TEAMFLY Team-Fly ® COMMENTS ABOUT ERICH A. HELFERT AND THIS BOOK “Erich Helfert’s book is a bona fide treasury for executives, managers, and entrepreneurs who need to understand financial management. I have used and recommended this great work in both corporate and university programs for more than ten years. Erich Helfert pos- sesses unique abilities to make clear the arcane that frequently enshrouds topics of finan- cial management.” Allen B. Barnes Past Provost IBM Advanced Business Institute (formerly Director of Executive Education, UCLA) “Erich Helfert’s book is a candidate for every consultant-to-management’s bookshelf. The underlying agenda is financial management as it pertains to effective resource allocation de- cisions. Framed in a dynamic model of the Business System, the beauty of Helfert’s presen- tation lies in its treatment of subsystems that differentiate between investment, operations and financing decisions, but which are also integrated into the overall managerial fabric.” Stanley Press CMC Book review September 2000 C2M Consulting to Management Journal “Erich Helfert possesses a rare ability to make financial concepts understandable to individu- als who lack a financial background. As a result we had Dr. Helfert conduct shareholder value creation classes for all senior managers and create a shareholder value course for all other salaried and hourly employees. The results of these efforts exceeded our high expectations.” L. Pendleton Siegel Chairman and Chief Executive Officer Potlatch Corporation “Erich Helfert has played an instrumental role in teaching HP managers of both financial and non-financial backgrounds in our long-standing Functional Management Program. His excellent financial overviews and simplified models effectively broaden our managers’ understanding and ownership of their fiscal responsibility to HP and our shareholders.” Robert P. Wayman Executive Vice President and Chief Financial Officer Hewlett-Packard Company “Dr. Helfert’s book and his teachings go a long way toward removing the mystery from the financial workings of an enterprise. His approach allows managers from all areas of the busi- ness to understand how their decisions impact shareholder value.” Stephen E. Frank President and Chief Operating Officer Southern California Edison “Erich Helfert has contributed to the development of financial skills of TRW managers through his case study preparation and presentations, his book Techniques of Financial Analysis, and his instruction. He continues to be included as a highly rated faculty member in TRW’s management development programs.” Peter S. Hellman Past President and Chief Operating Officer TRW Inc. hel78340_FM.qxd 9/27/01 10:56 AM Page i This page intentionally left blank. FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES A Guide for Managers ERICH A. HELFERT, D.B.A. New York Chicago San Francisco Lisbon London Madrid Mexico City Milan New Delhi San Juan Seoul Singapore Sydney Toronto McGraw-Hill hel78340_FM.qxd 9/27/01 10:56 AM Page iii Copyright © 2001 by The McGraw-Hill Companies. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-139541-5 The material in this eBook also appears in the print version of this title: 0-07-137834-0. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trade- marked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corpo- rate training programs. For more information, please contact George Hoare, Special Sales, at george_hoare@mcgraw-hill.com or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create deriv- ative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw- Hill’s prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WAR- RANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUD- ING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or other- wise. DOI: 10.1036/0071395415 abc McGraw-Hill To Anne hel78340_FM.qxd 9/27/01 10:56 AM Page v This page intentionally left blank. ABOUT THE AUTHOR Erich A. Helfert is an internationally recognized management consultant in cor- porate finance, strategic planning, and executive education in financial/economic decision making and shareholder value creation. He gained his professional expe- rience from a combination of distinguished business and academic careers. Dr. Helfert was vice president, corporate planning, at Crown Zellerbach Corpora- tion, a major integrated paper and forest products company. Prior to his 20-year corporate career, he served on the faculty of the Harvard Graduate School of Busi- ness for eight years, teaching finance and managerial economics in the MBA pro- gram, and consulting in management development and strategy with major companies. A native of the Sudetenland, formerly Austria, he received his BS from the University of Nevada and earned both an MBA (with high distinction) and a DBA (as a Ford Foundation Fellow) at the Harvard Business School. Dr. Helfert writes and lectures extensively in his field, and his books and articles have been pub- lished in the United States and abroad. His first literary work, Valley of the Shadow, a factual historical novel about his experiences in central Europe at the end of World War II, was published recently. Dr. Helfert is cofounder, chairman and CEO of Modernsoft, Inc., San Ma- teo, California, developers of Financial Genome, an advanced knowledge-based financial analysis and business modeling software, which is complementary to Fi- nancial Analysis: Tools and Techniques. vii hel78340_FM.qxd 9/27/01 10:56 AM Page vii Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. This page intentionally left blank. ix CONTENTS Preface xvii Introduction xxi Chapter 1 The Challenge of Financial/Economic Decision-making 1 Lessons for the Millennium 2 The New Economy 2 Some Key Questions 3 The Basics Never Change 6 The Economic Manager 7 Understanding Business Economics 8 Appropriate Economic Tools 9 The Practice of Financial/Economic Analysis 10 Day to Day Decisions and Operational Planning 10 Supporting Strategy Development 11 Performance Assessment and Incentives 12 Valuation and Investor Communications 14 The Value Creating Company 15 Relevant Decision Information 15 Economic Incentives 17 Total Systems Management 18 Chapter 2 A Systems Context for Financial Management 21 A Dynamic Perspective of Business 22 Decision Context 22 The Business System 26 Investment Decisions 29 Operating Decisions 31 Financing Decisions 33 Interrelationship of Strategy and Value Creation 36 hel78340_FM.qxd 9/27/01 10:56 AM Page ix Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. [...]... Projection of Financial Requirements 16 1 Pro Forma Financial Statements 16 3 Pro Forma Income Statement 16 4 Pro Forma Balance Sheet 16 7 Pro Forma Cash Flow Statement 17 1 Cash Budgets 17 4 Operating Budgets 17 8 Sales Budget 17 9 Production Budget 18 1 Interrelationship of Financial Projections 18 1 Financial Modeling 18 4 Sensitivity Analysis 18 6 Key Issues 18 7 Analytical Support 18 9 Chapter 6 Dynamics and Growth... Earnings 12 1 Market Indicators 12 3 Lenders’ Point of View 12 6 Liquidity 12 6 Financial Leverage 12 8 Debt Service 13 0 Ratios as a System 13 2 Elements of Return on Assets 13 3 Elements of Return on Equity 13 4 Integration of Financial Performance Analysis 13 7 Some Special Issues 13 9 Inventory Costing 14 0 Depreciation Methods 14 1 The Impact of Inflation 14 4 Key Issues 14 5 Analytical Support 14 7 Chapter 5... Restructuring and Combinations 411 Restructuring and Value 411 xv hel78340_FM.qxd 9/27/ 01 10:56 AM Page xvi xvi Contents Combinations and Synergy 414 Combinations and Share Values 415 Integration of Value Analysis 417 Perspectives 418 Expectations 419 Time Period 419 Cash Flow Pattern 419 Ongoing Values 420 Comparables 420 Negotiations 4 21 Key Issues 4 21 Analytical Support 423 APPENDIX I Financial Analysis... Growth of the Business System 19 1 Leverage 19 2 Operating Leverage 19 3 xi hel78340_FM.qxd 9/27/ 01 10:56 AM Page xii xii Target Profit Analysis 202 Financial Leverage 203 Financial Growth Plans 209 Basic Financial Growth Model 210 Sustainable Growth and the Sustainable Growth Equation 214 Integrated Financial Plan 217 Key Issues 220 Analytical Support 222 Chapter 7 Cash Flows and the Time Value of Money... company we address next hel78340_ch 01. qxd 9/27/ 01 10:58 AM Page 10 10 Financial Analysis: Tools and Techniques The Practice of Financial/ Economic Analysis The financial/ economic analysis sponsored and used by the economic manager can be viewed within a broad hierarchy of decision-making needs The diagram in Figure 1 1 shows four key areas in the typical business where financial/ economic analysis is a... the investing community 1 Copyright 20 01 The McGraw-Hill Companies, Inc Click Here for Terms of Use hel78340_ch 01. qxd 9/27/ 01 10:57 AM Page 2 2 Financial Analysis: Tools and Techniques For many years the purpose and contribution of this book have been to help make financial/ economic analysis a practical, understandable and usable process for managers and analysts, and we argue with conviction that applying... Management and Shareholder Value 89 Cash Management 89 Working Capital Management 90 Investment Management 91 Key Issues 91 Analytical Support 93 Chapter 4 Assessment of Business Performance 95 Ratio Analysis and Performance 95 Management’s Point of View 97 Operational Analysis 98 Resource Management 10 7 Profitability 11 2 Owners’ Point of View 11 5 Investment Return 11 6 Team-Fly® hel78340_FM.qxd 9/27/ 01 10:56... hel78340_ch 01. qxd 9/27/ 01 10:58 AM Page 11 CHAPTER 1 The Challenge of Financial/ Economic Decision-Making 11 of-the-pants decision-making can become the ingrained way of doing things, unless the company has instilled a basic sense of decisional discipline and provided guidance through simple but useful decision rules and processes The successful company will have an integrated set of metrics and criteria, and. .. relationship to financial statements and analytical tools as presented in Chapter 2 The coverage of analytical methods begins in Chapter 3 with funds flow analysis, moves on to financial performance analysis, covers financial projections, and culminates in a discussion of the financial dynamics useful in modeling financial conditions and growth capabilities Chapters 7 through 11 deal with more specialized... hel78340_FM.qxd 9/27/ 01 10:56 AM Page xiv xiv Cost of Shareholders’ Equity 305 Preferred Stock 305 Common Equity 306 Weighted Cost of Capital 312 Cost Choices 312 Weighting the Proportions 313 Calculating the Weighted Cost of Capital 315 Cost of Capital and Return Standards 317 Cost of Capital as a Cutoff Rate 318 Risk Categories 319 Cost of Capital in Multibusiness Companies 3 21 Multiple Rate Analysis . 17 1 Cash Budgets 17 4 Operating Budgets 17 8 Sales Budget 17 9 Production Budget 18 1 Interrelationship of Financial Projections 18 1 Financial Modeling 18 4 Sensitivity Analysis 18 6 Key Issues 18 7 Analytical. Restructuring and Combinations 411 Restructuring and Value 411 hel78340_FM.qxd 9/27/ 01 10:56 AM Page xv xvi Contents Combinations and Synergy 414 Combinations and Share Values 415 Integration. xi Disposition of Earnings 12 1 Market Indicators 12 3 Lenders’ Point of View 12 6 Liquidity 12 6 Financial Leverage 12 8 Debt Service 13 0 Ratios as a System 13 2 Elements of Return on Assets 13 3 Elements of