Read the textbook according to the questions. After understanding the questions, answer the questions in your own language. Don’t copy the sentences in the book.
2. The answer can only come from the textbook, there is no need to find additional information.
3. Do not change the format of the test paper without authorization, and write the answers in the designated places
4. Copying answers and information from the Internet is not allowed
Student Name: _____________________
Please read the following requirements carefully before start your assignment:
1. Each question is worth 10 points.
2. The purpose of the assignment is to help you get familiar with key concepts of finance and to
guide you to read the textbook before coming to class.
• You do not need to read all content of the textbook: you are only required to read enough
to answer questions of this assignment.
• The assignment asks you to “use your own words”—you need to read the textbook,
UNDERSTAND the concepts, and use your own words to answer questions.
• Your answers should be only based on the textbook, DO NOT use any other sources.
3. Please write all your answers after Type your answers below, Please do not change the
format of this assignment.
4. TWU considers it a serious offense when an individual attempts to gain unearned academic
credit. Please make sure you read and understand the TWU Academic Integrity discussed on
the course syllabus and course Moodle page.
– Your submission will be checked using TurnItIn where originality will be checked against
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– It is possible you receive a high similarity number: I will ignore the similarity in the
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– Any submission that is deemed to contain plagiarized material will receive an “F” mark.
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6. Submit on Moodle “Pre-class Assignment”.
– Name your submission as A1_LastName_FirstName (e.g. A1_Liu_Chen)
– Your assignment grade will be deducted by 10% with a wrong file name.
-1-
Read Chapter 1 of the textbook and use your own words to answer the following questions.
When you read Chapter 1: please focus only on the definition of the financial statement
terms and the ratios. You do not need to worry about “The Unidentified Industries Game”.
1. Based on Chapter 1: Use your own words to explain the following items on the assets side of a
company’s balance sheet:
1) Marketable Securities (also called “short-term investment”)
2) Account receivables
3) Current assets
4) Property, plant, and equipment (PP&E)
Type your answers below:
2. Based on Chapter 1: Use your own words to explain the following items on the liabilities side
of a company’s balance sheet:
1) Account payables
2) Accrued items
3) Current liabilities
Type your answers below:
3. Based on Chapter 1: Use your own words to explain the differences of equity, debt, and total
assets
Type your answers below:
4. Based on Chapter 1: Use your own words to explain the following items on a company’s
income statement:
1) Cost of goods sold (also called “COGS”)
2) Selling, general, and administrative expenses (also called “SG&A”)
3) EBIT
Type your answers below:
5. A company has the following items for the fiscal year 2023:
– Cash = 2 million
– Marketable securities = 6 million
– Account receivables (A/R) = 1 million
– Inventories = 6 million
– Total current liabilities = 8 million
Calculate the company’s Current Ratio and Quick Ratio
Type your answers below – please show your calculation process:
-2-
6. A company has the following items for the fiscal year 2023:
– Revenue =10 million
– Cost of goods sold = 3 million
– EBIT = 4.5 million
– Net income = 3 million (also called net profit)
Calculate the company’s Net Profit Margin
Type your answers below – please show your calculation process:
7. A company has the following items for the fiscal year 2023:
– Revenue =10 million
– EBIT = 4.5 million
– Net income = 3 million
– Total Equity = 30 million
– Total Assets = 40 million
Calculate the company’s ROA and ROE
Type your answers below – please show your calculation process:
8. A company has the following items for the fiscal year 2023:
– Total Equity = 20 million
– Total Debt = 5 million
– Total Assets = 30 million
– EBIT = 4 million
– Interest expense = 1 million
Calculate the company’s ratios of Debt to Assets, Assets to Shareholders’ Equity and Interest
Coverage Ratio
Type your answers below – please show your calculation process:
9. Write the formula for the following ratios and what each ratio measures:
1) Inventory Turnover and Days Inventory
2) Receivable Collection Period
Type your answers below:
10. A company has the following items for the fiscal year 2023:
– Sales = 10 million
– Cost of goods sold = 6 million
– Inventory = 2 million
– Account Receivables = 1 million
– Account Payable = 2.5 million
Calculate the company’s ratios of Inventory Turnover, Days Inventory and Receivable
Collection Period
Type your answers below – please show your calculation process:
-3-
11. Write down the DuPont framework. How would you explain to your non-MBA non-Finance
friends about the DuPont framework and why it is important?
Type your answers below:
12. A company has the following items for the fiscal year 2023:
– Revenue = 10 million
– EBIT = 4 million
– Net income = 2 million
– Total Equity = 15 million
– Total Assets = 30 million
Calculate the company’s Net Profit Margin, Asset Turnover and ROE
Type your answers below – please show your calculation process:
Read Chapter 2 of the textbook and use your own words to answer the following questions.
When you read Chapter 2: You only need to read enough on pages 53-69 to finish my
questions below. I will spend a lot of class time talking about cash!
13. Based on Chapter 2:
1) Use your own words to explain Operating Cash Flows (OCF)
2) Use your own words to explain Free Cash Flows (FCF)
Type your answers below:
14. Read the section on the Cash Conversion Cycle (or “Cash Cycle”) and use your own words to
answer the questions:
1) Explain cash conversion cycle and why it is important to companies?
2) Is it possible that a company has a negative cash cycle? Is it a good thing or a bad thing?
Type your answers below:
15. A company has days of inventory 80 days, days receivable of 30 days, and days payable of 60
days. Calculate the company’s funding gap and interpret the number.
Type your answers below – please show your calculation process:
16. A company has days of inventory 30 days, days receivable of 30 days, and days payable of 90
days. Calculate the company’s cash cycle and interpret the number.
Type your answers below – please show your calculation process:
-4-
Read Chapter 4 of the textbook and use your own words to answer the following questions.
When you read Chapter 4: You only need to read enough to finish my questions below.
17. If the risk-free rate is 2%, the market risk premium (also called the equity risk premium) is 5%,
and a company has a beta of 1.5. What is the company’s cost of equity?
Type your answers below – Please first show the formula for CAPM and show your calculation
process:
18. Assume a company has 10 million of total assets: 60% of the total asset is from debt and 40%
is from equity. The company has a 12% cost of equity and a 7% cost of debt. The company has
a tax rate of 30%. What is the company’s weighted average cost of capital (WACC)?
Type your answers below – Please first show the formula for WACC and show your calculation
process:
Read Chapter 5 of the textbook and use your own words to answer the following questions.
When you read Chapter 5: You only need to read enough to finish my questions below.
19. Use your own words to answer the following questions:
1) Write the formula for the P/E ratio and what it measures?
2) Should you invest in a company with high P/E or low P/E? Why?
Type your answers below:
20. A company has the following items for the fiscal year 2023:
– Revenue = 20 million
– Net income = 5 million
– The company has 2 million shares of stock
– Stock price per share = $50
Calculate the company’s Earnings Per Share and P/E ratio
Type your answers below – please show your calculation process:
-5-
How Finance Works
THE HBR GUIDE TO THINKING SMART ABOUT THE NUMBERS
MIHIR A. DESAI
H A R VA R D B U S I N E S S R E V I E W P R E S S
“As a chief financial officer, I recognize how critical it is to
communicate financial intuitions clearly, early, and often
within an organization. Within technology companies, financial fluency is an essential component of evaluating new
and disruptive innovations, and the ability to bridge technology and finance is not widespread. For finance practitioners and general managers, Mihir’s book provides the
perfect combination of intuitive explanations, contemporary
examples, and rigor so that both finance pros and novices
can truly enhance their capabilities.”
— HELEN RILEY, Chief Financial Officer, X
“Professor Desai’s class at Harvard Business School was one
of my favorites because it helped me understand critical financial questions that underpin every industry, including
technology. This book re-creates that experience by combining Desai’s methods of teaching the fundamentals, giving
students the tools to build intuition, and testing those skills
through a variety of real-life cases. Informative and engaging,
this book will arm you with knowledge and, more important,
help build your intuition around a variety of financial and
business-related situations. This is a must-read for business
students and aspiring business leaders—or anyone looking
to deepen their understanding of finance.”
— MARNE LEVINE, Chief Operating Officer, Instagram
“Professor Desai has accomplished a rare feat: transforming
the typically complex and often dry subject of finance into
a lively and accessible tour de force, without trivializing its
importance. On the contrary, he persuasively argues that finance is the lifeblood of the economy and therefore a construct
everyone should understand. But it’s not just about crunching
numbers and knowing how to read a balance sheet, both of
which are lucidly explained here. As in his previous work,
Professor Desai takes pains to remind us of the larger issues
at stake: the true essence of finance is about information and
incentives and trying to solve capitalism’s fundamental problem of allocating capital to generate value. As the CEO of
a firm dedicated to long-term investing, I wholeheartedly
welcome the light he casts on creating and measuring that
value.”
— CYRUS TAR APOREVAL A, President and CEO,
State Street Global Advisors
“Professor Mihir Desai’s advice—both practical and witty—
was an inspiration when I was a student at Harvard Business School and a guiding light for me as an entrepreneur
just starting out on my S’well journey. I’m thrilled that he’s
written this book so that even more people can benefit from
his wisdom!”
—SAR AH K AUSS, founder and CEO, S’well
“To those who are not in the discipline, finance is like a riddle
wrapped in a mystery inside an enigma, filled with buzzwords,
accounting ratios, and complex institutional details. While this
plays into the hands of financial consultants and bankers who
charge hefty prices for unraveling these unknowns, Mihir
Desai’s book on how finance works is masterful at laying bare
the simple truths and the commonsense principles that underlie much of finance. It leads readers on a tour of the key concepts, institutions, and tools in finance with humor and grace,
and readers, no matter what their background or interests, will
come out more informed and enlightened by the journey.”
— ASWATH DAMODAR AN, Professor of Finance, NYU Stern
School of Business; author, The Little Book of Valuation
“For anyone who wants to be able to utilize financial information, whether as a firm lawyer, a general counsel, or in
business generally, How Finance Works provides clarity and
guidance to what can be, for many, an intimidating arena.
Mihir Desai is an outstanding professor, and the strengths
that make him such an outstanding professor—humor; explaining complexity with ease; ensuring that his students
learn how to access financial information themselves rather
than deferring to others, through the use of games and problem solving; and his encouragement to simply look for interesting things rather than pretending to be a financial
analyst—are all present in this book. How Finance Works is
a pleasure to read and invaluable in daily use.”
— DAVID WOLFSON, Executive Director,
Milbank, Tweed, Hadley & McCloy
“Finally, someone has provided a mechanism for gaining intuition about finance for those of us who deliberately avoided
any financial studies in school—physicians! Recognizing
that the only way health care can evolve is by accepting that
it is, in fact, a business, How Finance Works gives those of
us engaged in health care leadership the opportunity to sit
with ‘the big folks’ without defaulting to the chief financial officers at the table. Most physicians have absolutely no
concept of finance and are intimidated by spreadsheets and
CFOs. Desai provides a welcome rescue!”
— MICHAEL JAFF, MD, President, Newton-Wellesley Hospital
“Leading a global technology company in a world awash in
change requires a lot of things, one of which is being comfortable in the realm of finance, even if you came up through
the leadership ranks by other means. Mihir manages to make
finance fun and accessible—and, by the end of it, you’ll have
the confidence, intuition, and understanding you need to
succeed as a leader or executive in any organization.
— JENNIFER MORGAN, President, Americas and
Asia Pacific Japan, SAP
How Finance Works
How Finance Works
THE HBR GUIDE TO THINKING SMART ABOUT THE NUMBERS
MIHIR A. DESAI
HARVARD BUSINESS REVIEW PRESS • BOSTON, MAS SACHU SETTS
Harvard Business Review Press titles are available at significant quantity
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tel. 800-988-0886, or www.hbr.org/ bulksales.
The web addresses referenced in this book were live and correct at the time
of the book’s publication but may be subject to change.
Copyright 2019 Harvard Business School Publishing Corporation
All rights reserved
Printed in the United States of America
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eISBN: 978-1-63369-671-6
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and Documents in Libraries and Archives Z39.48-1992.
To Parvati, Ila, Mia, and Teena
Contents
Introduction . . . 1
CHAPTER 5
The Art and Science of Valuation . . . 149
Financial Analysis . . . 9
How to value a home, an education, a project,
or a company
Using ratios to analyze performance—
all while playing a game
CHAPTER 6
CHAPTER 1
Capital Allocation . . . 187
CHAPTER 2
The Finance Perspective . . . 51
Why finance is obsessed with cash and the future
How to make the most impor tant decisions facing
CEOs and CFOs
Conclusion . . . 223
CHAPTER 3
The Financial Ecosystem . . . 85
Understanding the who, why, and
how of capital markets
CHAPTER 4
Sources of Value Creation . . . 113
Risk, costly capital, and the origins of value
Answers . . . 229
Glossary . . . 243
Notes . . . 257
Index . . . 259
Acknowledgments . . . 267
About the Author . . . 269
How Finance Works
Introduction
Introduction 3
F
or many, finance is cloaked in mystery and quite intimidating. This unfortunate outcome is no coincidence. Many in finance like to shroud what they do
in order to intimidate outsiders. But if you want to progress
in your career, you’ll need to engage deeply in finance—it is
the language of business, the lifeblood of the economy, and
increasingly a dominant force in capitalism. So neglecting
finance and hoping to survive meetings by thoughtfully nodding your head is an increasingly untenable choice.
Fortunately, you can learn the central intuitions of finance
without mastering the intricacies of spreadsheet modeling
or the pricing of derivatives. This book aims to provide you
with the most central intuitions of finance so that you will
never find finance intimidating again. Mastering the intuitions won’t make you a financial engineer—there are likely
more than enough of those. Instead, internalizing these intuitions will provide the foundation for addressing financial
issues with confidence and curiosity for the rest of your life.
The book emerged from my efforts to teach finance to
MBA students, law students, executives, and undergraduates
with a wide variety of backgrounds. During the last two decades of teaching, I’ve emphasized diagrams, graphs, and
real-world examples over equations and Mickey Mouse numerical examples in an effort to preserve relevance while also
4 How Finance Works
shearing off unneeded complexity. In the process, I’ve found
that it’s possible to maintain rigor without being overly precise. I’ll try to do the same in the pages that follow.
Prerequisites
My father spent his career in marketing for pharmaceutical
companies in Asia and the United States. At age fifty-eight,
he turned to finance for a rewarding second career that lasted
more than a decade. He combined a deep understanding of
the industry with newfound financial expertise to become an
equity research analyst. But it was a difficult journey.
During that decade, I was learning finance as an analyst
on Wall Street, as a graduate student, and as a young professor. We had long conversations in which he would ask me
about the many things that he would encounter in this foreign world of finance that he didn’t understand. As I tried to
communicate the intuitions for price-earnings multiples and
discounted cash flows, he showed me the power of curiosity
and perseverance as he made that difficult transition.
The only prerequisites for this book are those same two
qualities: curiosity and perseverance. With sufficient curiosity about finance, you’ll have the questions that will guide
your learning through these chapters. And with sufficient
perseverance, you can work your way through the harder
material and know that you will arrive at the other side
with a deeper appreciation for finance and a toolkit for your
professional life. I hope you’ll find it both demanding and
worthwhile.
Intended Audience
This book is for everyone who wants to deepen their understanding of finance. Those new to finance will find material
that is accessible and provides core intuitive building blocks
and the foundations to start speaking about finance. Those
immersed in finance know that it is easier to “talk the talk”
of finance than it is to “walk the walk.” The central intuitions
of finance are slippery, and the book will provide an opportunity for them to deepen their understanding beyond
the rote application of ideas or terms. Ambitious executives will be able to reflect on their many interactions with
financial experts and investors and engage with them more
meaningfully.
A Road Map
You can dip in and out of this book as you desire or as questions in your workplace arise, almost like a reference book.
But the book has been architected consciously and is meant
Introduction 5
to be read through from front to back. The chapters build on
each other.
Chapter 1: Financial Analysis
We will begin by creating a foundation in financial analysis that provides much of the language of finance. How do
you interpret economic performance using historical financial accounts? What do all those ratios and numbers mean?
A challenging but fun game will allow you to see the realworld relevance of the many ratios that finance focuses on.
By design, this chapter stands apart from the rest of the book.
Hands-on and interactive, it’s an expansive introduction and
warm-up before moving into other parts of the book.
Chapter 2: The Finance Perspective
Many think that financial analysis and ratios are what finance is all about. In fact, it’s just the beginning—to see that,
we’ll establish two foundations of the finance perspective:
cash matters more than profits; and the future matters more
than the past and the present. What are the true sources of
economic returns? Why might accounting be problematic?
If the future matters so much, how do we arrive at values
today based on those future cash flows?
Chapter 3: The Financial Ecosystem
The world of finance—of hedge funds, activist investors, investment banks, and analysts— can seem baffling and somewhat opaque. But it is critical to understand that world as
you progress in finance and as a manager. We’ll try to answer two questions: Why is the financial system so complex?
Could there be an easier way?
Chapter 4: Sources of Value Creation
The most critical questions in finance relate to the origins of
value creation and how to measure it. We’ll dig deeper into
some of the tools developed in chapter 2 to answer many questions: Where does value come from? What does it mean to create value? What is a cost of capital? How do you measure risk?
Chapter 5: The Art and Science of Valuation
Valuation is a critical step in all investment decisions. In this
chapter, we’ll explore how valuation is an art informed by
science and outline what the art is and what the science is.
How do you know how much a company is worth? What
investments are worth making? And how can we avoid the
most common pitfalls in valuation?
6 How Finance Works
Chapter 6: Capital Allocation
Finally, we’ll examine a fundamental problem that preoccupies financial managers at every company—what to
do with excess cash flows. This chapter integrates much
of what we’ve learned along the way. Should you invest in
new projects? Should you return cash to shareholders? If
so, how?
Guides to the World of Finance
Throughout, we’ll rely on five individuals who bring their
insights and experiences from the real world to accompany
the book’s conceptual framework. I have chosen them to provide multiple perspectives on the financial ecosystem developed in chapter 3.
Two chief financial officers (CFOs) represent corporations,
two investors represent both private and public perspectives,
and an equity research analyst (like my father) stands in the
middle of the financial ecosystem.
The first CFO, Laurence Debroux, is the CFO of
Heineken, a global beverage company with operations in
more than a hundred countries. Debroux went to business
school in France, joined an investment bank, and then de-
cided to move to the corporate side. Having served as the
CFO of a number of companies, she’s a great guide to thinking about how corporations around the world invest and how
they interact with capital markets.
The second CFO is Paul Clancy, former CFO of Biogen,
a global biotechnology company. Clancy spent a number of
years at PepsiCo before becoming CFO at Biogen. He provides a particularly valuable perspective on how to think
about funding innovation and R&D activities.
The first investor is Alan Jones of Morgan Stanley, the
global head of private equity for the investment bank. Jones
and his team find undervalued companies and try to buy
them on behalf of clients.
The second investor protagonist is Jeremy Mindich, a cofounder of Scopia Capital. Mindich began as a journalist but
realized that his ability to dig deep into companies would help
him succeed in finance as well. After working for various
hedge funds, he cofounded Scopia Capital, now a multibilliondollar hedge fund in New York. As a hedge fund manager,
Mindich is constantly evaluating companies, determining
whether they’re under- or overvalued.
The two investors will explain how they assess companies,
value them, and subsequently try to create value with their
investments.
Introduction 7
The fifth expert is Alberto Moel, formerly of Bernstein,
an equity research analysis firm. Moel interacts regularly
with companies by talking to CFOs and CEOs and providing recommendations to investors. He’ll show how
analysts examine companies, figure out what’s going on
inside them, and determine their value, in effect serving
as a bridge between the corporations represented by Debroux and Clancy and the investors represented by Jones
and Mindich.
Together, they’ll ground our insights in the real world
and help you understand how to use these lessons in practice.
The implications for practice will also be featured in brief
Real-World Perspectives throughout the book and extended
case studies, called Ideas in Action, that conclude the chapters. Reflections are occasional questions that relate to the
ideas in the chapter, and every chapter ends with questions
that cover all the relevant material.
So let’s start with a little game.
1
Financial Analysis
Using ratios to analyze performance—all while playing a game
Financial Analysis 11
T
o help you develop financial intuitions, we’re going
to play a little game. This game will introduce the
world of finance by creating an understanding of
how to use numbers to evaluate performance—the critical process of financial analysis. Financial analysis answers
some of the most fundamental questions that financial
professionals—from CFOs and managers to investors and
bankers—need to answer, questions that go to the root of a
company’s performance, viability, and potential.
Financial analysis is much more than accounting. In this
chapter, we won’t go through the mechanics of accounting
(e.g., debits and credits) but rather develop intuition around
financial ratios that use accounting. In using ratios during
this game, you’ll understand that by comparing numbers in
a common way, you can develop intuition for the sources of
performance.
How safe is it to lend to a company? How financially rewarding is it to be a shareholder of a company? How much
value does this company provide? Each of these questions
cannot be answered by looking at any one number in isolation. Ratios provide a comparison of relevant numbers in
a common way, which makes sense of otherwise meaningless numbers. In the context of this game, you will identify
fourteen leading companies just on the basis of a series of
ratios. After seeing how industries can be identified by ratios, you’ll use your newfound knowledge to analyze one
12 How Finance Works
company’s performance across time—and see how numbers
can be used to create a narrative of the company’s fortunes
and failures.
Let the games begin!
Making Sense of the Numbers
Take a look at table 1-1, which is the backbone of this chapter. It provides a variety of ratios for fourteen real companies
in 2013 that span different industries, organized by column.
Notice that the companies have been anonymized by design. That constitutes the game: as you progress through this
chapter, exploring the ratios, you’ll develop your financial
intuition by matching each column of numbers to the corresponding company.
Table 1-1 is roughly organized into three horizontal sections. The first section represents the distribution of assets
owned by a company, which includes its cash holdings, equipment, and inventory. The second section shows how these companies finance those assets, by either borrowing money and/
or raising money from their owners or shareholders. The final
section is a series of financial ratios that assess performance,
which requires going beyond what a company owns and how
they finance those purchases. Sometimes finance people seem
to divide everything by everything, just to confuse us. But this
isn’t the case. Ratios make interpretation possible because single numbers in isolation are meaningless (i.e., Is $100 million
of income good or bad? You can only know by comparing
that figure to revenue or something else).
The industries and associated companies represented are
shown in table 1-2. As you can see, these are leading companies from varied industries.
There are 406 different numbers in table 1-1, which can be
quite intimidating. Many may not make a lot of sense right
now. Don’t panic. I’ll quickly explain what twenty-eight of
the numbers mean—the “100s” across the rows for total
assets and total liabilities and shareholders’ equity represent various totals for the first two sections. The companies
aren’t the exact same size, but rather, the figures are percentages that represent the distribution of assets and financing sources. Accordingly, the numbers in those two sections
add up to 100 when rounded.
To help in your analysis, table 1-3 provides a general representation of a balance sheet with the specific data for Starbucks—a global retail chain—in 2017. The “assets” side (or
the left side) of the balance sheet seen in table 1-3(b) enumerates what Starbucks owns, and the “liabilities and shareholders’ equity” side (or the right side) outlines how those assets
are financed. On your personal balance sheet, your clothes,
washing machine, television, automobile, or home are your
TABLE 1-1
The unidentified industries game
Balance sheet percentages
A
B
C
D
E
F
G
H
I
J
K
L
M
N
Assets
Cash and marketable securities
Accounts receivable
Inventories
Other current assets
Plant and equipment (net)
Other assets
35
10
19
1
22
13
4
4
38
9
16
29
27
21
3
8
4
37
25
7
4
5
8
52
20
16
0
4
46
14
54
12
1
4
7
22
64
5
0
6
16
10
9
3
3
6
47
32
5
4
21
2
60
7
16
26
17
4
32
5
4
6
21
1
36
32
2
2
3
2
60
31
16
2
0
5
69
9
7
83
0
0
0
10
Total assets*
100
100
100
100
100
100
100
100
100
100
100
100
100
100
Liabilities and shareholders’ equity
Notes payable
Accounts payable
Accrued items
Other current liabilities
Long-term debt
Other liabilities
Preferred stock
Shareholders’ equity
0
41
17
0
9
7
0
25
0
22
15
9
2
17
15
19
8
24
8
9
11
17
0
23
3
2
1
9
17
24
0
44
5
6
5
6
29
38
0
12
2
3
3
18
9
9
0
55
0
2
3
2
10
5
0
78
0
8
9
7
33
18
0
25
11
18
4
11
25
13
0
17
0
12
5
10
39
10
0
24
4
13
5
4
12
7
0
54
4
2
1
2
32
23
0
36
1
6
6
12
16
22
0
38
50
21
0
3
13
4
0
10
Total liabilities and shareholders’ equity*
100
100
100
100
100
100
100
100
100
100
100
100
100
100
1.12
0.78
1.19
0.18
1.19
0.97
2.64
2.07
1.86
1.67
2.71
2.53
10.71
9.83
0.87
0.49
0.72
0.20
2.28
1.53
1.23
0.40
1.01
0.45
0.91
0.71
1.36
1.23
7.6
20
0.09
0.27
1.877
−0.001
−0.001
3.97
−0.005
7.35
0.05
3.7
8
0.02
0.06
1.832
−0.023
−0.042
2.90
−0.122
−6.21
0.00
32.4
63
0.19
0.33
1.198
0.042
0.050
4.44
0.222
11.16
0.07
1.6
77
0.20
0.28
0.317
0.247
0.078
2.27
0.178
12.26
0.45
NA
41
0.33
0.70
1.393
0.015
0.021
8.21
0.171
3.42
0.06
10.4
82
0.11
0.14
0.547
0.281
0.153
1.80
0.277
63.06
0.40
NA
52
0.10
0.11
0.337
0.010
0.004
1.28
0.005
10.55
0.23
31.5
8
0.33
0.57
1.513
0.117
0.177
4.00
0.709
13.57
0.22
14.9
4
0.36
0.59
3.925
0.015
0.061
5.85
0.355
5.98
0.05
5.5
64
0.39
0.62
1.502
0.061
0.091
4.23
0.384
8.05
0.15
7.3
11
0.16
0.18
2.141
0.030
0.064
1.83
0.117
35.71
0.06
2.3
51
0.36
0.47
0.172
0.090
0.016
2.77
0.043
2.52
0.28
NA
7
0.17
0.29
0.919
0.025
0.023
2.66
0.060
4.24
0.09
NA
8,047
0.63
0.56
0.038
0.107
0.004
9.76
0.039
NA
0.15
Financial ratios
Current assets/current liabilities
Cash, marketable securities, and
accounts receivable/current liabilities
Inventory turnover
Receivables collection period (days)
Total debt/total assets
Long-term debt/capitalization
Revenue/total assets
Net profit/revenue
Net profit/total assets
Total assets/shareholders’ equity
Net profit/shareholders’ equity
EBIT/interest expense
EBITDA/revenue
*Column totals have been rounded to equal 100.
Source: Mihir A. Desai, William E. Fruhan, and Elizabeth A. Meyer, “The Case of the Unidentified Industries, 2013,” Case 214–028 (Boston: Harvard Business School, 2013).
14 How Finance Works
TABLE 1-2
TABLE 1-3
Industries and companies to identify in the game
Representative balance sheets
Industry
Company
Airline
Southwest
Bookstore chain
Barnes & Noble
Commercial bank
Citigroup
Computer software developer
Microsoft
Department store chain, with its “own brand” charge card
Nordstrom
Electric and gas utility, with 80 percent of its revenue
from electricity sales and 20 percent of its revenue
from natural gas sales
Duke Energy
Online direct factory-to-customer personal computer
vendor, with more than half of its sales to business
customers and most its manufacturing outsourced
Dell
Online retailer
Amazon
Parcel delivery ser vice
UPS
Pharmaceutical company
Pfizer
Restaurant chain
Yum!
Retail drug chain
Walgreens
Retail grocery chain
Kroger
Social networking ser vice
Facebook
assets. Any debt you might have is a liability, and the rest
is your shareholders’ equity. Shareholders’ equity and net
worth are interchangeable terms—we’ll use shareholders’
equity in what follows.
To assess performance from the ratios in the third section,
we’ll draw on income statements, which reflect the ongoing operations of a firm. Table 1-4 provides a general representation of an income statement with the specific data for
Starbucks in 2017. Income statements show how a company
Assets: What a company owns
Liabilities and shareholders’
equity: how assets are financed
Current assets
Cash
Accounts receivable
Inventories
Other current assets
Noncurrent assets
Property, plant, and equipment
Intangibles and other assets
Current liabilities
Accounts payable
Other current liabilities
Noncurrent liabilities
Long-term debt
Other liabilities
Total assets
Total liabilities and
shareholders’ equity
Shareholders’ equity
Retained earnings
Other equity accounts
(a) Balance sheet
Liabilities and
shareholders’ equity
Assets
Cash
Accounts receivable
Inventories
Other current assets
Property, plant, and
equipment
Intangibles and other assets
19%
6
9
2
34
Accounts payable
Other current liabilities
Long-term debt
Other liabilities
5%
15
36
5
29
Total shareholders’ equity
38
Total assets*
100
Total liabilities and
shareholders’ equity*
100
*Totals have been rounded to equal 100.
(b) Balance sheet from Starbucks’ 2017 annual report
Financial Analysis 15
we figure out which company is which, let’s go through each
section and identify some of the more extreme numbers. We
will then explain what the numbers represent.
TABLE 1-4
Representative income statement from
Starbucks’ 2017 annual report
Income
Revenue
100%
Cost of goods sold
−40
Gross profit
60
Selling, general, and administrative expenses
−42
Operating profit (or earnings before interest
and taxes, EBIT)
18
Interest
−1
Pretax income
17
Taxes
−6
Net profit
11%
realizes net profit after taking into account all its revenues
and costs, much as you might consider your salary as revenue and your costs (e.g., food, housing, and so on) before you
can figure out what you might be able to save.
Much of finance involves looking at a bunch of numbers
and coming up with interesting things to say about them.
Knowing a little about the ratios in table 1-1, what do you
think about these numbers? You may be curious why some
are so different from others. If so, excellent! The beginning
of much financial analysis consists of looking at a series of
numbers and thinking they are interesting. The best first
step when looking at a sea of numbers is to look for extreme
numbers and then create a story about these numbers. Before
Assets
Because companies invest in assets in order to fulfill their
mission, it is critical to develop an intuitive understanding of
assets. In some sense, assets are the company itself. HäagenDazs, for example, owns the ice cream it’s going to sell, the
factories to make that ice cream, and the trucks to deliver it.
Assets are no more complicated than that. As seen in table 1-5,
assets are ordered by the degree to which they can be changed
into cash; assets that can easily be changed into cash are called
current assets, and they appear at the top. What numbers
strike you as particularly interesting in each row of table 1-5?
Cash and marketable securities
Starting with the first row of table 1-5, notice that companies F and G have more than half of their assets in cash and
marketable securities. That should strike you as strange.
Why would any company hold so much cash? This is a deep
question in finance today as companies hold more cash than
ever before—in aggregate, $2 to $3 trillion for US companies
16 How Finance Works
TABLE 1-5
Assets for the unidentified industries game
Balance sheet percentages
A
B
C
D
E
F
G
H
Cash and marketable securities
35
4
27
25
20
54
64
9
Accounts receivable
10
4
21
7
16
12
5
3
Inventories
19
38
3
4
0
1
0
3
Other current assets
1
9
8
5
4
4
6
6
Plant and equipment (net)
22
16
4
8
46
7
16
Other assets
13
29
37
52
14
22
Total assets*
100
100
100
100
100
100
I
J
K
L
M
N
5
16
4
2
16
7
4
26
6
2
2
83
21
17
21
3
0
0
2
4
1
2
5
0
47
60
32
36
60
69
0
10
32
7
5
32
31
9
10
100
100
100
100
100
100
100
100
Assets
*Column totals have been rounded to equal 100.
alone. As one example, Apple holds more than $250 billion
in cash. We’ll return to this question in more detail later,
but large cash holdings can generally be understood as (a)
an insurance policy during uncertain times, (b) a war chest
for making future acquisitions, or (c) a manifestation of the
absence of investment opportunities.
Given the forgone interest, it is unwise for companies to
hold cash alone, so they invest much of their cash in government securities that can quickly be turned into cash—
so-called marketable securities. Since marketable securities
can be quickly converted into cash, they are often combined
with cash in balance sheets.
Accounts receivable
Accounts receivable are amounts that a company expects to
receive from its customers in the future. As trust grows in a
relationship between a company and its customers, the company might be willing to allow customers to pay later. Many
companies extend credit, allowing their customers, usually
other businesses, to pay after thirty, sixty, or even ninety days.
One company (N) has the majority of its assets in receivables.
Why do you think that is? Why would companies B, H, and
I have such few receivables?
Financial Analysis 17
Reflections
Consider three companies: Walmart (a multinational retail corporation), Staples (an office supplies
chain), and Intel (a semiconductor chip manufacturer). Which one will have the highest amount of
accounts receivable relative to its sales?
In 2016, Walmart had accounts receivable on its
balance sheet of $5.6 billion, or 1.1 percent of sales.
Staples had $1.4 billion in accounts receivable, or
6.7 percent of sales. And Intel had $4.8 billion, or
8.9 percent of sales. Companies like Intel that sell to
other companies will have a higher amount of their
sales reflected as receivables. Walmart has limited
receivables because it largely deals with consumers.
Staples represents an interesting middle case as
it has both business-to-business and businessto-consumer businesses.
Inventories
Inventories are the goods (or the inputs that become those
goods) that a company intends to sell. Inventories include
raw materials, products that are being finished, and final
goods. Häagen-Dazs’s inventories include all the ice cream
it produces and the associated chocolate, dulce de leche, and
coffee beans needed to make its ice cream.
Notice that some companies (E, G, M, and N) don’t have
inventories. How could a company have nothing to sell?
The answer is—and this is going to be the first clue for
the overall exercise—that those companies likely provide
services. Think of a law firm, an advertising company, or a
medical practice—they don’t have physical goods they sell,
so they are service providers.
Property, plant, and equipment
“Property, plant, and equipment” (PP&E) is the term for the
tangible, long-term assets that a company uses to produce
or distribute its product. This can include its headquarters,
factories, machines in those factories, and stores. For example, a utility might have large hydroelectric dams and retail
stores may have many outlets as part of their PP&E. Notice
that companies I, L, and M have large shares in this category,
higher than 60 percent. Which industries would those be?
Other assets
In addition to the large amounts of cash for some companies, there are some companies, like company D, with large
amounts in “other assets.” Indeed, the rising importance
of both cash and other assets are two dominant trends in
18 How Finance Works
finance. But what does “other” mean? Other assets can mean
many things, but are likely to be intangible assets—things
you can’t put your hands on but are valuable nonetheless—
things like patents and brands.
The one twist to this is that accountants don’t assign value
to intangible assets unless they know those values precisely.
So, for example, Coca-Cola has a very valuable brand, maybe
the most valuable thing it owns, but it really doesn’t know
exactly how valuable its brand is. So accountants ignore it.
That’s the accounting principle of conservatism. The idea
that we should ignore something just because we don’t know
its precise value is also something that makes many people in
finance distrust accounting.
When a company buys another company, many intangible
assets that couldn’t previously be valued precisely now have
a value according to accounting, because someone actually
paid for it as part of an acquisition. This leads to one particularly important component of other assets: goodwill. When a
company acquires another company for more than the value
of its assets on their balance sheet, that difference is typically
recorded on the acquiring company’s balance sheets as goodwill. As a consequence, companies with lots of other assets
and goodwill are likely those that have bought other companies with many intangible assets that were previously unrecorded because of conservatism.
Reflections
Microsoft spent $26.2 billion in 2016 to acquire
LinkedIn, which had assets with a book value of
$7.0 billion. The $19.2 billion Microsoft paid above
the book value will show up on Microsoft’s balance
sheet as “other assets,” including goodwill. What
did Microsoft pay for that was worth that additional $19.2 billion?
As one example, Microsoft could benefit from
LinkedIn’s information on its 433 million users to
optimize its marketing of enterprise solutions and
productivity products. The value of the data on
LinkedIn’s users never showed up on its balance
sheet because of the difficulty in valuing it, but by
purchasing LinkedIn, Microsoft made that value
manifest.
Liabilities and Shareholders’ Equity
The second section, liabilities and shareholders’ equity, provides information on how companies finance themselves
(see table 1-6). Essentially, there are only two sources of finance for purchasing assets—lenders and owners. Liabilities
represent those amounts financed by lenders to whom the
company owes amounts; shareholders’ equity, or net worth,
corresponds to the funds that shareholders provide.
Financial Analysis 19
TABLE 1-6
Liabilities and shareholders’ equity for the unidentified industries game
Balance sheet percentages
A
B
C
D
E
F
G
H
I
J
K
L
M
N
Liabilities and shareholders’ equity
Notes payable
0
0
8
3
5
2
0
0
11
0
4
4
1
50
Accounts payable
41
22
24
2
6
3
2
8
18
12
13
2
6
21
Accrued items
17
15
8
1
5
3
3
9
4
5
5
1
6
0
Other current liabilities
0
9
9
9
6
18
2
7
11
10
4
2
12
3
13
Long-term debt
9
2
11
17
29
9
10
33
25
39
12
32
16
Other liabilities
7
17
17
24
38
9
5
18
13
10
7
23
22
4
Preferred stock
0
15
0
0
0
0
0
0
0
0
0
0
0
0
Shareholders’ equity
25
19
23
44
12
55
78
25
17
24
54
36
38
10
Total liabilities and shareholders’
equity*
100
100
100
100
100
100
100
100
100
100
100
100
100
100
*Column totals have been rounded to equal 100.
You might notice parallels in your own life. Your debts
(credit cards, mortgages, car loans, and student loans) have
helped you finance your assets (a house, a car, and most important, your very valuable human capital). The difference
between your assets and liabilities is your shareholders’ equity (or net worth).
As you’ll see in table 1-6, the patterns of financing are different across all the companies and industries. Company G,
for example, uses a lot of shareholder equity as a source of
financing. Others, like company N, use very little. That mix
of financing is referred to as capital structure—a topic we’ll
return to in chapter 4. Liabilities are ordered by the length of
time companies have to repay them; and liabilities that need
to be paid back soon are labeled “current.”
Accounts payable and notes payable
Accounts payable represent amounts due to others, often
over a short time, and typically to the company’s suppliers.
One company’s accounts payable frequently correspond to
another company’s accounts receivable. Company A owes a
large amount of money to its suppliers. Why would that be?
20 How Finance Works
One possibility is that company A is in financial trouble and
can’t pay its suppliers. Another possibility is that it willfully
takes a long time to pay its suppliers. Which explanation is
more plausible?
Sometimes firms may have notes payable, a short-term financial obligation. You’ll notice that company N is the only
one that heavily uses notes payable. Company N also has far
more receivables than the other companies, making it look
altogether strange. Which company do you think would
look so distinctive?
Reflections
Previously, we considered the accounts receivables positions of Walmart, Staples, and Intel.
For each company, think about which customer
might owe them money. In other words, which
companies have accounts payable that correspond to the accounts receivables for these three
companies?
Intel is the simplest example. It sells its chips to
manufacturers of electronics with computing ability,
so Lenovo or Dell would be its customers. So Intel’s
accounts receivable correspond to the accounts
payable of Lenovo or Dell.
Accrued items
Accrued items broadly represent amounts due to others
for activities already delivered. One example is salaries: a
balance sheet may be produced in the middle of a pay period, and the company may owe salaries that have not been
paid yet.
Long-term debt
As we move from short-term liabilities to long-term liabilities in table 1-6, we encounter debt for the first time. Unlike the other liabilities, debt is distinctive because it has an
explicit interest rate. You’ve likely encountered debt in your
life. For example, students borrow money and, in doing so,
take on debt to pay for college, just as homeowners borrow
to buy homes. In table 1-6, you’ll see that some of the companies borrow a fair amount—30 percent to 40 percent of
their assets have been financed with debt.
Preferred and common stock
Shareholders’ equity represents an ownership claim with
variable returns—in effect, the owners get all residual cash
from the business after costs and liabilities. Debt has a fixed
Financial Analysis 21
Reflections
Take a look at the percentage of assets associated
with long-term debt for company E (29 percent)
and company I (25 percent). Which company’s debt
do you think is riskier?
To answer this question, you should also consider
the cash levels of the two companies— company E
has 20 percent of its assets in cash while company
I has only 5 percent of its assets in cash. Financial
analysts sometimes think of cash as “negative debt”
because it could be used to pay off debt immediately. In this case, company E can be considered to
have net debt of 9 percent while company I has net
debt of 20 percent. In this sense, company I would
be riskier to lend additional amounts to relative to
company E.
return (i.e., interest rate) and no ownership claim, but it gets
paid first before equity holders in the event of a bankruptcy.
Equity holders have a variable return and an ownership claim
but can be left with nothing if a company goes bankrupt.
Typically, shareholders’ equity, net worth, owner’s equity,
and common stock are all effectively synonyms. Shareholders’ equity is not only the amount originally invested in a
company by the owners. As a company earns net profits,
those profits can be paid out as dividends or reinvested in
the company. These retained earnings are a component of
shareholders’ equity because it is as if the owners received a
dividend and reinvested it in the company—just as they did
when they originally invested in the company.
Only one company, company B, has preferred stock. Why
is that? For that matter, what is that? How could one type
of owner be preferred? Preferred stock is often called a hybrid instrument because it combines elements of both debt
and equity claims. Like debt, a preferred dividend can be
fixed and paid before common stock dividends, but like
equity, preferred stock is associated with ownership and is
paid after debt in the event of a bankruptcy. Preferred stock
is, unsurprisingly, preferred: when the world goes bad, preferred stockholders get paid before common stockholders,
and when things go well, they get to benefit from the upside,
unlike debt holders, as shareholders.
Why would a company issue such a security? Imagine a
company that has hit hard times and faces a risky future.
Would you want to invest in their common stock if failure
was a real possibility? And would you want to lend to it and
only get a fixed return that might not correspond to the riskiness of the business? The unique attributes of preferred
stock can allow a company to finance itself during precarious times.
22 How Finance Works
Reflections
Venture capital firms, which provide funding for
entrepreneurial ventures, almost always receive
preferred stock in exchange for their funding. Why
do they prefer this form of financing?
Preferred stock allows them to protect their investment in the event that the company does poorly,
while still participating in the upside if the company
does well. They do this by converting their preferred
stock into regular common stock when things go
well.
Understanding Ratios
Now that we’ve had a chance to think about how companies
are represented by their balance sheets, let’s get to something
even more meaningful in terms of analyzing a company—
financial ratios. Ratios are the language of business, and finance people love to create them, talk about them, flip them
upside down, break them apart, and so on.
Ratios make numbers meaningful by providing comparability across companies and through time. For example,
Coca-Cola’s net profit for 2016 was $7.3 billion. Is that a
lot of money for the company? It’s hard to tell without con-
text. Alternatively, knowing that Coca-Cola’s net profit was
16 percent of its revenue (net profit divided by revenue) is
much more helpful. Likewise, knowing that Coca-Cola has
$64 billion in liabilities may not mean very much; knowing
that 71 percent of its assets are financed with liabilities (liabilities divided by assets) tells us a lot more about that company.
You can also compare those ratios to other companies’ ratios
and to previous performance.
Broadly speaking, the ratios in table 1-7 deal with four
questions. First, how is the company doing in terms of generating profits? Second, how efficient or productive is the
company? Third, how does it finance itself? The final question revolves around liquidity, which refers to the ability of
a company to generate cash quickly. If all your assets are in
real estate, you are illiquid. And if all your wealth is in your
checking account, you’re highly liquid.
Liquidity
Most companies go bankrupt because they run out of cash.
Liquidity ratios measure this risk by emphasizing the company’s ability to meet short-term obligations with assets that
can quickly be converted into cash. Suppliers like to see high
liquidity ratios because they want to ensure that their customers can pay them. For shareholders, greater liquidity cre-
Financial Analysis 23
TABLE 1-7
Ratios for the unidentified industries game
Financial ratios
A
B
C
D
E
F
G
H
I
J
K
L
M
N
Current assets/current liabilities
1.12
1.19
1.19
2.64
1.86
2.71
10.71
0.87
0.72
2.28
1.23
1.01
0.91
1.36
Cash, marketable securities, and
accounts receivable/current liabilities
0.78
0.18
0.97
2.07
1.67
2.53
9.83
0.49
0.20
1.53
0.40
0.45
0.71
1.23
Inventory turnover
7.6
3.7
32.4
1.6
NA
10.4
NA
31.5
14.9
5.5
7.3
2.3
NA
NA
Receivables collection period (days)
20
8
63
77
41
82
52
8
4
64
11
51
7
8,047
Total debt/total assets
0.09
0.02
0.19
0.20
0.33
0.11
0.10
0.33
0.36
0.39
0.16
0.36
0.17
0.63
Long-term debt/capitalization
0.27
0.06
0.33
0.28
0.70
0.14
0.11
0.57
0.59
0.62
0.18
0.47
0.29
0.56
0.038
Revenue/total assets
1.877
1.832
1.198
0.317
1.393
0.547
0.337
1.513
3.925
1.502
2.141
0.172
0.919
Net profit/revenue
−0.001
−0.023
0.042
0.247
0.015
0.281
0.010
0.117
0.015
0.061
0.030
0.090
0.025
0.107
Net profit/total assets
−0.001
−0.042
0.050
0.078
0.021
0.153
0.004
0.177
0.061
0.091
0.064
0.016
0.023
0.004
Total assets/shareholders’ equity
3.97
2.90
4.44
2.27
8.21
1.80
1.28
4.00
5.85
4.23
1.83
2.77
2.66
9.76
Net profit/shareholders’ equity
−0.005
−0.122
0.222
0.178
0.171
0.277
0.005
0.709
0.355
0.384
0.117
0.043
0.060
0.039
EBIT/interest expense
7.35
−6.21
11.16
12.26
3.42
63.06
10.55
13.57
5.98
8.05
35.71
2.52
4.24
NA
EBITDA/revenue
0.05
0.00
0.07
0.45
0.06
0.40
0.23
0.22
0.05
0.15
0.06
0.28
0.09
0.15
ates a trade-off. Yes, they want to ensure that the company
doesn’t go bankrupt. But highly liquid assets, like cash and
marketable securities, may not provide much of a return.
Current Ratio
it needs to close? Will its current assets be sufficient to pay
off its current liabilities (including those owed to suppliers)?
This ratio is a key way to think about if a supplier should
extend credit to a company and if a company will be able to
survive the next six or twelve months.
Current assets
current liabilities
Quick Ratio
The current ratio asks a question on behalf of a company’s
suppliers: Will this company be able to pay its suppliers if
(Current assets − inventory)
current liabilities
24 How Finance Works
Reflections
Let’s think about three different companies:
Rio Tinto Group, a global mining and metals
corporation; NuCor Corporation, a mini-mill steel
producer; and Burberry, a luxury fashion house.
For each, which ratio would you prefer to see—
the quick ratio or the current ratio?
This question hinges on which company you think
has the riskiest inventory. In many ways, Burberry is
likely to have the riskiest inventory because there is
no spot market available for it to liquidate its inventory. If it makes a stylistic mistake on a new product,
it may find it impossible to sell that inventory, even
at a discount. By contrast, Rio Tinto—and NuCor, to
a lesser degree—may be more able to dispose of
their inventory quickly because they deal in materials that have a spot market.
The quick ratio resembles the current ratio, but excludes
inventories from the numerator. Why make a big deal out
of inventories? You might think inventories are about operations, but to finance people, inventories represent risk
that needs to be financed. And inventory can be very risky.
Think about BlackBerry, which competed in the smartphone market where products quickly grow obsolete. In
2013, the company released the Z10 late and was forced to
declare that $1 billion of inventory was, in fact, worth zero.
For companies with high-risk inventory, the quick ratio provides a more skeptical view of their liquidity.
Profitability
Profitability can be assessed in a number of different ways
because the appropriate measure depends on the specific
question being asked. And profitability can also be assessed
without traditional accounting-based profit measures.
As always, it’s important to compare profits to something.
For example, you could look at net profit, or the income after
all costs and expenses, and compare it to sales (to represent
the margin) or to shareholders’ equity (to represent the return to a shareholder). Both are key measures of profitability.
One measure asks: For every dollar of revenue, how much
money does a firm get to keep after all relevant costs? The
other, when you divide profits by shareholders’ equity, asks:
For every dollar a shareholder puts into a company, how
much do they get back every year? That’s the notion of a
return, specifically a return on equity.
Profit Margin
Net profit
revenue
Financial Analysis 25
As seen in table 1-1, there are several different measures of
profits that consider different sets of costs. Gross profit only
subtracts the expenses related to the production of goods
from revenue, while operating profit also subtracts other
operating costs, such as selling and administrative costs. Finally, net profit also subtracts interest and tax expenses from
operating profit. Interestingly, companies A and B have negative profit margins, while companies D and F have profit
margins of approximately 25 percent.
Return on Equity (ROE)
Net profit
shareholders’ equity
This ratio, often called return on equity (ROE), measures the
annual return that shareholders earn. In particular, for every
dollar of equity that shareholders invest in a business, what
is their annual flow of income? As two examples, company
C has an ROE of 22 percent, while company M has an ROE
of only 6 percent.
Return on Assets
Net profit
total assets
Often called return on assets, this ratio asks: How much
profit does a company generate for every dollar of assets?
This corresponds to asking how effectively a company’s assets are generating profits.
EBITDA Margin
EBITDA
revenue
EBITDA is one of the all-time great finance acronyms and is
best said quickly—“E-BIT-DA.” It’s also an indication that
we’re moving away from the accounting idea of profits and
toward the emphasis on cash in finance. What is EBITDA?
Let’s begin by breaking it into two parts—EBIT and DA.
EBIT is just a fancy finance term for something you
already know as operating profit. If you work up from
the bottom of the profit statement, you can recharacterize
operating profit as “earnings before interest and taxes,” or
EBIT. Since some companies have different tax burdens
and capital structures, EBIT provides a way to compare
their performances more directly. For example, an American publisher and a German publisher might face different
tax rates. Net profit, which factors in taxes, would provide
a distorted view; EBIT, which excludes tax charges, would
not.
26 How Finance Works
What about DA? DA stands for “depreciation and amortization.” Depreciation refers to how physical assets, such as
vehicles and equipment, lose value over time, and amortization refers to that same phenomenon but for intangible
assets. The reason to emphasize DA is because they are expenses that are not associated with the outlay of cash; it is
just an approximation of the loss of value of an asset. Suppose
you build a factory. In accounting, you have to depreciate it
and charge yourself an expense for that depreciation. But in
finance, we emphasize cash and there was no cash outlay, so
EBITDA—or earnings before interest, taxes, depreciation,
and amortization—is a measure of the cash generated by operations. Because DA was subtracted to arrive at EBIT, DA
needs to be added back to get to EBITDA.
As we’ll see in chapter 2, the emphasis on cash is a lynchpin of the finance perspective. One example I’ll develop
more fully later, Amazon, has little profitability but significant EBITDA. Among the companies in table 1-7, it’s
notable that company D generates a remarkable amount of
cash—45 percent, or 45 cents for every dollar of revenue!
Similarly, company L has a reasonable profit margin of
9 percent, but a whopping EBITDA margin of 28 percent.
Why would that be?
Financing and Leverage
Leverage is one of the most powerful concepts in finance,
and it corresponds roughly to our previous discussions of financing choices and capital structure. You may have friends
in finance who get weepy-eyed when they talk about leverage. Empires have been built and destroyed because of
leverage, and you’ll see why.
Why is it called “leverage”? The easiest way to understand the power of leverage is to recall the power of a lever
in an engineering context. Imagine a big rock that you can’t
possibly move by yourself. A lever will allow you to move
that rock, seemingly magically, by multiplying the force
you apply to the task. And that’s a precise analogue for
what happens with leverage in finance. Just as a lever lets
you move a rock you couldn’t otherwise move, leverage in
finance allows owners to control assets they couldn’t control
otherwise.
Let’s consider your own personal balance sheet after you
buy a home. What if no mortgages were available for you to
buy a home? If you had $100, you could only buy a home that
was worth $100. With a mortgage market, you can borrow
money to buy a home that is worth, say, $500. Let’s see what
your balance sheet looks like under those two circumstances.
(See table 1-8.)
Financial Analysis 27
TABLE 1-8
Balance sheets for home purchases
Case A
Case B
Assets
Liabilities and
net worth
Assets
$100 home
$100 net worth
$500 home
Liabilities and
net worth
$400 mortgage
$100 equity
In effect, leverage allows you to live in a house you have no
right to live in. It almost as magical as the lever helping you
move a rock.
Here’s the big question: Are you richer in case A or case
B? Some think you’re richer in case A because you don’t owe
anything. Some think you’re richer in case B because you live
in a larger home. In fact, your wealth is no different; in both
cases, you have $100 of shareholders’ equity.
Leverage not only allows you to control assets you have no
right to control, but it also increases your returns. Imagine
that the house increases in value by 10 percent in the two
cases. In case A, the return to your shareholders’ equity is
10 percent, but in case B, your return is 50 percent if the
house value increases to $550, but the mortgage remains at
$400.
Unfortunately, it’s not all milk and honey. If the house declines in value by 20 percent, the return to your shareholders’
equity is −20 percent in case A, but in case B, your return
is −100 percent! So managing leverage is critical because
Real-World Perspectives
Alan Jones, global head of private equity for Morgan Stanley, commented on private equity’s
use of leverage:
The home mortgage analogy is
really quite apt. Say we are buying
a company that is worth $100. We
can buy that company outright with
either $100 of equity or with $70 of
debt that we borrow from someone
else and $30 of our own capital.
If the value of that asset doubles
during our ownership, in the first
instance, our return is that incremental $100, or about a 100 percent
return over whatever time we’ve
held it. But if we bought that same
asset using $70 of other people’s
money (i.e., debt), we’ve got equity
that’s now worth $130 versus the
$30 that we originally invested. So
instead of just doubling our money,
we’ve gotten a return of more than
four times on our money. As a result,
people are attracted to get as much
of “other people’s money” as they
can.
28 How Finance Works
it enables you to do things you couldn’t otherwise do and
because it magnifies your returns—in both directions.
a company’s financing comes from debt and therefore diverts
attention from liabilities that are part of operations.
Debt to Assets
Assets to Shareholders’ Equity
Total debt
total assets
Assets
shareholders’ equity
The ratio of total debt to total assets measures the proportion
of all assets financed by debt. It provides a balance sheet perspective on leverage.
Leverage provides the ability to control more assets than an
owner would otherwise have the right to control. This ratio
tells us precisely how many more assets an owner can control relative to their own equity capital. As a consequence, it
also measures how returns are magnified through the use of
leverage.
Debt to Capitalization
Debt
debt + shareholders’ equity
The ratio of long-term debt to capitalization provides a
somewhat more subtle measure of leverage by emphasizing
the mix of debt and equity. The denominator in this ratio
is capitalization—the combination of a company’s debt and
equity. As we saw, there are two primary types of financing
for a company, and we think about them differently. Debt
has a fixed interest cost associated with it, while equity holds
a variable rate of return—which means it fluctuates—along
with ownership rights. This ratio tracks what proportion of
Interest Coverage Ratio
EBIT
interest expense
The three previous measures were constructed from balance
sheets, but the critical question is often the degree to which a
company can make its interest payments. The ratio of EBIT
to interest expense measures a company’s ability to fund interest payments from its operations and uses only data from the
income statement.
Financial Analysis 29
Reflections
Over the past two decades, pharmaceutical companies have been
slowly increasing their leverage.
For example, in 2001, Merck had a
debt-to-equity ratio of 0.53; Pfizer’s
was 1.14. In 2016, Merck’s debt-toequity ratio was 1.28; Pfizer’s was
1.58. What was going on in this
industry to cause this shift?
One possible explanation for this
change is that pharmaceutical companies are generating more stable
cash flows that can ser vice larger
debt amounts. Large pharmaceutical companies increasingly purchase
promising technologies from bio-
technology companies rather than
undertaking the risky process of developing new treatments and medicines themselves. As a result, large
pharmaceutical companies’ overall
risk has decreased, and lenders have
been more willing to extend credit
to them.
Private equity companies sometimes use debt in transactions
known as LBOs— leveraged buyouts—to purchase companies. In
these transactions, the company
borrows to buy out many shareholders, leaving it much more
highly levered than previously.
As one example, a ratio of 1 indicates that a company is
just able to make its interest payments with its current operations. In your own life, consider the comparison between
your monthly income and any mortgage payments as an
analogous measure.
A hybrid measure using elements from both the income
statement and the balance sheet—debt/EBITDA—is a way
What sorts of industries would
you expect to be the targets
of LBOs?
In short, companies with stable
business models and committed
customers are good candidates
for LBOs. If the business has stable cash flows, it is able to sustain
higher leverage in a more secure
way than companies with very risky
technologies. Classic LBO targets
include tobacco companies, gaming
companies, and utilities because of
their committed customers and predictable demand with little threat of
substitution.
to combine information from the balance sheet and the income statement.
Productivity or Efficiency
Productivity is a popular buzzword, but what does it mean
from a finance perspective? In short, increases in productivity
30 How Finance Works
Reflections
The effect of information technology over the past several decades is
an important example of productivity increases. For example, retailers
and wholesalers, and Walmart in
particular, contributed significantly
to the aggregate productivity gains
of the 1990s in the United States.
According to the McKinsey Global
Institute, “Wal-Mart directly and
indirectly caused the bulk of the
productivity acceleration through
ongoing managerial innovation
that increased competitive intensity and drove the diffusion of
best practice”1 in retail. How
were these gains manifest in the
economy?
These gains could be manifest in
rising wages, returns to capital providers, and lower prices for consum-
mean you can squeeze more from less. More narrowly, productivity ratios measure how well a company utilizes its assets
to produce output. Over the long run, increases in productivity are the most important contributor to economic growth.
Asset Turnover
Revenue
total assets
This ratio measures how effectively a company is using its assets to generate revenue. This is a critical measure of a company’s productivity.
ers. While many commentators have
bemoaned the absence of wage
gains from rising productivity, these
productivity gains have reduced
consumer prices significantly, and
lower-income individuals have benefited from those reduced prices.
So productivity gains may not have
reduced income inequality, but
they did reduce consumption
inequality.
Inventory Turnover
Cost of goods sold
inventory
Inventory turnover measures how many times a company
turns over or sells all its inventory in a given year. The higher
the number, the more effectively the company is managing
its inventory as it sells products. Because inventory is essentially a risky asset that needs to be financed, a higher inventory turnover is financially valuable.
We can use this turnover number to get another measure
of inventory management: days of inventory.
Financial Analysis 31
Days Inventory
365 ÷ inventory turnover
Dividing the number of days in a year (365) by the inventory turnover provides the average number of days a piece
of inventory is kept inside a company before it is sold. Take
a look at company C in table 1-1. It turns over its inventory
more than thirty times a year, which corresponds to keeping
inventory around for slightly more than ten days. In contrast,
company B has an inventory turnover of only four times a
year, which means that inventory is sticking around for almost a hundred days!
Receivables Collection Period
365 ÷
sales
receivables
After a company sells its inventory, it needs to get paid
for it. The lower this figure, the faster a company is getting
cash from its sales. As you can see, company N looks pretty
strange—it collects cash from its customers after more than
twenty years! What could give rise to such a situation?
Do you notice anything about the numbers for the other
companies? The remaining companies can be roughly divided into one group that collects very quickly (fewer than
thirty days) and another group that collects more slowly.
That difference will be a significant clue for what types of
companies they are.
Let the Games Begin
Now that you have a better understanding of all the numbers, try to puzzle your way through which numbers correspond to which company. You’ll learn more by trying to
arrive at the solution yourself than simply reading ahead.
To get started, see table 1-9, where some of the more
notable numbers from our previous discussion are highlighted. Rather than trying to identify all fourteen companies at once, let’s focus on two subsets—service companies
and retailers—that we can clearly identify, and then we’ll
look at the rest.
Service Companies
Looking at the ratios, service companies are relatively easy to
spot. Since they provide services rather than tangible goods,
they don’t hold inventories—which points to companies
E, G, M, and N. So which four companies can we match
to E, G, M, and N? Two of the companies have “service”
in their name: the parcel delivery service, which is UPS,
and the social networking service, which is Facebook. What
TABLE 1-9
The unidentified industries game
Balance sheet percentages
A
B
C
D
E
F
G
H
I
J
K
L
M
N
Assets
Cash and marketable securities
Accounts receivable
Inventories
Other current assets
Plant and equipment (net)
Other assets
35
10
19
1
22
13
4
4
38
9
16
29
27
21
3
8
4
37
25
7
4
5
8
52
20
16
0
4
46
14
54
12
1
4
7
22
64
5
0
6
16
10
9
3
3
6
47
32
5
4
21
2
60
7
16
26
17
4
32
5
4
6
21
1
36
32
2
2
3
2
60
31
16
2
0
5
69
9
7
83
0
0
0
10
Total assets*
100
100
100
100
100
100
100
100
100
100
100
100
100
100
Liabilities and shareholders’ equity
Notes payable
Accounts payable
Accrued items
Other current liabilities
Long-term debt
Other liabilities
Preferred stock
Shareholders’ equity
0
41
17
0
9
7
0
25
0
22
15
9
2
17
15
19
8
24
8
9
11
17
0
23
3
2
1
9
17
24
0
44
5
6
5
6
29
38
0
12
2
3
3
18
9
9
0
55
0
2
3
2
10
5
0
78
0
8
9
7
33
18
0
25
11
18
4
11
25
13
0
17
0
12
5
10
39
10
0
24
4
13
5
4
12
7
0
54
4
2
1
2
32
23
0
36
1
6
6
12
16
22
0
38
50
21
0
3
13
4
0
10
Total liabilities and shareholders’ equity*
100
100
100
100
100
100
100
100
100
100
100
100
100
100
1.12
0.78
1.19
0.18
1.19
0.97
2.64
2.07
1.86
1.67
2.71
2.53
10.71
9.83
0.87
0.49
0.72
0.20
2.28
1.53
1.23
0.40
1.01
0.45
0.91
0.71
1.36
1.23
7.6
20
0.09
0.27
1.877
−0.001
−0.001
3.97
−0.005
7.35
0.05
3.7
8
0.02
0.06
1.832
−0.023
−0.042
2.90
−0.122
−6.21
0.00
32.4
63
0.19
0.33
1.198
0.042
0.050
4.44
0.222
11.16
0.07
1.6
77
0.20
0.28
0.317
0.247
0.078
2.27
0.178
12.26
0.45
NA
41
0.33
0.70
1.393
0.015
0.021
8.21
0.171
3.42
0.06
10.4
82
0.11
0.14
0.547
0.281
0.153
1.80
0.277
63.06
0.40
NA
52
0.10
0.11
0.337
0.010
0.004
1.28
0.005
10.55
0.23
31.5
8
0.33
0.57
1.513
0.117
0.177
4.00
0.709
13.57
0.22
14.9
4
0.36
0.59
3.925
0.015
0.061
5.85
0.355
5.98
0.05
5.5
64
0.39
0.62
1.502
0.061
0.091
4.23
0.384
8.05
0.15
7.3
11
0.16
0.18
2.141
0.030
0.064
1.83
0.117
35.71
0.06
2.3
51
0.36
0.47
0.172
0.090
0.016
2.77
0.043
2.52
0.28
NA
7
0.17
0.29
0.919
0.025
0.023
2.66
0.060
4.24
0.09
NA
8,047
0.63
0.56
0.038
0.107
0.004
9.76
0.039
NA
0.15
Financial ratios
Current assets/current liabilities
Cash, marketable securities and
accounts receivable/current liabilities
Inventory turnover
Receivables collection period (days)
Total debt/total assets
Long-term debt/capitalization
Revenue/total assets
Net profit/revenue
Net profit/total assets
Total assets/shareholders’ equity
Net profit/shareholders’ equity
EBIT/interest expense
EBITDA/revenue
*Column totals have been rounded to equal 100.
Source: Mihir A. Desai, William E. Fruhan, and Elizabeth A. Meyer, “The Case of the Unidentified Industries, 2013,” Case 214–028 (Boston: Harvard Business School, 2013).
Financial Analysis 33
about the other two? Banks are service providers and so are
airlines, so the other two companies are Southwest Airlines and Citigroup. The airline is somewhat tricky because
you might have thought that those planes and spare parts are
inventory. But the airlines’ primary line of business does not
involve selling planes or spare parts—they transport people,
and that’s clearly a service with no notion of inventory.
Let’s try to figure out which column in table 1-10 corresponds to which company by beginning with some lowhanging fruit.
Company N: The outlier
Which company owns receivables that take a long time to
collect, and a large fraction of their financing comes from
notes payable? Who could expect to collect from customers
in twenty years on average?
The answer is a bank. Banks are difficult to relate to
because their balance sheets are mirrors of our own. The
loans that you consider your liabilities are a bank’s assets.
So the mortgage from the housing example is an asset for a
bank. And the deposits that you consider your assets are the
bank’s liabilities—its notes payable. Citigroup has the highest amount of leverage in the group, a characteristic that is
true of the banking industry in general.
TABLE 1-10
Identifying the service companies
Balance sheet percentages
E
G
M
N
Assets
Cash and marketable securities
Accounts receivable
Inventories
Other current assets
Plant and equipment (net)
Other assets
20
16
0
4
46
14
64
5
0
6
16
10
16
2
0
5
69
9
7
83
0
0
0
10
Total assets*
100
100
100
100
Liabilities and shareholders’
equity
Notes payable
Accounts payable
Accrued items
Other current liabilities
Long-term debt
Other liabilities
Preferred stock
Shareholders’ equity
5
6
5
6
29
38
0
12
0
2
3
2
10
5
0
78
1
6
6
12
16
22
0
38
50
21
0
3
13
4
0
10
100
100
100
100
1.86
1.67
10.71
9.83
0.91
0.71
1.36
1.23
NA
41
0.33
0.70
1.393
0.015
0.021
8.21
0.171
3.42
0.06
NA
52
0.10
0.11
0.337
0.010
0.004
1.28
0.005
10.55
0.23
NA
7
0.17
0.29
0.919
0.025
0.023
2.66
0.060
4.24
0.09
NA
8,047
0.63
0.56
0.038
0.107
0.004
9.76
0.039
NA
0.15
Total liabilities and shareholders’
equity*
Financial ratios
Current assets/current liabilities
Cash, marketable securities, and
accounts receivable/current
liabilities
Inventory turnover
Receivables collection period (days)
Total debt/total assets
Long-term debt/capitalization
Revenue/total assets
Net profit/revenue
Net profit/total assets
Total assets/shareholders’ equity
Net profit/shareholders’ equity
EBIT/interest expense
EBITDA/revenue
*Column totals have been rounded to equal 100.
34 How Finance Works
What’s it like to run a bank? Banks run a “spread” business
where they charge you more for loans than they give you on
their deposits. In the process, they take your short-term capital (deposits) and transform it into long-term capital (loans)
for the economy. That transformation of short-term capital
into long-term capital is why we value banks so greatly and
why they sometimes fail. The mismatch between a bank’s
assets and liabilities combines with high leverage to create
little margin for error. Nearly every financial crisis begins
with questions about asset quality, which lead to outflows of
deposits, which must be funded with rapid sales of loans by
the banks, which lead to declining loan prices, which lead to
an uncontrollable cycle that can result in their destruction.
Capital-intensive service providers
How can we distinguish between the remaining three companies? Companies E and M have much more property,
plant, and equipment than the other companies, including
company G. Southwest Airlines and UPS are fundamentally
transportation companies, and they both own planes and a lot
of equipment. Take a look at the numbers to see how they differ in other respects. (See companies E and M in table 1-10.)
One of the most significant differences between these two
companies is that company M gets paid in seven days, on
average, which likely means it sells mostly to individuals.
In contrast, company E takes considerably longer to collect,
which would suggest that it’s much more likely to be selling
to other businesses. Southwest Airlines sells to people like
you and me, and we pay immediately. UPS, in contrast, does
business with other companies as a logistics provider. So
company E is likely to be UPS, and company M is Southwest
Airlines. Can you find another data point that backs up this
hypothesis?
Company E has a lot of other liabilities. What are those
long-dated liabilities that UPS owes? These liabilities are
pensions and obligations to retirees. It takes some knowledge
of these companies to know this, but UPS has one of the
largest defined benefit pension plans in the world. Defined
benefit pension plans are something that budget airlines
avoid, but UPS, an older company that was once owned by
employees, has maintained their traditional pensions.
The cash-rich, equity-dependent service company
By the process of elimination, Facebook is company G. But
does it conform to what you expect? Company G has a large
amount of equity and lots of cash—is that consistent with G
being Facebook? Facebook is the youngest company on the
list, and it had recently gone public in 2013. Because values
Financial Analysis 35
on balance sheets are recorded at the time of the issuance
or acquisition (remember that conservatism principle?), high
equity numbers can coincide with younger companies. What
did it do with all the money that it raised? At the time, it
held the money it raised in cash.
As Facebook has matured, its balance sheet has changed.
Facebook has since completed a number of large acquisitions,
including WhatsApp and Instagram. How would those acquisitions be manifest in their balance sheets? Facebook’s cash
levels have come down, and those “other assets” we discussed
have risen. Because Facebook bought other companies for
much more than their book value (because Facebook valued
all those intangible assets that accounting ignores), Facebook’s
goodwill accounts would have increased. It paid $19 billion
for WhatsApp in 2014, and the book value of WhatsApp was
only $51 million. That excess of the purchase price over the
book value showed up as goodwill for Facebook.
collection period is going to be short because customers pay
immediately via cash or credit. In contrast, businesses that
do business with other businesses give credit of a minimum
of thirty days.
So the retailers are A, B, H, I, and K. Which companies
on the list are retailers that sell directly to consumers? Amazon, Barnes & Noble, Kroger, Walgreens, and Yum! are all
retailers. We can exclude Nordstrom here because the chain
has its own brand charge card, so its customers, unlike those
of the other companies, can take a long time to pay for their
purchases. Through its charge card, Nordstrom behaves
more like a bank than a retailer.
How can we sort through these five retailers? If you’ve
ever worked at a retail store, you know that it’s all about
moving inventory. These five companies differ dramatically
in the way that they turn over their inventory. Some turn
over inventory really quickly (company H). Others take a
long time (for example, company B). (See table 1-11.)
Retailers
When reviewing the receivables collection period, we saw
that the companies were divided between those that collect
quickly and those that take considerably longer. What kinds
of companies would collect from customers so quickly? Since
retailers sell goods directly to consumers, their receivables
Companies with distinctive inventory turnover
So which company in this group would move inventory
really quickly? Company H turns their inventory thirty-two
times a year, so they have only eleven days of inventory at any
one time. You should hope that this is Yum! and, in fact, it
36 How Finance Works
TABLE 1-11
Identifying the retailers
Balance sheet percentages
A
B
H
I
K
Assets
Cash and marketable securities
35
4
9
5
Accounts receivable
10
4
3
4
4
6
Inventories
19
38
3
21
21
Other current assets
1
9
6
2
1
Plant and equipment (net)
22
16
47
60
36
Other assets
13
29
32
7
32
Total assets*
100
100
100
100
100
Liabilities and shareholders’ equity
Notes payable
0
0
0
11
4
Accounts payable
41
22
8
18
13
Accrued items
17
15
9
4
5
Other current liabilities
0
9
7
11
4
Long-term debt
9
2
33
25
12
Other liabilities
7
17
18
13
7
Preferred stock
0
15
0
0
0
Shareholders’ equity
25
19
25
17
54
Total liabilities and shareholders’ equity*
100
100
100
100
100
is. The grocery chain also has perishable goods, but given its
selection of dry food and canned goods, its turnover will be
considerably slower than that of a restaurant chain.
At the other extreme, company B turns over inventory
really slowly—almost ninety days. Which company has inventory that ages relatively well and takes a long time to
move? If you’ve ever been in a bookstore, that should sound
familiar. But is there anything else about company B that
feels like a bookstore?
Company B is also notable because it’s losing money.
Bookstores worldwide are disappearing. Bookselling is a very
tough business, given the rise of Amazon, and this shows up
as a negative profit margin. And company B is also the only
one that had to issue preferred stock, further indicating its
troubled financial position.
Financial ratios
Current assets/current liabilities
1.12
1.19
0.87
0.72
1.23
Cash, marketable securities, and accounts
receivable/current liabilities
0.78
0.18
0.49
0.20
0.40
Inventory turnover
7.6
3.7
31.5
14.9
7.3
Receivables collection period (days)
20
8
8
4
11
0.09
0.02
0.33
0.36
0.16
Total debt/total assets
Long-term debt/capitalization
0.27
0.06
0.57
0.59
0.18
Revenue/total assets
1.877
1.832
1.513
3.925
2.141
Net profit/revenue
−0.001
−0.023
0.117
0.015
0.030
Net profit/total assets
−0.001
−0.042
0.177
0.061
0.064
Total assets/shareholders’ equity
3.97
2.90
4.00
5.85
1.83
Net profit/shareholders’ equity
−0.005
−0.122
0.709
0.355
0.117
EBIT/interest expense
7.35
−6.21
13.57
5.98
35.71
EBITDA/revenue
0.05
0.00
0.22
0.05
0.06
*Column totals have been rounded to equal 100.
The final three retailers
The remaining three companies—A, I, and K—differ sharply
when it comes to property, plant, and equipment, with company A having the least of that item. We know that two of
these companies are brick-and-mortar operations (Walgreens
and Kroger), so Amazon, an online marketplace, would have
lower property, plant, and equipment, and might be A.
But given Amazon’s position in today’s economy, let’s find
the confirming evidence. What else is distinctive about com-
Financial Analysis 37
pany A that might coincide with what we think about Amazon? First, company A was not making any money. If you’ve
followed Amazon, you know that it’s notorious for not making any profits. We’ll explore Amazon further in chapter 2.
The second piece of confirmatory evidence is that company A has a large amount of payables, which could mean
that it is in trouble or that it is granted credit easily by suppliers because of its size. Given the amount of cash that company A has, we know they are not in financial trouble. So,
company A looks like Amazon, with its strong position in
the marketplace and power over its suppliers.
That leaves us with two more: the retail drug chain and
grocer for I and K.
One big difference is that company I has considerably
more property, plant, and equipment than company K.
Think about the last time you were in a grocery store or a
drugstore. Which had a lot more equipment? In the grocery
business, managing the cold chain is really expensive, so the
one with more equipment, I, is probably the grocery store.
But let’s look for more clues.
Company I also collects more quickly than company K,
further evidence that it’s the grocer because grocery stores are
more likely to get immediate payments. A significant fraction
of drugstore revenues may come from insurance companies,
which would mean drugstores would become a bit like a B2B
firm. And company I is turning inventory faster as well, as we
would expect for a grocer. So we can conclude that company
K is the drugstore Walgreens and company I is Kroger.
The Stragglers
After the retailers and service companies, we’re left with a
motley crew—Microsoft, Nordstrom, Duke Energy, Pfizer,
and Dell—that are presented in table 1-12.
Three of the companies, C, D, and F, have barely any
PP&E, while the remaining two companies have very significant PP&E. One is likely Duke Energy, which has power
plants, and the other is likely Nordstrom, a brick-and-mortar
retailer. But which is which?
To double-check, look at the three remaining companies
and gauge their property, plant, and equipment. Dell, Pfizer,
and Microsoft don’t really do any heavy manufacturing so
their low levels of PP&E make sense.
Which of the two companies with significant property,
plant, and equipment is Duke Energy and which is Nordstrom? The key differentiating factor here is inventory. Nordstrom would have a large amount of inventory, while Duke
Energy has very little (electricity can’t be stored). So company
L turns out to be Duke Energy, and company J is retailer
Nordstrom. Also, the big EBITDA margin for company
L means that it is generating a large amount of depreciation and amortization. That’s what utilities do. And often
38 How Finance Works
TABLE 1-12
Identifying the stragglers
Balance sheet percentages
C
D
F
J
L
Assets
Cash and marketable securities
Accounts receivable
Inventories
Other current assets
Plant and equipment (net)
Other assets
27
21
3
8
4
37
25
7
4
5
8
52
54
12
1
4
7
22
16
26
17
4
32
5
2
2
3
2
60
31
Total assets*
100
100
100
100
100
Notes payable
Accounts payable
Accrued items
Other current liabilities
Long-term debt
Other liabilities
Preferred stock
Shareholders’ equity
8
24
8
9
11
17
0
23
3
2
1
9
17
24
0
44
2
3
3
18
9
9
0
55
0
12
5
10
39
10
0
24
4
2
1
2
32
23
0
36
Total liabilities and shareholders’
equity*
100
100
100
100
100
1.19
0.97
2.64
2.07
2.71
2.53
2.28
1.53
1.01
0.45
32.4
63
0.19
0.33
1.198
0.042
0.050
4.44
0.222
11.16
0.07
1.6
77
0.20
0.28
0.317
0.247
0.078
2.27
0.178
12.26
0.45
10.4
82
0.11
0.14
0.547
0.281
0.153
1.80
0.277
63.06
0.40
5.5
64
0.39
0.62
1.502
0.061
0.091
4.23
0.384
8.05
0.15
2.3
51
0.36
0.47
0.172
0.090
0.016
2.77
0.043
2.52
0.28
Liabilities and shareholders’
equity
Financial ratios
Current assets/current liabilities
Cash, marketable securities, and
accounts receivable/current liabilities
Inventory turnover
Receivables collection period (days)
Total debt/total assets
Long-term debt/capitalization
Revenue/total assets
Net profit/revenue
Net profit/total assets
Total assets/shareholders’ equity
Net profit/shareholders’ equity
EBIT/interest expense
EBITDA/revenue
*Column totals have been rounded to equal 100.
in the utility industry, people talk about EBITDA as opposed to profitability because they know how distorting all
that depreciation and amortization can be.
Of the last three—Dell, Microsoft, and Pfizer—notice
that company C has a really low profit margin and companies
D and F have really astounding profit margins (greater than
20 percent) and EBITDA margins (greater than 40 percent).
Which of the remaining three companies is in the commodifying industry? Over the past ten to fifteen years, the laptop
industry has become very commodified, which shows up as
depressed profitability. That kind of commodification hasn’t
happened in software or in pharmaceuticals.
Also, company C holds on to inventory for only slightly
more than ten days, which matches Dell’s just-in-time
business model. Dell begins manufacturing only after it
takes orders. As a consequence, it keeps inventory as low
as possible.
Identifying the Last Two Companies
The two companies left look very much alike, which makes
this last step the hardest. One important difference is that
company D has a lot of other assets, which means it is probably in an intangible capital–intensive industry that has been
consolidating.
Financial Analysis 39
If you follow the pharmaceutical industry, you probably
suspect that company D is Pfizer. Pfizer has had a long string
of acquisitions, from Pharmacia to Wyeth to Hospira, as the
entire industry has consolidated. So company D is Pfizer,
and company F is Microsoft. Another piece of confirmatory
evidence can help us nail this down. You’ll see that company
D has considerably more other liabilities than company F.
That, too, is consistent with D being Pfizer as it has an oldstyle pension plan, while Microsoft, as a much younger company, has a defined contribution pension plan. Finally, you
may know that Microsoft holds large cash balances, which
corresponds to company F.
We did it! That was a really tough game, but if you review these ratios and the underlying logic, you’ll have a great
foundation for understanding the rest of the book.
The Most Important Ratio
After going through all those numbers, is it possible to think
of any one number as the most important number of all?
Which of those many ratios is the most important for managers to focus on?
This question is controversial, but many financial analysts focus on return on equity (ROE), since that number
measures the returns to owners, who are arguably the ul-
FIGURE 1-1
The DuPont framework
Return on equity
(ROE)
= Profitability × Productivity ×
Leverage
Profit
margin
Asset
turnover
Leverage
Net profit
revenue
Revenue
assets
Assets
shareholders’
equity
timate bosses within a company. Because ROE is a widely
used measure, it’s important to understand the factors that
contribute to an ROE. The DuPont framework, a method
of analyzing a company’s financial health originated by
the DuPont Corporation in the early part of the twentieth
century, provides a useful way to understand the levers of
ROE. (See figure 1-1.)
The DuPont framework breaks ROE algebraically into
three ingredients: profitability, productivity, and leverage.
Profitability. The first important contributor to ROE is
how profitable a company is. That goes back to the notion of
profit margin. For every dollar of revenue, how much does it
earn in net profit?
40 How Finance Works
Productivity. Being profitable is important, but an ROE
can be bolstered by productivity as well. To measure a company’s productivity, we use the asset turnover ratio, which
measures how efficiently a company can use its assets to
generate sales.
fect, and two problems stand out. First, because it includes
the effects of leverage, it does not purely measure operational
performance. That’s why some people prefer a return on
capital, which compares EBIT to a firm’s capitalization (debt
plus equity). Second, as we’ll see later, it does not correspond
to the cash-generating capability of a business.
Leverage. As we saw, leverage can magnify returns. It is
also an important contributor to ROE. In this setting, we
can measure leverage by dividing a company’s assets by its
shareholders’ equity.
This simple formula allows you to discover the sources of
a high ROE. Like all other measurements, ROE is imper-
The DuPont Framework in Action
Let’s test our newfound financial intuition by looking at ten
very different companies to see how their determinants of
ROE differ. (See table 1-13.) As we look at the ten companies,
TABLE 1-13
DuPont analysis
ROEs and levers of per formance for 10 diverse companies, 1998
Return on equity (%)
=
Profit margin (%)
×
Asset turnover (times)
×
Bank of America Corporation
=
×
×
Carolina Power and Light
=
×
×
Exxon Corporation
=
×
×
Food Lion, Inc.
=
×
×
Harley-Davidson, Inc.
=
×
×
Intel Corporation
=
×
×
Nike, Inc.
=
×
×
Southwest Airlines Co.
=
×
×
Tiffany and Company
=
×
×
The Timberland Company
=
×
×
Financial
leverage (times)
Financial Analysis 41
we’ll try to answer two questions: First, which of the four
pieces of the DuPont framework is going to be the most similar across these ten very different companies: ROE, profitability, productivity, or leverage? Second, for each portion
of the formula, which companies will have the highest and
lowest values?
For the first question, try to think about why these numbers might be different and what might drive them together.
For the second question, try to think through what each
piece of the Dupont framework represents conceptually.
The answer to the first question is ROE. The range of
ROEs in table 1-14 is much narrower than the range of values in the remaining three columns (just compare the highest to the lowest). So why is ROE the most similar across all
the companies?
While these companies don’t compete in product markets,
they all compete in capital markets. Consequently, the rewards to shareholders can’t deviate too far from each other
because capital will be driven away from low performers
and toward better performers. That’s why ROEs look most
similar.
Should all the ROEs look the same? No, because of
the relationship between return and risk (we’ll do much
more on this in chapter 4). If shareholders bear more risk,
they’re going to demand a higher return. So capital markets
and the competition across companies drive returns to shareholders together and risk drives them apart.
Let’s examine some of the highs and lows of the different
columns, starting with profitability. Profitability for Food
Lion is quite low, 2.7 percent. For Intel, it’s remarkably high.
Why?
While you might be tempted to attribute these gaps to
different levels of competition, the reality is that all these
companies operate in a competitive world. In fact, profitability measures a company’s value addition and varies with
the amount of that value addition. Food retailers just don’t
add much value, so even the very best food retailers get margins of only 4 percent. In contrast, think about Intel. It takes
sand and makes it into computers. That’s real value added.
So profitability is going to reflect that underlying process of
value addition.
Why is Food Lion the highest on asset turnover? What’s
it like to run a grocery store? It doesn’t make money on every
box of cereal sold. The whole game is turning over those inventories as quickly as possible. That’s why asset turnover is the
most important factor in achieving ROE for food retailers.
Finally, as discussed, leverage is a critical tool in finance.
Which companies have high or low leverage? The bank is
highest, but it is also exceptional in its business, so let’s consider the remaining companies.
42 How Finance Works
TABLE 1-14
DuPont analysis
ROEs and levers of per formance for 10 diverse companies, 1998
Return on equity (%)
=
Profit margin (%)
×
Asset turnover (times)
×
Financial leverage (times)
Bank of America Corporation
11.2
=
10.8
×
0.1
×
13.5
Carolina Power and Light
13.5
=
12.8
×
0.4
×
2.8
Exxon Corporation
14.6
=
6.3
×
1.1
×
2.1
Food Lion, Inc.
17.0
=
2.7
×
2.8
×
2.3
Harley-Davidson, Inc.
20.7
=
9.9
×
1.1
×
1.9
Intel Corporation
26.0
=
23.1
×
0.8
×
1.3
Nike, Inc.
12.3
=
4.2
×
1.8
×
1.7
Southwest Airlines Co.
18.1
=
10.4
×
0.9
×
2.0
Tiffany and Company
17.4
=
7.7
×
1.1
×
2.0
The Timberland Company
22.2
=
6.9
×
1.8
×
1.8
Of the remaining companies, which has the highest leverage and the lowest leverage? Carolina Power & Light has the
highest leverage, and Intel has the lowest. Why? Varying levels of leverage reflect the amount of business risk because it is
unwise to pile financial risk on top of business risk. Carolina
Power and Light has stable demand, and its pricing is likely
regulated, so its cash flows are steady. Accordingly, it can sustain higher amounts of leverage.
In contrast, a business that is very high risk, like Intel,
should not carry large amounts of leverage. Think about
what Intel does. It creates a new chip every two years that
does…
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