Financial Analysis E-Book

Steven M. Bragg

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 689

Veröffentlichungsjahr: 2012

Beschreibung

"The latest edition goes beyond ho-hum analysis techniques and provides concrete problem solving. The text is sprinkled with real-world problems (and the analytical tools to solve them) that will be familiar to accounting professionals everywhere. A must-have for anyone looking to improve their company's decision making . . . and their own role in it." --George R. MacEachern President, Grosvenor Financial Services "Steve Bragg has presented yet another comprehensive reference tool for the finance professional. Financial Analysis: A Controller's Guide is the perfect reference guide for today's controller, presenting not only traditional financial analysis information, but also various types of analyses that will benefit any type of organization. This book is a must-have for any financial professional desiring to make a relevant contribution to his/her organization." --Jodi Nefzger, CPP Director of Finance, Masonic Home of Missouri Today's proactive controllers can soar past their mundane responsibilities and become active participants in their corporation's success with the visionary tools found in Steven Bragg's Financial Analysis: A Controller's Guide, Second Edition. Now updated to include analyses of intangible asset measurement and performance improvement as well as evaluation methods to determine which products and services should be eliminated, Financial Analysis: A Controller's Guide, Second Edition helps financial managers upgrade their skills so they can answer their organization's call for company operations reviews, investment evaluations, problem reporting, and special investigation requests. Controllers prepared to address this growing need for more innovative financial analysis will open doors to a variety of promotions and high-level interactions with other departments. Become a highly valued member of your company's infrastructure with the indispensable tools found in Financial Analysis: A Controller's Guide, Second Edition.

Leseprobe

Contents

Title

Copyright

Dedication

About the Author

Preface

Part One: Overview

Chapter 1: Introduction

Chapter 2: The Role of Financial Analysis

Part Two: Financial Analysis

Chapter 3: Evaluating Capital Investments

Hurdle Rate

Payback Period

Net Present Value

Internal Rate of Return

Cash Flow Modeling Issues

Capital Investment Proposal Form

Postcompletion Project Analysis

Problems with the Capital Budget Approval Process

Summary

Chapter 4: Evaluating Financing Options

Types of Funding Options

Costs of Funding Options

Risks Associated with Funding Options

Control Problems Associated with Financing Options

Leasing

Loans

Common Stock

Convertible Securities

Preferred Stock

Stock Rights

Warrants

Summary

Chapter 5: Evaluating Cash Flow

Evaluating Working Capital

Creating a Cash Flow Model for a Capital Investment

Creating and Evaluating a Cash Forecast

Incremental Cash Flow Analysis

Interpreting Variations in the Flow of Cash

Summary

Chapter 6: Evaluating Acquisition Targets

Overview of Acquisition Analysis

Obtaining Information for an Acquisition Analysis

Personnel Analysis

Patent Analysis

Brand Analysis

Capacity Analysis

Asset Analysis

Liability Analysis

Profitability Analysis

Cash Flow Analysis

Fraud Analysis

Synergy Analysis

Complexity Analysis

Contractual and Legal Issues

Table of Analysis Topics

Summary

Chapter 7: Increasing Shareholder Value

Linking Shareholder Value and Cash Flows

Pricing

Material Costs

Labor Costs

Interest Income and Expense

Research and Development Efforts

Taxation

Working Capital

Fixed Assets

Debt

Owner’s Equity

Summary

Chapter 8: Intangible Asset Measurement and Performance Enhancement

Value of Intangible Assets

Difficulty of Intangible Asset Measurement

Metrics for Research and Development Intangible Assets

Funding Decisions for Research and Development Projects

Assigning a Value to Processes

Summary

Chapter 9: Breakeven Analysis

Basic Breakeven Formula

Impact of Fixed-Cost Changes on Breakeven

Impact of Variable-Cost Changes on Breakeven

Impact of Pricing Changes on Breakeven

Case Studies in Breakeven Analysis

Summary

Chapter 10: Business Cycle Forecasting

Nature of the Business Cycle

Impact of the Business Cycle on a Corporation

History of Business Cycles

Theories Behind Business Cycle Forecasting

Elements of Business Cycle Forecasting

Business Cycle Forecasting at the Corporate Level

Summary

Endnotes

Part Three: Operational Analysis

Chapter 11: Evaluating Management Performance

Choosing Performance Review Measures

Behavioral Changes Resulting from Performance Review Measures

Specific Performance Review Measures

How to Compile Performance Review Measures

Reporting Performance Review Measures

Summary

Chapter 12: Analyzing Process Cycles

Definition of a Process Cycle

Analyzing the Purchasing Cycle

Analyzing the Revenue Cycle

Analyzing the Order Fulfillment Cycle

Summary

Chapter 13: Product and Service Profitability Analysis

Eliminating Unprofitable Products

Profitability Analysis for Services

Summary

Chapter 14: Financial Analysis of Operational Topics

Analysis of Accounting and Finance

Analysis of Computer Services

Analysis of Engineering

Analysis of Human Resources

Analysis of Logistics

Analysis of Production

Analysis of Sales

Analysis of Outsourcing

Reporting Results to Target Departments

Summary

Chapter 15: Capacity Utilization Analysis

Relationship Between Profits and Capacity Utilization

Uses for Capacity Planning

Capacity Baseline

Presenting Capacity Information

Problems with Capacity Analysis

Summary

Part Four: Other Analysis Topics

Chapter 16: Financial Analysis with an Electronic Spreadsheet

Financial Statement Proportional Analysis

Financial Statement Ratio Analysis

Automated Ratio Result Analysis

Leverage Analysis

Trend Analysis

Forecasting

Cash Flow Analysis

Capital Asset Analysis

Compounding Analysis

Investment Analysis

Risk Analysis

Summary

Chapter 17: “What If” Analysis with an Electronic Spreadsheet

“What If” Analysis with Single Variables

“What If” Analysis with Double Variables

“What If” Analysis with Goal Seek

Summary

Chapter 18: Financial Analysis Reports

Types of Financial Analysis Reports

General Management Reports

Revenue Reports

Material Cost Reports

Labor Reports

Standard Margin Reports

Budget Reports

Investment Reports

Cash Flow Reports

Breakeven Reports

Capacity Reports

Summary

Chapter 19: Determining the Cost of Capital

Components of the Cost of Capital

Calculating the Cost of Debt

Calculating the Cost of Equity

Calculating the Weighted Cost of Capital

Incremental Cost of Capital

Using the Cost of Capital in Special Situations

Modifying the Cost of Capital to Enhance Shareholder Value

Summary

Chapter 20: Analyzing Risk

Incorporating Risk into Financial Analysis

Data Collection

Measures of Data Dispersion

Graphical Representations of Data Dispersion

Regression Analysis

Reporting on Risk

Summary

Appendices

Appendix A: Symptoms and Solutions

Appendix B: Commonly Used Ratios

Index

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Bragg, Steven M.

Financial analysis: a controller’s guide / Steven M. Bragg—2nd ed.

p. cm.

Includes index.

ISBN-13: 978-0-470-05518-2 (alk. paper)

ISBN-10: 0-470-05518-9

1 Controllership. 2. Corporation—Finance. 3. Financial statements. I. Title.

HG4026.B663 2006

658.15—dc22

2006046753

To my fabulous wife, Melissa

About the Author

Steven Bragg, CPA, CMA, CIA, CPIM, has been the chief financial officer or controller of four companies, as well as a consulting manager at Ernst & Young and auditor at Deloitte & Touche. He received a master’s degree in finance from Bentley College, an MBA from Babson College, and a Bachelor’s degree in Economics from the University of Maine. He has been the two-time president of the Colorado Mountain Club, is an avid alpine skier and mountain biker, and is a certified master diver. Mr. Bragg resides in Centennial, Colorado, with his wife and two daughters. He has published the following books through John Wiley & Sons:

Accounting and Finance for Your Small Business

Accounting Best Practices

Accounting Control Best Practices

Billing and Collections Best Practices

Business Ratios and Formulas

Controller’s Guide to Costing

Controller’s Guide to Planning and Controlling Operations

Controller’s Guide: Roles and Responsibilities for the New Controller

Controllership

Cost Accounting

Design and Maintenance of Accounting Manuals

Essentials of Payroll

Fast Close

Financial Analysis

GAAP Guide

GAAP Implementation Guide

Inventory Accounting

Inventory Best Practices

Just-in-Time Accounting

Managing Explosive Corporate Growth

Outsourcing

Payroll Accounting

Payroll Best Practices

Sales and Operations for Your Small Business

The Controller’s Function

The New CFO Financial Leadership Manual

The Ultimate Accountants’ Reference

Throughput Accounting

Also:

Advanced Accounting Systems (Institute of Internal Auditors)

Run the Rockies (CMC Press)

Subscribe to Steve’s FREE accounting best practices newsletter and podcast/blog at www.stevebragg.com. His podcast is also available through iTunes.

Preface

This book is designed to assist a company controller, or any other member of the accounting and finance staffs, in the analysis of all corporate activities. These activities include the ones covered by most traditional financial analysis books—the evaluation of capital investments, financing options, cash flows, and the cost of capital. However, these topics are not nearly sufficient for an active controller who is concerned with not only the performance of every department, but also potential acquisition candidates, the capacity levels of company equipment and facilities, and the relative levels of risk associated with new or existing investments. This book covers all of these additional topics and more. Within these pages, the reader will find a thorough analysis of the following topics:

Evaluating capital investments, financing options, and cash flows

. The first portion of the book attends to these traditional financial analysis topics.

Evaluating acquisition targets

. The analysis of acquisition candidates is a major activity for those organizations that grow by this means. The book itemizes the specific analysis activities to complete.

Increasing shareholder value

. The book describes a number of areas in which shareholder value can be improved.

Improving intangible asset measurement and performance

. The book covers a variety of measurement techniques for such areas as research and development and processes, as well as performance enhancement for research and development.

Determining the breakeven point

. The book covers the mechanics of the breakeven calculation, as well as how to use it to recommend changes to operations.

Forecasting future business conditions

. The book notes a number of factors useful for predicting business cycles.

Evaluating operations, processes, and managers

. The book discusses the specific measurements and corrective actions that can be used for all major company departments, process cycles, and manager performance evaluations.

Eliminating products and services

. The book describes the proper calculation methods to determine which products and services should be eliminated.

Evaluating capacity utilization

. The book describes how to measure capacity utilization and what corrective action to recommend in cases in which there are bottlenecks or excess available capacity.

Using Microsoft Excel to conduct financial analysis

. The book describes the specific Excel formulas that can be used to conduct reviews of the financial statements, as well as capital expenditures, investments, and project risk analyses. A separate chapter addresses the calculation of both single- and multivariable equations using Excel.

Using sample analysis reports

. The book presents a wide array of standard financial analysis reports that can be adapted for use by the reader, such as weekly management reports, payroll reports, and utilization reports.

Determining the cost of capital

. The book describes the reasons for using the cost of capital, how to calculate it, and under what conditions to modify or use it.

Analyzing risk

. The book discusses the concept of risk, how it should be integrated into a financial analysis, various tools for calculating risk, and how to integrate it into an analytic report for use by management.

With the particular attention given to operational analysis in this book, as well as the wide-ranging coverage of all other financial analysis topics, the corporate controller will find that this is a handy reference that can be used time and again for a variety of analytic purposes.

A special note of thanks to my editor, Sheck Cho, who has assisted in the completion of so many manuscripts.

Steven M. Bragg

Centennial, Colorado

November 2006

PART ONE

OVERVIEW

Chapter 1

Introduction

A controller is responsible for a wide array of functions, such as processing accounts payable and receivable transactions, properly noting the transfer of assets, and closing the books in a timely manner. Properly completing these functions is critical to a corporation, which relies on the accurate handling of transactions and accurate financial statements. These activities clearly form the basis for anyone’s successful career as a controller. However, the outstanding controller must acquire skills in the area of financial analysis in order to be truly successful.

By obtaining a broad knowledge of financial analysis skills and applying them to a multitude of situations, a controller can acquire deep insights into why a company is performing as it does, and can transmit this information to other members of the management team, along with recommendations for improvements that will enhance the corporation’s overall financial performance. By knowing how to use financial analysis tools, a controller can rise above the admittedly mundane chores of processing accounting transactions and make a significant contribution to the management team. By doing so, the controller’s understanding of the inner workings of the entire corporation improves and raises his or her visibility within the organization, which can eventually lead to a promotion or additional chances to gain experience in dealing with other departments. Thus, the benefits of using financial analysis are considerable, not only for the company as a whole, but for the controller in particular.

This book is designed to assist the controller in obtaining a wide and in-depth view of the most important financial analysis topics. Toward this end, the book is divided into four parts.

Part One covers the overall layout and content of the book, as well as the role of financial analysis and making management and investment decisions. This includes notations regarding the several types of financial analysis, as well as the various kinds of questions that one can answer through its use. Part One concludes with a discussion of the need for judgment by a controller in interpreting analysis results.

Part Two covers the primary financial analysis topics. Chapter 3 discusses the evaluation of capital investments, which involves assembling cash flow information into a standard cash flow format for which a net present value calculation can be used to determine the discounted cash flow that is likely to be obtained. Chapter 4 describes the various financing options that a controller may be called on to review. For example, is it better to lease an item, and if so, should it be an operating or capital lease? Alternatively, should it be rented or purchased? What are the risks of using each financing option, and can the current mix of company financial instruments already in use have an impact on which option to take? All of these questions are answered in Chapter 4. Chapter 5 covers the essentials of why cash inflows and outflows are the key forces driving financial analysis and notes the wide variety of situations in which cash flow analysis can be used, as well as how to construct and interpret cash flow analysis models.

Chapter 6 is full of checklists and advice regarding how to conduct an analysis of any prospective merger or acquisition candidates, with an emphasis on making a thorough review of all key areas so that there is minimal risk of bypassing the review of a key problem area that could lead to poor combined financial results. Chapter 7 notes several ways to increase shareholder value and discusses the reasons why enhanced cash flow is the predominant method for doing so, as well as how to use leverage to increase shareholder value, while being knowledgeable of the dangers of pursuing this strategy too far.

Chapter 8 describes how to calculate the value of several types of intangible assets, and also provides numerous suggestions for enhancing the results of research and development activities.

Chapter 9 covers the deceptively simple topic of breakeven analysis, which is the determination of the sales level at which a company makes no money. The discussion covers how to calculate the breakeven point, why it is important, the kinds of analysis for which it should be used, and how to use subsets of the breakeven analysis to determine breakeven levels of specific divisions or product lines.

Finally, Chapter 10 covers the forecasting of business cycles. Although this is an issue normally left to bank economists or chief financial officers (CFOs), the controller is sometimes called on to forecast expectations for the industry in which a company operates. This chapter gives practical pointers on where to obtain relevant information, how to analyze it, and how to make projections based on the underlying data. These chapters comprise the purely financial analysis part of the book. Though Part Two alone is adequate for the bulk of all analysis work that a controller is likely to handle, there are still many operational analysis issues that a controller should be able to review and render an opinion about. That is the focus of Part Three.

Part Three covers operational analysis, which is the detailed review of information about company operations, department by department. Chapter 11 covers the methods for choosing an appropriate set of performance review measures for each member of the management team, how to measure and report this information, and the types of behavioral changes that can result when these measures are used. Though the specific performance measures used are typically made by the CFO or the human resources director, these people may (and should) ask the controller’s opinion regarding the best measures. If so, this chapter gives the controller a good basis on which to make recommendations.

Chapter 12 reviews how to analyze process cycles. These are the clusters of transactions about which a company’s operations are grouped, such as the purchasing cycle and the revenue cycle. If there are problems with the process cycles, then there will be an unending round of investigations and procedural repairs needed to fix them; because the controller is usually called on to conduct the repair work, it makes a great deal of sense to analyze them in advance to spot problems before they fester.

Chapter 13 addresses a topic that many companies ignore—the evaluation of products and services with the goal of eliminating those that are unprofitable or which do not contribute to company goals.

Chapter 14 covers a major topic—the analysis of all primary departments, such as sales, production, engineering, and (yes) accounting. Specific measurements are noted for determining the efficiency and effectiveness with which each department is managed, alongside suggestions regarding why measurement results are poor and what recommendations to make for improving the situation.

Chapter 15 concludes the operational analysis section with a review of capacity utilization, how to measure it, why it is important, sample report formats to use, and recommendations to make based on the measured results. All of these chapters are designed to give a controller an excellent knowledge of how all company operations are performing, and what to recommend to the management team if problems arise.

Part Four covers a number of other analysis topics. Chapter 16 covers the primary formulas that a controller can use in the Microsoft Excel program to analyze financial statements, projected cash flows, investments, and risk. Chapter 17 expands on the use of Excel spreadsheets by detailing how they can be used to solve single- and multivariable problems. Chapter 18 includes many report formats that the reader can use for the reporting of such varied analyses as employee overtime, capacity utilization, and key weekly measures for the management team.

Chapter 19 discusses how to meld the cost of debt and equity to arrive at the cost of capital, and also notes how it should be used and where to use it. Finally, in Chapter 20, there is a discussion of risk—what it is, how it can impact a financial or operational analysis, what kinds of measurement tools are available for calculating its extent, and how to report a risk analysis to management in an understandable fashion.

There are also two appendices in the book. In Appendix A, there is a list of the most common symptoms of financial problems that a controller will encounter, alongside a list of recommended analyses and solutions for each symptom that will point one in the direction of how to obtain a fix to the problem. Appendix B contains a list of the most commonly used ratios, which are useful for analyzing both overall financial results and the specific operational results of individual departments.

This book is designed to give a controller, or anyone in the accounting and finance fields, a thorough knowledge of how to analyze an organization, from individual projects upward to complete departments, and on to entire divisions and companies. For those who are searching for specific analysis tools, it is best read piecemeal, through a search of either the table of contents or the index. However, for those who wish to gain a full understanding of all possible forms of analysis, a complete review of the book is highly recommended.

Chapter 2

The Role of Financial Analysis

Historically, the primary purpose of the accounting department has been to process transactions: billings to customers, payments to suppliers, and the like. These are mundane but crucial activities that are unseen by the majority of company employees, but still necessary to an organization’s smooth operations. However, the role of the accounting staff has gradually changed as companies encounter greater competition from organizations throughout the world. Now, a company’s management needs advice as well as a smooth transaction flow. Accordingly, the controller is being called on not only to fulfill the traditional transaction processing role, but also to continually review company operations, evaluate investments, report problems and related recommendations to management, and fulfill requests by the management team for special investigations. All of these new tasks can be considered financial analysis, for they require the application of financial review methods to a company’s operational and investment activities.

There are several types of financial analysis. One is the continuing review and reporting of a standard set of measures that give management a good view of the state of company operations. To conduct this type of analysis, a controller should review all key company operations, consult the literature for examples of adequate measures that will become telltale indicators of operational problems, develop a timetable and procedure for generating these measurements on a regular basis, and then devise a suitable format for issuing the results to management. For these operational reviews, there are several points to consider:

Target measurements

. There is no need to create and continually recalculate a vast array of measures that will track every conceivable corporate activity. Instead, it is best to carefully review operations, with a particular view of where problems are most likely to arise, and create a set of measurements that will track those specific problems.

Revise measurements

. No measurement will be applicable forever. This is because a company’s operations will change over time, which calls for the occasional review of the current set of measurements, with an inclination to replace those that no longer yield valuable information with new ones that focus on new problems that are of more importance in the current operating environment.

Educate management about the measures used

. Though most financial analysis measurements appear to be very straightforward and easily understood, this is from the perspective of the accounting staff, which has been trained in the use of financial measurements. The members of the management group to whom these measurements are sent may have no idea of the significance of the information presented. Accordingly, the controller should work hard not only to educate managers about the contents of financial analysis formulas, but also to keep reeducating them to ensure that explanations do not fade in their memories.

Add commentary to measurements

. Even a well-trained management team may not intuitively understand the underlying problems that cause certain measurement results to arise. To forcibly bring their attention to the key measurements, a controller should add a short commentary to any published set of measurements. This is an excellent way to convert a numerical report into a written one, which many people find much easier to understand.

In short, the financial analysis that relates to the continuing evaluation of current operations involves a great deal of judgment regarding the applicability of certain measures, as well as a great deal of work in communicating the results to management for further action.

A second type of financial analysis that a controller will sometimes be called on to perform is the analysis of investments. Though this work should fall within the range of responsibility of the treasurer’s staff in the finance department, many smaller organizations have no finance staff at all, which means that the work falls on the accounting staff instead. Three subcategories of analysis fall under the review of investments:

1. The analysis of securities. When a company either has or is contemplating investing its excess funds in various investment vehicles, such as bonds or stocks, the controller can evaluate the rate of return on each one and render an opinion regarding it. The tools for making this analysis were developed long ago and are simple to calculate. However, the controller may also be called on to evaluate the relative risk of each investment, which is not so subject to quantitative analysis. Instead, the controller must have an excellent knowledge of the liquidity of an investment, as well as its risk of default. This requires additional security analysis skills, heavily seasoned with judgment.

2. The analysis of financing options. The controller is frequently called on to review the cost of various financing options when a company is considering acquiring assets. To do so, the controller must not only be able to provide an accurate and well-documented answer that clearly reveals the least expensive alternative, but also have a sufficient knowledge of available options to suggest other financing variations that have not yet been tried.

3. The analysis of capital expenditures. When a company wishes to make a capital expenditure, the ultimate test of whether the right decision was made is if the acquisition eventually creates a cash flow that exceeds the cost of financing it. The controller is called on to analyze predicted cash flows in advance, determine the cost of capital, calculate the net present value of cash flows, and pass judgment on the reasonableness of the acquisition, while factoring in the risk of cash flows being inaccurate. These tasks require not just a knowledge of cash flow analysis and discounting methods, but also how to rationally judge the accuracy of predicted cash flows and estimate the risk associated with them.

In the final type of financial analysis, the controller receives a special request from management to perform a financial analysis. Such a request can cover any topic at all. Some examples of one-time management requests that require financial analysis are:

What would happen to sales if credit levels were tightened?

What would happen to the accounts receivable balance if credit levels were loosened?

What would happen to the raw material turnover rate if purchases were made in weekly increments instead of monthly?

What will be the inventory investment if the company adds one distribution warehouse?

What will be the savings if the company passes through freight costs to customers?

What will happen to the total gross margin if the price of one product is cut by 10 percent?

What will happen to the corporate medical expense if the company requires employees to pay an extra $10 per month on their medical insurance?

These questions represent a wide range of queries, all of them valid, and all of them likely to be encountered on a regular basis. A controller’s reputation within a company will be partially based on his or her ability to quickly and accurately respond to these requests. Alternatively, late or inaccurate responses can create a great deal of damage, not only for the controller, but for the reputation of the entire accounting department. To enhance the controller’s credibility and give management accurate responses to their questions, a controller should follow these steps:

Clarify the question

. There is nothing worse than trying to remember the question asked by a requestor; making an assumption about what is being asked, rather than confirming with the requestor; and then finding later on that the resulting financial analysis answered the wrong question. To save a great deal of wasted effort, one must always write down the request at once, read it back, and clarify any points before beginning the analysis.

Verify assumptions

. There are some assumptions built into any financial analysis. For example, what is the cost of capital to be used for a discounted cash flow analysis? What is the assumed rate of customer retention if prices are dropped by 10 percent? Rather than guess at an assumption that will be an integral part of a financial analysis, it is much better to confirm the information before proceeding. Otherwise, the person who requested the information may receive an incorrect answer.

Determine what answer the requestor is looking for

. This does not mean that the controller is angling for the correct answer for which to provide a backup set of financial analysis. However, it is important to reduce the investigation to as small an area as possible in order to save analysis time. For example, if a manager asks for a complete printout of all unpaid accounts payable, further questioning may reveal that the person wants to see only what is unpaid for one specific supplier, which reduces the accounting staff’s work in compiling the requested information.

Investigate from the top down

. A common error for many people involved in financial analysis is to conduct a top-to-bottom analysis in great detail. Instead, it is best to start at the most summary level and proceed downward through successive layers of detail until sufficient information has been accumulated to provide an answer. Do not ever proceed further, because the question has already been answered, and lower levels of detail usually require the largest amounts of research work. For one exception to this rule, see the following item.

Answer follow-up questions in advance

. Once the results have been compiled, it is worthwhile for the controller to inspect it from the perspective of the recipient and anticipate any additional questions that may be raised. Obtain the answers to the additional questions and include them in the analysis. Not only does this approach keep the recipient from having to return to the controller for more follow-up questions, but it also shortens the time that management must take to arrive at a decision based on the analysis. Also, the controller will quickly earn a reputation for being a discerning analyst who reads deeply into the results of his or her work. This situation occurs, for example, when an accounts receivable turnover calculation results in a significantly worsened turnover ratio over the previous month. The obvious follow-up question is to find out which customers are not paying as quickly, and why. The controller can determine the answers to these questions before being asked, and add them to the turnover analysis prior to presenting it to management.

Confirm all data

. Before conducting the actual analysis, confirm that the sources of data are for the correct time period, cover the correct entity, and contain all needed information. If not, dig further to obtain the correct data. By not taking this step, one can conduct a comprehensive set of analyses with the wrong information, and then have to go back and start over again.

Verify all formulas

. Even with the correct underlying data, one can still issue the wrong results if the formulas used are the wrong ones. This is a particular problem when the analysis is an addition to work done in previous periods, when a slightly different formula may have been used. Consequently, when adding to a trend line of analysis results, be sure to re-create the results from the last period to verify that the formula currently in use resulted in the previously calculated amount. This method ensures calculation consistency from period to period.

Suspect unusual results

. If the end result of a financial analysis is a highly unusual result that does not intuitively make sense, then it probably doesn’t. The controller should assume that either a data gathering or computational error has been made and review the work papers. It may be useful to have someone else review the work, because they can review the information from a fresh point of view and are more likely to spot mistakes. Only after an intensive internal review should one assume that the results are correct and present the results to management. The reason for this lengthy review process is that management will react to an unusual result with a full-blown investigation of its own, so the accounting staff should review its documentation before management does so, too.

Add supporting commentary

. If the financial analysis is full of ratios, percentages, and statistical measures, it is a good bet that the recipient will have no idea regarding the conclusion that is buried somewhere among all the numbers. To be more clear, add supporting commentary that translates the math into an easily readable conclusion.

Find the appropriate form of presentation

. Even with the analysis and commentary in hand, it is important to consider how this information should be passed along to the requestor. Is a brief voice mail or e-mail sufficient to relay the results, or is a formal presentation or written report necessary? This is where a good knowledge of the requestor’s preferred form of communication comes in handy. This is not a trivial step, since preparing a full presentation instead of an e-mail can consume a large part of the accounting staff’s time, whereas being too informal can injure the reputation of the department.

Determine if a calculation system is needed

. Once the requested information has been provided, ask the recipient if the information should be recalculated and presented on a regular basis. In most cases it will not, because the bulk of requests are to answer situational questions that do not require continuing analysis. It is important to ask this question, because some controllers will mistakenly assume that the same information will be requested in the future and will then consume an inordinate amount of the accounting staff’s time in regenerating information that no one needs.

Throughout this overview of the role of financial analysis, the focus has been on three main points. The first is that proper financial analysis requires a solid grounding in financial analysis tools. This book is designed to provide the backbone of that knowledge. However, two more tools are needed. One is the ability to convert the results of a financial analysis into a format that can be easily communicated to and understood by the targeted recipient. For this, a controller must have a fine-tuned ability to convert accounting and financial terminology into everyday terms. Finally, and of greatest importance, is the use of judgment in several areas. A controller must be able to correctly discern what question is being asked by management so that the resulting financial analysis work is focused on the collection of the correct data and its interpretation with the correct formulas. Further, a controller must exercise judgment in interpreting the results and deciding if additional work is needed to ensure that the root causes of any problems have been found. Judgment is needed to ensure that the most critical results are quickly and forcefully communicated to management. Only by showing a mastery of all three items will a controller become an expert in the use of financial analysis. The knowledge for the first item is contained in this book. The other two must be learned through diligence, repetitive analysis, and by watching how analysis is conducted by others who have mastered the trade. In short, knowledge must be supplemented by experience.

PART TWO

FINANCIAL ANALYSIS

Chapter 3

Evaluating Capital Investments

One of the most common financial analysis tasks with which a controller is confronted is evaluating capital investments. In some industries, the amount of money poured into capital improvements is a very substantial proportion of sales, and so is worthy of a great deal of analysis to ensure that a company is investing its cash wisely in internal improvements. This section reviews the concept of the hurdle rate, as well as the three most common approaches for evaluating capital investments. It concludes with reviews of the capital investment proposal form and the postcompletion project analysis, which brings to a close the complete cycle of evaluating a capital project over the entire course of its acquisition, installation, and operation.

HURDLE RATE

When controllers are given capital investment proposal forms to review, they need some basis on which to conduct the evaluation. What makes a good capital investment? Is it the project with the largest net cash flow, the one that uses the least capital, or some other standard of measure?