capital Therefore, the question of whether current assets exceed current liabilities is crucial

When current assets are greater than current liabilities, there is sufficient liquidity to enable the enterprise to survive However, when current liabilities are greater than current assets, the enterprise may well be in imminent danger of bankruptcy The financial ratio used to measure this risk is current

assets divided by current liabilities, and is known as the current ratio It is expressed as (for example)

2.5 to 1 or 2.5:1 or just 2.5 A current ratio greater than 1 is the bare minimum to indicate survival, but

it lacks any margin of safety We will explain why financial ratios are only rough approximations, not precise indicators, and why it is therefore important to allow for a reasonable margin of safety, or cushion For this reason, a current ratio of 1 is not at all impressive evidence of liquidity In most cases, from a practical point of view, a current ratio of 2 or more just begins to provide credible

evidence of liquidity An example of a current ratio can be found in the current sections of a balance sheet shown earlier in Chapter 1:

Current assets usually include:

• Cash and cash equivalents

• Securities expected to become liquid by maturing or being sold within a year

• Accounts receivable (which Nutrimin did not have, because it did not sell to its customers

• Other current payables, such as taxes, wages, or insurance

• The current portion of long-term debt

Some items included in current assets need further explanation These are:

• Cash equivalents are near-cash securities, such as U.S Treasury bills maturing in three months or less

• Accounts receivable are amounts owed by customers, and should be reported on the balance sheet at “realizable value,” which means at the amount reasonably expected to be collected in cash Any accounts whose collectability is in doubt must be reduced to realizable value by deducting an allowance for doubtful debts

• Inventories in some cases may not be liquid in a crisis situation (except at fire sale prices) This condition is especially likely for goods of a perishable, seasonal, high-fashion, or trendy nature, or items subject to technological obsolescence, such as computers Since inventory can readily lose value, it must be reported on the balance sheet at the “lower of cost or market value.” This means that the amount reported for inventory on the balance sheet is what it cost to acquire (including freight and insurance) or—if lower—the cost of replacement or the expected selling price less costs of sale

Despite these requirements designed to report inventory at a realistic amount, inventory is regarded

as an asset subject to inherent liquidity risk, particularly in difficult economic times, and especially for items that are subject to obsolescence, theft, or deterioration For these reasons, the current ratio is often modified by excluding inventory, so that the modified ratio is current assets excluding inventory,

divided by current liabilities This modified ratio is known as the quick ratio or the acid test ratio In

the case of Nutrimin, it is $40,600 divided by $40,000, which is about 1, as of December 31 This indicates that Nutrimin has a barely adequate quick ratio, with no margin of safety at all It is a red flag, or warning signal

These are the turnover ratios, which consist of:

• Accounts receivable turnover

liquidity Or, more simply, achieving better turnover of working capital can significantly improve liquidity Therefore, turnover ratios provide valuable information The working capital turnover ratios are described next

The 91-day turnover period is found by dividing a year, 365 days, by the accounts receivable

turnover ratio of 4, to get the average of 91 days This is how long on average it takes to collect

accounts receivable That is fine if our credit terms call for payment 90 days from invoice But it is not fine if credit terms are 60 days, and it is alarming if credit terms are 30 days

Accounts receivable, unlike vintage wines or antiques, do not improve with age Accounts

receivable turnover should be in line with credit terms, and it signals increasing danger to liquidity as turnover gets further out of line with credit terms