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THE ESSENTIALS OF FINANCIAL ANALYSIS
By SAMUEL C. WEAVER
The McGraw-Hill Companies, Inc.Copyright © 2012The McGraw-Hill Companies, Inc.
All rights reserved.
THE ROLE AND FUNCTIONS OF ACCOUNTING AND FINANCE
Corporate finance is a middle ground between economics and accounting. Corporate finance is based on theoretical economic concepts applied to the "hard" numbers developed by accountants. Finance uses accounting information to analyze economic events. In a phrase, finance is applied economics. While accounting is the language of business, finance is its literature. Financial analysis provides a systematic approach to making business decisions.
Finance is not an end in and of itself. It is a tool used to monitor, evaluate, and communicate the results of business decisions. Finance is a tool used to assess past events as well as anticipate the consequences of future decisions. It is a tool that is well suited for the board room and the production-shop floor, the executive suite and the distribution center, and corporate and divisional staff offices to a distant sales office. Improving financial performance is the responsibility of every member of the organization, either directly or indirectly.
FINANCE IS EVERYONE'S JOB
In order to take on a general management role or become the head of a business unit or functional unit, every manager must have a working knowledge of finance. He or she must be adaptive in improving day-to-day operations and enhancing the value of the organization. Managers must know how to make strategic investment decisions as well as operational decisions that use the many tools introduced and illustrated in this book.
Large corporations have specific staff to handle financial analysis and to help managers make business decisions. In many organizations, diverse cross- functional project teams are formed to tackle specific assignments. These teams may include members from operations such as sales, marketing, production, and logistics and staff areas such as human resources, engineering, research and development, and legal. These teams often will include a finance professional to help lead and guide the group's efforts toward financially sound decisions. It is important for each functional area to better understand the role of finance and for finance to understand the role of the other functional areas as well as the company's business model, its supply chain, and its strategic direction.
In smaller organizations, it is even more important for functional areas to understand finance and financial implications because often there is no dedicated financial analysis staff to assume responsibility.
Both the nonfinancial professional and the financial professional must be able to understand and clearly communicate financial results and objectives. In a way, all managers are financial managers because everyone has an impact on the bottom line and affects the value of the organization. Whatever your position, you need to know about the following necessary topics to be a more effective member of any business team:
Reading, understanding, and using financial statements
Analyzing financial statements to determine the financial health of a company and its competitors, suppliers, and customers
Managing the supply chain
Planning the financial direction in support of the organization's mission, goals, and objectives
Investing in the business through new products, new facilities, and cost- saving equipment
Financing business growth through various techniques
Determining the intrinsic value of the organization and how to enhance that value
Growing the business via acquisitions
Many members of an organization have bonuses and other compensation tied to achieving certain specific financial goals as well as the organization's common financial objectives. It is important to understand the drivers for attaining those goals as well as the other areas that are affected.
For example, sales and marketing often share an objective centered on top-line (sales) growth. This objective can be achieved easily with price reductions, advertising, or promotions (such as a buy-one-get-one-free offer) and so on. Of course, all those "solutions" have income and cash-flow effects that may have a negative impact on the financial health of the organization. By extending the objectives for the sales and marketing group to include sales and income targets, the situation is partially resolved. However, sales and marketing will quickly learn about extended dating on accounts receivables. That is, instead of 30 days for a customer to pay its bills, customers are given 60 or more days to pay. While there are only minimal indirect income statement effects (i.e., additional interest expense or lost interest income), the balance-sheet implications and additional investment in working capital add pressure to financing availability and even may result in less business reinvestment in other areas.
Engineering, production, logistics, and research may want to manufacture products using the latest equipment with the fastest capabilities in a world class manufacturing facility. However, the financial implications must be understood. That is, does this investment provide an adequate rate of return? What are other business ramifications? Financing limitations may be imposed, balance sheets may be weakened, and business risk may increase substantially. Perhaps a less expensive alternative would provide maximum shareholder value without having a discernible impact on the quality of the product. Capital investment analysis determines the value-enhancement attributes of any capital project, whereas financial strategic planning anticipates the financial impact and assists in ranking alternative approaches.
Business is a series of managed conflicts. Marketing and sales want to sell an infinite variety of products, whereas production would like to produce one product. The conflicts can be resolved through financial information and its valuation impact. It is the systematic and common approach that leads to resolving these tensions successfully. Finance provides a common focus on goal attainment and value enhancement.
Real-world examples and discussions about familiar business topics provide comforting links to finance and business. For example, some engineers and other professionals are familiar with capital budgeting from the technical (or equipment) side but do not understand the financial aspects of the process. Through this book, that gap will be closed, and the professional will appreciate the financial rationale for capital investment analysis.
FINANCE IN THE ORGANIZATIONAL STRUCTURE OF THE FIRM
The nature of finance activities can be explained within the framework of where finance fits in the organizational structure of the firm.
Figure 1-1 provides a picture of a general organization structure. The board of directors represents the shareholders. The chairperson of the board therefore has major responsibilities on behalf of the shareholders. The chief executive officer (CEO) is the highest-ranking company employee. The CEO is involved with the strategic direction of the organization. As shown in Figure 1-1, some corporations have a chief operating officer (COO). The COO is responsible for the day-to-day operations because the divisions and their presidents report directly to the COO.
One of the top executives is the vice president of finance or chief financial officer (CFO), who is responsible for the formulation and implementation of major financial policies. The title maybe enhanced by the title of senior or executive vice president. T
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