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Corporate financial analysis with exxcel


Corporate
Financial
Analysis
with

Microsoft
Excel
®


This page intentionally left blank


Corporate
Financial
Analysis
with

Microsoft
Excel

®

Francis J. Clauss

N e w Y o r k    C h i c a g o    S a n F r a n c i s c o    L i s b o n    L o n d o n    M a d r i d    M e x i c o C i t y  
M i l a n    N e w D e l h i    S a n J u a n    S e o u l    S i n g a p o r e    S y d n e y    T o r o n t o


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Contents

Preface   vii
Introduction: An Overview of Financial Management   xi

1: Corporate Financial Statements   1
2: Analysis of Financial Statements   35
3: Forecasting Annual Revenues   69
4: Turning Points in Financial Trends   123
5: Forecasting Financial Statements   167
6: Forecasting Seasonal Revenues   185
7: The Time Value of Money   213
8: Cash Budgeting   251
9: Cost of Capital   291
10: Profit, Break-Even, and Leverage   317
11: Depreciation and Taxes   343


vi  ❧  Contents

12: Capital Budgeting: The Basics   363
13: Capital Budgeting: Applications   401
14: Capital Budgeting: Risk Analysis with Scenarios   435
15: Capital Budgeting: Risk Analysis with Monte Carlo Simulation   455
Epilogue   485
Index   489


Preface

In today’s global economies, spreadsheets have become a multinational language. They are the tools of
choice for analyzing data and communicating information across the boundaries that separate nations.
They have become an important management tool for developing strategies and assessing results.
Spreadsheets have also become an important tool for teaching and learning. They have been widely
adopted in colleges and universities. They have the advantage of being interactive, which makes them
ideal for teaching on the Internet as well as self-learning at home.
Corporate Financial Analysis with Microsoft Excel teaches both financial management and spreadsheet programming. Chapters are organized according to the essential topics of financial management,
beginning with corporate financial statements. The text discusses management principles and provides
clear, step-by-step instructions for using spreadsheets to apply them. It shows how to use spreadsheets for
analyzing financial data and for communicating results in well-labeled tables and charts. It shows how to
be better managers and decision makers, not simply skilled spreadsheet programmers.
The text assumes no more knowledge of computers and spreadsheets than how to turn a computer
on, how to use a mouse, and how to perform the arithmetic operations of addition, subtraction, multiplication, and division. The first chapter begins with instructions for such basic spreadsheet actions as entering text and data, using cell references to express the relationships between items on spreadsheets and to
calculate values, editing and formatting entries, and so forth. By the end of the text, the reader will have a


viii  ❧  Preface

working knowledge of a variety of financial functions available in Excel for such things as the time value
of money and the payoffs of capital investments. He or she will also know how to use Excel’s powerful
tools for forecasting, doing sensitivity analysis, optimizing decisions, and using Monte Carlo simulation
to evaluate risks. In short, anyone who studies the text will acquire a toolbox of spreadsheet skills that will
help him or her understand and apply the principles of financial management—and be better prepared
for a successful career in the business world.

Models Rather Than Solutions
Corporate Financial Analysis with Microsoft Excel shows how to create models that provide realistic information. Unlike pocket calculators, which are limited in their output, spreadsheet models can supply solutions over a wide range of conditions and assumptions. Models help identify what must be done to achieve
desired results, determine the best strategies and tactics for maximizing profits or minimizing losses, identify conditions that must be avoided, or prepare for what might happen. Learning from models is cheaper,
faster, and less hazardous than learning from real life. Spreadsheet models make this possible.

Managing Risks
Global competition puts a premium on the ability to handle risk. Although it may not appear as a separate
item in a CFO’s job description, risk assessment underlies all financial decisions. Risk is a high-stakes
game of “What if?” analysis. Corporate Financial Analysis with Microsoft Excel shows how to use Monte
Carlo simulation and other spreadsheet tools to gamble like a professional—without the cost. A bit of
intelligent programming is the only ante needed to play the game. Spreadsheets help define the risks
due to uncertain customer demands, the ups and downs of business cycles, changes by competitors, and
other conditions outside a manager’s control. In place of expensive experiments or learning in the school
of hard knocks, you can use spreadsheet models to assess the risks and impacts of contemplated actions
without actually taking them.

Teamwork
Increased worldwide competition and a market-driven economy have forced corporations to restructure
their functional hierarchies in ways that promote teamwork. Rigid hierarchies that once divided finance,
marketing, production, quality control, and other business functions are disappearing. In their place,
functions and responsibilities are being shared in tighter alliances between areas of specialization. These
changes extend outside corporate walls to subcontractors and suppliers.

The Enabling Role of IT
Information technology (IT) is the essential tool that enables a corporation to think globally and act
locally. IT is the backbone of today’s management information systems that corporations use to achieve
higher levels of teamwork. Spreadsheets, databases, and special software are the “nuts and bolts” of ERP
and other systems that link computer networks and telecommunication systems and that create extended
teams.


Preface  ❧  ix

Better Than Algebra
Most students are already familiar with spreadsheets by the time they enter college or complete their freshmen year. It is safe to say they understand the basic principles of spreadsheets better than those of algebra.
Row and column labels transform the values in a spreadsheet’s cells into concrete concepts rather than the
abstract notations of algebraic formulas. They help one visualize the logical relationships between variables much better than equations with Xs and Ys. Spreadsheets simply provide a better way than algebra
to learn any subject that involves understanding numbers.

Communicating
Spreadsheets are used to prepare tables and charts for making presentations that can be easily understood
by others and that justify recommended courses of action. Spreadsheets are much more than sophisticated
calculators. They are “digital storytellers” that can help you get your message across to others.

A Proven Text
Corporate Financial Analysis with Microsoft Excel is the result of the author’s use of spreadsheets for teaching financial management over a four-year period. Classes have been conducted at both the graduate and
undergraduate level. The text has been used for teaching in a classroom as well as for distance-learning
on the Internet (via the CyberCampus system at Golden Gate University in San Francisco).

Skills Pay the Bills
Students have found that spreadsheets make learning easier and enhance their understanding of the
complexities of financial management. The spreadsheet skills they have acquired have helped many of
the author’s students gain employment and earn raises and promotions. That is the success story related
by numerous students who have studied Corporate Financial Analysis with Microsoft Excel and applied
its teachings.

Understanding
Spreadsheets are outstanding pedagogical tools for both teaching and learning. They are akin to the popular Sudoku puzzles in having an arrangement of columns and rows. Like Sudoku puzzles, spreadsheets
teach an understanding of the logical relationships between cell entries. Of course, a spreadsheet for a
company’s financial statements, or its month-to-month cash budget, or the projected cash inflows and outflows of expansions of corporate facilities is much larger and complex than a Sudoku grid. Students in the
author’s classes have repeatedly stated that financial modeling with spreadsheets helps them understand
much better the inner workings of corporations and the strategies and tactics of business management
for operating in worldwide markets. The interactive feature of spreadsheets, with immediate feedback for
the results of their decisions in creating and using models, has provided challenges that keep students
actively engaged in the process of learning. After more than half a century in the business and educational
fields, the author finds spreadsheets to be a most useful pedagogical tool. Student response confirms that
belief.


x  ❧  Preface

An Appreciation
The author has been blessed with an outstanding bunch of students in his graduate classes. Most were
working full time to support themselves and their families while attending “distance-learning” classes
on Golden Gate University’s CyberCampus. They were mature, most with 10 to 20 years of real-life
business experience. Their jobs ranged from entry level to managers and executives, with a few CFOs,
CEOs, and vice presidents. They were eager to learn and invested a great deal of their time in doing the
weekly homework assignments and posting their responses to my questions for discussion. They shared
their experiences and how they coped with problems. Their places of business and their experience were
worldwide—one of the advantages of teaching a class on the Internet. Their feedback has been invaluable in shaping and improving Corporate Financial Analysis with Microsoft Excel, The author is deeply
indebted to them.
Francis J. Clauss
Golden Gate University
San Francisco, California


Introduction
An Overview of Financial Management

Before plunging into the creation of Excel models for financial management, it is worth a brief stop to
look at the following:
• The functions and responsibilities of financial managers
• The position of financial managers and their functions in a corporate hierarchy
• The relationship of financial management to other functions, such as production and operations, marketing, sales, and quality control.
• The importance of teamwork and communications
• The role of information technology in financial management
• The role of spreadsheet models in financial management

Functional Specialization and Linkages
Today’s corporations need many talents—more than any individual or business discipline can provide.
Here are a just a few of the more obvious business functions that need different talents:
• Serving customers
• Manufacturing a variety of products
• Conducting research and developing new products


xii  ❧  Introduction










Investing in facilities and equipment
Controlling the quality of goods and services
Ordering and receiving goods from suppliers.
Distributing goods to worldwide markets
Paying workers and suppliers
Hiring workers with various types and levels of skills
Collecting sales revenues from customers
Managing short-term investments and borrowings

Individuals with the different talents needed to operate a business are organized in a hierarchy of
departments. At the lowest levels, workers perform the specific functions and responsibilities assigned to
them. At the upper levels, managers direct and coordinate the levels below them.
The concept of an organizational structure according to specific functions and responsibilities is simple.
Implementing it can be difficult. At their best, business organizations are models of efficiency. At worst, they
are wasteful bureaucracies. When bureaucracies run amok, the inevitable results are administrative delays,
poor service, shoddy products, late deliveries, high costs, alienated customers, and eventual bankruptcy.
Think of a business as a chain consisting of links. Just as a chain is no stronger than its weakest link,
so a business organization is no stronger than its weakest function. And just as a chain is a joining of
many links to form a structural network, so business organizations are chains of separate functions joined
together in a common enterprise.
Financial managers are an essential part of corporate networks. Their functions are inextricably
linked to those of other managers, both financial and nonfinancial. Success depends on how well each
does his or her job, and how well they work together as separate parts of the same corporate team.
As we develop financial models in the chapters that follow, keep in mind the concept of chains,
linkages, and networks—and the need for all parts to work together.

Organizational Charts
Perhaps the quickest way to get a picture of corporate structures and the roles of financial managers is to
look at an organizational chart. Figure 0-1 shows a typical organizational chart of the upper and lower
levels of management for a manufacturing company. There are many variations on the chart shown, but
this functional layout is generally followed.
A Board of Directors is elected by the company’s stockholders to represent their interests as the
company’s owners. A corporate board is headed by a Chairman of the Board and typically has a number
of standing committees, such as an executive committee, a finance committee, an auditing committee, a
human resources and compensation committee, and others.
The president reports to the Board of Directors and is usually designated the firm’s Chief Executive
Officer (CEO). Immediately below the company president is the executive vice president, who may be
designated the Chief Operating Officer (COO). An administrative vice president and an executive staff


An Overview of Financial Management  ❧  xiii
Figure 0-1

A Basic Organizational Chart for a Manufacturing Company, which Shows Upper- to
Middle-Management Levels of Various Functions

Board of Directors

President or
Chief Executive Officer

Executive
Vice President

Administrative
Vice President

Vice President
of Finance
Treasurer

Executive
Staff

Vice President
of Sales and Marketing

Vice President
of Operations

Sales

Plant Manager

Financial Planning

Marketing

Engineering Design

Cash Management

Distribution

Purchasing

Credit Management

Market Research

Quality Control

Capital Investment

Product Planning

Receiving and Shipping

Portfolio Management
Controller
Financial Accounting
Cost Accounting
Tax Management
Data Processing


xiv  ❧  Introduction

are common in large companies. A firm’s legal counsel is usually part of the executive staff. Members of
the staff have advisory positions rather than line or functional responsibilities.
The vice presidents of finance, sales and marketing, and operations are line positions that are
responsible for actually carrying out the company’s business. The vice president of finance is usually the
company’s chief financial officer (CFO). The essential functions of financial management are separated
between those reporting to the company’s treasurer and those reporting to its controller. Data processing
is an important support function under the vice president for finance, although it is often a function at
the vice-presidental level itself.
The details of how functions and responsibilities are organized vary from company to company and
from industry to industry. Therefore, the organizational chart of any company will differ in details from
Figure 0-1.
The structure shown in Figure 0-1 for financial management is common to many types of companies. The structures for sales and marketing and for operations, however, vary with the industry. For
example, the vice presidents for sales or sales directors of hotels have separate functional managers under
them for marketing to conference groups and to the tour industry. The sales directors of airlines have
separate functional managers for passenger sales and cargo sales, as well as administrators responsible for
reservations, schedules, and tariffs.
The organizations for companies in service industries also vary from that shown in Figure 0-1, which
is typical for a manufacturing company. For example, the operating functions of hotels are divided between
a front desk manager, executive housekeeper, chief operating engineer, materials manager, and security
manager. The responsibilities of the materials manager are further divided into those for the food and
beverage manager, restaurant and café manager, room services manager, and catering manager. Airline
operations are divided into flight operations, ground operations, and flight equipment maintenance.
Anyone interested in managing would do well to study organizational charts. Study those of the
company for which you work or would like to work. Understand the functions and responsibilities that go
with each box, and how the boxes are related to each other. Do the same with the organizational charts
of other firms that are available, especially those of competitors. Learn how companies are organized and
how your functions and responsibilities interface with others. Companies value employees who know how
to be members of their team.

A Quick Look at the F&Rs of Chief Financial Officers
Chief Financial Officers (CFOs) are responsible for their firm’s financial management. Their functions
and responsibilities (F&Rs) have three major components. The first is categorized as their controllership
duties. These are backward-looking activities that deal with compiling and reporting historical financial
information such as a company’s financial statements. This information, in turn, is based on the firm’s
financial and cost accounting systems. Shareholders, investors, analysts, and creditors, as well as the company’s upper and lower levels of managers, rely on the accuracy and timeliness of the data and reports
for their actions. The second deals with treasury duties. These deal with the firm’s current and ongoing


An Overview of Financial Management  ❧  xv

activities, such as: deciding the firm’s capital structure (i.e., determining the best mix of debt, equity,
and internal financing); deciding how to invest the company’s money, taking into consideration risk and
liquidity; and managing cash inflows and outflows. The third deals with strategic planning. This is a
forward-looking activity. It includes economic forecasting of the future of the company and the impacts
on it of future changes in markets, competition, and the general economy. It includes using forecasts to
position the company for future profitability and long-term survival.

Teamwork
Organizational charts show the division of functions and responsibilities. Teamwork is what puts them
back together and combines the parts into an effective organization. Success depends on how well the
parts work as a team. Collaboration is more than just a good idea; it is the only way to survive the challenges that confront modern corporations.
As companies grow in size, the administrative levels between executives at the top and workers at
the bottom grow in number. The administrative levels form a loop that routes directions and commands
down to the line organizations, which actually provide service and goods to customers, and then collects
information at the working level and passes it up in the form of reports to those at the top. Top-heavy
structures discourage teamwork and reduce efficiency.
Entrenched ways of thinking or doing business are difficult to displace. A crisis is often needed to
provide the impetus for change. World War II was such a crisis. It brought together the team that created
the world’s first atomic bomb, the weapon that hastened the end of World War II.
The code name for the atomic bomb’s development was the Manhattan Project. It assembled a team
of scientists, led by the brilliant physicist J. Robert Oppenheimer, and sequestered them in an isolated
community in the Jemez Mountains of New Mexico. That community became the city of Los Alamos.
The team was given the unlimited support of the U.S. government under the direction of Major General
Leslie R. Groves. The incredibly complex technical details of the bomb’s development need not be
recited here. What is significant is that the members of the team surmounted all the problems and detonated the first man-made atomic explosion at the Trinity Site in New Mexico on July 16, 1945. The team
accomplished this feat in only 28 months. To put this accomplishment in perspective, Detroit automakers
still take three years or more to design a new automobile and get it into production.
The demonstration at Trinity Site was followed three weeks later, on August 6, with the dropping of
the first atomic bomb on Hiroshima, Japan. On August 9, a second bomb was dropped on Nagasaki. Japan
gave up the struggle five days later. On September 2, formal surrender ceremonies were held aboard the
battleship USS Missouri that ended World War II.
What the Manhattan Project demonstrates so well is the power of interdisciplinary teamwork. That it
took a wartime crisis to bring such a team together is also worth noting. As attempts to change peacetime
private industry have since demonstrated, it often takes a corporate crisis to overcome the resistance to
change administrative structures. The crisis needed to restructure an entrenched hierarchy into an efficient workforce may be a face-to-face confrontation with bankruptcy as the alternative.


xvi  ❧  Introduction

Despite opposition to change, the concepts of interdisciplinary teamwork that succeeded at Los
Alamos are being applied today to make corporations more effective and competitive. Their focus is on
doing a job, not on maintaining an organization. The purpose of the organization is to do the work, rather
than the purpose of the work is to justify an administrative hierarchy. Corporate restructuring is based
on that simple concept—to determine how best to provide goods and services to customers, and then to
organize the functions around the activities and processes for doing the work.
The concept of teamwork appears throughout this book. In real life, it is often disguised as a buzzword
like “concurrent design” when discussing product design and the interactions between design engineers,
manufacturing specialists, and procurement personnel. Financial managers use the term “activity-based
costing” for accounting systems that identify the activities and organizations responsible for costs rather
than collecting costs at an aggregate level, which rather defeats the purpose of cost control. (The importance of activity-based costing is discussed in Chapter 8: Cash Budgeting.) Other terms are “total quality
management” or “TQM” when the focus is on product quality, and “Just-in-Time” or “JIT” when discussing inventory management. Learn the buzzwords because they are part of today’s jargon. More than that,
learn what they really mean, and don’t let any huckster con you into a myopic view of how to apply them.
Many with shortsighted understandings failed when they tried to implement buzzword concepts without
recognizing their widespread consequences. The true essence of each is teamwork—truly corporate-wide
teamwork that enlists personnel in the corporate enterprise regardless of their workplaces and to whom
they report.
In terms of the organizational structure of Figure 0-1, teamwork means eliminating the up-and-down
ladders of administrative levels that keep workers from working together. Instead of imposing vertical
movements along “chains of command,” the corporate structure is “flattened out” so that workers can
move horizontally between organizations and work as teams.

Information Technology and Management
Computer-based management information systems (MISs) are management tools that facilitate teamwork. Their development can be traced to computer-based cost accounting systems and to the Materials
Requirements Planning systems introduced into factories in the 1970s. Today’s MISs are corporate-wide.
They go by various names, such as Enterprise Planning Systems. In a very real sense, they replace the
rungs on administrative ladders.
Figure 0-2 shows the Forecast-Plan-Implement-Control Loop that is an important part of an MIS.
Each box contains a brief summary of what it should contain.
MISs collect detailed data on a variety of costs, how well services and goods satisfy quality requirements, how well customers are satisfied, and other criteria used to evaluate business operations. They
accumulate the data in huge databases. Spreadsheets and special software are used to withdraw values
from the databases and convert them to information, and then assemble the information in the form of
reports, tables, and charts.


An Overview of Financial Management  ❧  xvii
Figure 0-2

The Forecast-Plan-Implement-Control Loop of Management Information Systems
EXTERNAL DATA
(General economic conditions,
technological advances, changes
in social customs and mores, etc.)

FORECAST
(Demand, sales, costs, etc.)

CONTROL
(Production output, costs,
quality levels, scrap rates,
customer satisfaction, etc.)

PLAN
(Capital investments, budgets,
schedules, inventory levels,
resource commitments, etc.)

TAKE ACTION
(Implement plan)
INTERNAL DATA
(Sales records, cost account
reports, financial records, etc.)

Information technology and MISs have expanded the boundaries of teamwork. It is no longer necessary or desirable to sequester team members in an isolated community that forces them to work together,
as in the wartime Manhattan Project. Members of international teams now communicate in computerbased languages they all understand, draw data for analysis from common databases, and exchange information at electronic speeds.
Figure 0-3 is a simple example of the concept of using information technology to show organizational linkages and promote understanding and teamwork. It is a spreadsheet that shows the essential elements of a corporate income statement, and the results of different strategies to improve profits. (We will
look at the details of income statements and other financial statements in the first and later chapters.) The
spreadsheet is simply a matrix of rows and columns for organizing the information. To simplify discussion,
the row numbers and column code are included in Figure 0-3.
Column B shows the base conditions. The company has annual revenues of $1 million (Cell B9).
Its cost of goods sold (COGS) is 60 percent of the sales revenues, its selling and other expenses are 30
percent of the sales revenues, and its tax rate is 35 percent of its net operating income (Cells B5:B7). With
these starting values, COGS is computed as $600,000 in Cell B10 (i.e., 60% of $1 million, or the product
of the values in Cells B5 and B9) and the firm’s gross profit is computed as $400,000 in Cell B11 (i.e.,
revenues of $1 million in Cell B9 minus COGS of $600,000 in Cell B10). Selling and other expenses are


xviii  ❧  Introduction
Figure 0-3

Evaluation of Three Strategies for Improving After-Tax Profits
A

Base

C
Strategy 1
Increase
Sales
Revenue
10%
60%
30%
35%

Base
Cost of goods sold (COGS), as percent of sales
60%
Selling and other expenses, as percent of sales
30%
Taxes, as percent of net income
35%
Income Statement
Annual sales revenues
$ 1,000,000 $ 1,100,000
Cost of goods sold
600,000
660,000
Gross profit
$ 400,000 $ 440,000
Selling and other expenses
300,000
330,000
Net operating income
$ 100,000 $ 110,000
Taxes
35,000
38,500
After-tax profit
$
65,000 $
71,500
Improvements from Base Conditions
Increase in after-tax profit, dollars
na
$6,500
Increase in after-tax profit, percent
na
10%

D

E

Strategy 2
Reduce
Selling and
Other
Expenses
10%
60%
27%
35%

Strategy 3
Reduce Cost
of Goods
Sold
10%
54%
30%
35%

$ 1,000,000
600,000
$ 400,000
270,000
$ 130,000
45,500
$
84,500

$ 1,000,000
540,000
$ 460,000
300,000
$ 160,000
56,000
$ 104,000

$19,500
30%

$39,000
60%

$120,000

AFTER-TAX PROFIT

3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34

B

IMPROVING THE “BOTTOM LINE” OF AN INCOME STATEMENT

1
2

$100,000
$80,000
$60,000
$40,000
$20,000
$-

Base

Strategy 1

Strategy 2

Strategy 3

computed as $300,000 in Cell BB12 (i.e., 30% of $1 million, or the product of the values in Cells B6 and
B9). Net operating income is computed as $100,000 in Cell B13 (i.e., Cell B11 minus Cell B12). Taxes
of $35,000 are computed in Cell B14 (i.e., 35% of $35,000, or the product of the values in Cells B7 and
B13). After-tax profit of $65,000 is computed in Cell B15 (i.e., net operating income in Cell B13 minus
taxes in Cell B14).
Columns C, D, and E show the results for three different strategies the company might use to
increase profit. Strategy 1 is to increase sales by 10 percent, strategy 2 is to reduce selling and other


An Overview of Financial Management  ❧  xix

expenses by 10 percent, and strategy 3 is to reduce COGS by 10 percent. Implementing the first strategy
requires actions primarily by the sales and marketing organizations, implementing the second requires
actions by various organizations, and implementing the third requires actions by the operations organization (e.g., improve any or all of the functions shown in Figure 0-1 for which the vice president of
operations is responsible). Note that a change of 10 percent in different functions produces significantly
different changes in profits.
Although the example is intentionally simple, it illustrates some important concepts. First, financial
results follow from actions in the various parts of a corporation. The results follow a path expressed by the
linkages between functions on the organization chart of Figure 0-1. Second, the linkages between organizations and between actions and results can be expressed by entries in the cells of spreadsheets. Third,
as a result of the first two, spreadsheets are extraordinarily powerful management tools—not merely for
calculating results for given conditions, but also for analyzing the interactions between organizations and
for evaluating the impacts of actions taken by different parts of a corporation. It also follows that spreadsheets are powerful management tools for promoting teamwork across organizational boundaries, as well
as powerful teaching tools for understanding business functions and their interrelationships.

Communicating
Spreadsheets are much more than sophisticated calculators. Their value is as much for communicating as
for calculating. They can help provide transparency into a corporation’s workings. They are easily incorporated into reports and management presentations.
Successful CFOs need to communicate clearly, fully, and honestly. Failure to do that caused a
number of corporate scandals in the recent past. Investors were misled by financial shenanigans at Enron,
WorldCom, Global Crossing, and other major corporations that filed for bankruptcy. Between 1997 and
2000, for example, Enron reported an annual growth of 70 percent in its annual revenues and 35 percent
in operating profit by moving debt off its books and other accounting tricks. Too late, lenders and other
investors discovered that true revenues were lower than reported, debt levels were higher, and prospects
for growth were less favorable. They began suing corporations and their executives, threatening them with
large dollar penalties and prison terms. In addition to honesty, they insisted on better transparency into
corporate performance.
Chief financial officers are no longer narrowly focused on the mechanics of finance. Duties that
once were transaction-intensive are now knowledge-intensive.
Today’s CFOs must be forward looking. They are responsible for planning that looks far into the
future and across broader markets. They are strategic partners in negotiating global alliances, managing
the risks of huge gambles, and organizing new corporate structures. They work closely with corporate
boards, the investment community, financial markets, and government regulatory agencies.
Together with chief executive officers, CFOs are the faces of business. They are the leaders for
creating teams at the corporate and working levels.


xx  ❧  Introduction

Spreadsheets as Tools for Financial Management
Life is complex. The famed naturalist John Muir likened the natural environment to a giant spider web.
“Touch just one strand and the whole web vibrates in response,” he pointed out. Corporations are also like
giant spider webs of interlocking functions and responsibilities. What happens in one part affects all.
Today, the functional elements of large corporations are linked together by system of computers and
software called enterprise management systems. The largest and best known of these are ORACLE and
SAS. Such systems do the “heavy lifting” for managing corporate-wide operations. Yet, even in corporations with such systems, many managers have installed Excel on their office computers and use it for
accessing information from corporate databases, analyzing it, and preparing reports.
Excel is entirely adequate for handling many business problems. It is more convenient, more accessible, and less costly than enterprise management systems. Indeed, using a large enterprise management
system to analyze problems that spreadsheets can handle easier and faster is like using an elephant gun to
shoot squirrels. Each has its proper place and use.
Excel is essentially a complete small-scale enterprise management system itself with substantial
power. Unfortunately, its capabilities are largely under-appreciated and overlooked. Excel can handle
much larger problems than most users recognize—including those who have used it for years. It is flexible
and can solve a wide diversity of financial and other business problems.
Students in the author’s classes have all, in fact, used Excel before, many for ten years or longer
on their jobs. Yet none were fully aware of all that Excel offers for doing their jobs better and easier.
Practically none had used it for doing Monte Carlo simulation or sensitivity analysis. Few knew how to
use Excel to evaluate the impact of changes in corporate strategies or tactics. Few knew how to use Excel
to calculate the risks for operating in an uncertain world. Many, in fact, had been unaware of even such
simple Excel tools as sorting, conditional formatting, and regression analysis or the commands for the time
value of money. You don’t need an enterprise management system to do these things. What you need is
to improve your Excel spreadsheet skills, which is one of this book’s goals.
But sound financial management requires more than spreadsheet skills. This book is also intended
to help you apply spreadsheet skills to improve your management skills.
As a financial manager, don’t take a narrow view of your job. Recognize your relationship to others in
the business. Understand their functions and responsibilities as well as your own, and how they’re related.
Understand the linkages in teamwork and how to make them. Use Excel in any financial analysis to help
link the functions in corporate networks, just as enterprise management systems can do. And use Excel to
communicate and coordinate as well as to calculate.


Chapter 1

Corporate Financial Statements

CHAPTER OBJECTIVES



















Management Skills
Identify the three key financial statements of corporations (i.e., the income statement, balance
sheet, and statement of cash flows) and describe their contents and purposes.
Follow the standard formats for organizing items on financial statements.
Interpret the items on financial statements and recognize how they’re related.
Recognize when errors have been made in financial statements.
Spreadsheet Skills
Create spreadsheets for financial statements.
Organize the content of spreadsheets in logical formats.
Label rows and columns to communicate clearly as well as to calculate correctly.
Enter data values to show the basis for calculated values.
Formulate and enter expressions to calculate values.
Wrap text in rows or columns.
Use cell references in expressions for calculated values that link the cells to other cells with data
or other calculated values.
Format values.
Hide rows or columns of financial statements so that only selected ones are displayed.
Link worksheets so that entries or values on one worksheet can be used for calculating values on
another worksheet in the same workbook.
Use Excel’s Formula Auditing tool to examine cell linkages.
Where possible, include tests that automatically detect errors or validate results.


2  ❧  Corporate Financial Analysis with Microsoft Excel®

Overview
A firm’s financial health is summarized in three key financial reports: (1) the income statement, (2) the
balance sheet, and (3) the cash flow statement. These reports summarize detailed information on a firm’s
financial actions during the preceding fiscal year and its financial position at the end. The Securities and
Exchange Commission (SEC) requires every corporation to include these reports in its annual stockholders’ report for at least the two most recent years.
Annual statements cover one-year periods ending at a specified date. For most firms, the ending
date is the end of the calendar year. Many large corporations, however, operate on 12-month cycles (or
fiscal years) that end at times other than December 31. In addition to annual reports to stockholders,
corporations usually prepare monthly statements to guide a corporation’s executives, as well as quarterly
statements that must be made available to stockholders of publicly held corporations.
Financial statements are based on values from a firm’s cost accounting system. The statements
follow the generally accepted accounting principles (GAAP) recommended by the Financial Accounting
Standards Board (FASB), which is the accounting profession’s rule-setting body. In addition to the financial statements, annual stockholders’ reports usually contain the president’s letter and historical summaries of key operating statistics and ratios for the past five or ten years.
The information in financial statements is used in several ways. Regulators, such as federal and state
security commissions, use it to enforce compliance by providing proper and accurate disclosures to stockholders and investors. Lenders or creditors use the reports to evaluate the credit rating of firms and their
ability to meet scheduled payments on existing or contemplated loans. Investors base their decisions to buy,
sell, or hold the corporation’s stock on the information in the reports. Corporate financial managers use the
information to ensure compliance with regulatory requirements, to satisfy creditors and shareholders, and
to monitor the firm’s performance. They also use the information to determine the value of other firms they
are thinking of buying, or the value of their own firms as a basis for negotiating a selling price. Employees
peruse financial statements to assess how well their firm is doing and to compare its current performance
with earlier periods. Corporate executives and boards of directors often view their annual stockholders’
reports as tools for marketing the company and its products and for building or improving their image.
This chapter shows how to use Excel to prepare financial statements. It defines the meanings of the
financial entries and identifies the formulae for using data values of some to calculate values for others.
The printouts in this chapter include column headings, row numbers, and grid lines to help identify the
cells where the formulas are entered. These can be eliminated when printing the spreadsheets in reports.
(Use the Sheet tab on File/Page Setup to show or hide them.)
Notes are included below the title of many spreadsheet printouts in order to identify key cell entries and give
other information. These programming notes are intended to help readers understand the modeling process,
the expressions for calculating values, and the links between cells.

The three financial statements have interlocking relationships to one another. Excel makes it possible to link cell entries in one worksheet to cell entries in another so that changing data values on either
worksheet changes related entries on the other.


Corporate Financial Statements  ❧  3

Preparing a spreadsheet begins with understanding its purpose: who will read it, what items it will contain, and how the items are related. Values for the items will be either data values or calculated values.
Some Important Steps for Creating Spreadsheet Models
• Provide a short, descriptive title at the top.
• Enter short, descriptive labels for the columns and rows. Include any units in which the values will be
expressed (e.g., $ million, $/day, etc.).
• Enter the known or data values. Check the entries to ensure the data has been entered correctly.
• Enter expressions for calculated values. Check the entries to ensure the expressions and calculated
values are correct. If you understand the logical relationships between items on a worksheet, you will find
it easier to recognize and correct errors as they are made rather than locating errors and correcting them
after a complex worksheet has been completed.

The Income Statement
Income statements provide a financial summary of a firm’s operation for a specified period, such as one
year ending at the date specified in the statement’s title. They show the total revenues and expenses during
that time. An income statement is sometimes called a “profit and loss statement,” an “operating statement,” or a “statement of operations.” Essentially, it tells whether or not the firm is making money.
Note that the income statement does not show cash flows or reflect the company’s cash position.
(The cash flow statement does that.) Certain items, such as depreciation, are an expense although they
do not involve a cash outlay. Some items, such as the sale of goods or services, are recognized as income
even though buyers have not yet paid for them. Other items, such as purchased materials, are recognized
as expenses even though the firm has not yet paid for them. Such income and expense items are recorded
when they are accrued (e.g., when sold goods are shipped), not when cash actually flows.

General Format
Figure 1-1 shows the basic elements of an annual income statement. It indicates the essential information that must be provided and the standard format. Annual income statements for large corporations
are organized in the same format as Figure 1-1. However, they often have a number of subdivisions with
additional detail for selected items.
The income statement is organized into several sections. The upper section (Rows 4 to 15 of
Figure 1-1) reports the firm’s revenues and expenses from its principal operations. Below that (Rows 16
to 24) are nonoperating items, such as financing costs (e.g., interest expense) and taxes.
The so-called “bottom line” (Row 25) reports the firm’s net income, or the net earnings that are
available to the firm’s stockholders. Holders of preferred stock are first in line to be paid from the firm’s
net income. They receive dividends in an amount that is fixed by the terms of the preferred stock. What
is left is the “net earnings available for common stockholders” (Row 27). The last item is also expressed
as the earnings per share (Row 28).


4  ❧  Corporate Financial Analysis with Microsoft Excel®
Figure 1-1

Income Statement for One Year
A

B

1

ABC COMPANY

2

Income Statement for the Year Ended December 31, 20X2

3
4 Total Operating Revenues (or Total Sales Revenues)
5 Less: Cost of Goods Sold (COGS)

$ thousand
(except EPS)
2,575.0
1,150.0

6 Gross Profits
7 Less: Operating Expenses
8
Selling Expenses
9
General and Administrative Expenses (G&A)
10 Depreciation Expense
11 Fixed Expenses

1,425.0
275.0
225.0
100.0
75.0

12 Total Operating Expenses

675.0

13 Net Operating Income
14 Other Income
15 Earnings before Interest and Taxes (EBIT)

750.0
20.0
770.0

16 Less: Interest Expense
17 Interest on Short-Term Notes
18 Interest on Long-Term Borrowing

10.0
50.0

19 Total Interest Expense

60.0
0

20
21
22
23
24

Pretax Earnings (Earnings before Taxes, EBT)
Less: Taxes
Current Tax
Deferred Tax
Total Tax (rate = 40%)

710.0
160.0
124.0
284.0

25 Net Income (Earnings after Taxes, EAT)
26 Less: Preferred Stock Dividends
27 Net Earnings Available for Common Stockholders
28 Earnings per Share (EPS), 100,000 shares outstanding
29 Retained Earnings
30 Dividends Paid to Holders of Common Stock

426.0
95.0
331.0
$3.31
220.0
111.0

Cell entries and notes
Italicized values in Cells B4, B5, B8, B9, B10, B11, B14, B17, B18, B22,
B26, and B29 are data entries. They are entered as values rounded to the
nearest whole dollar (e.g., the entry in Cell B4 is 2750000) and formatted in
thousands with one decimal point. Values in the other cells are calculated
by the following entries:
B6:
B12:
B13:
B15:
B19:
B20:
B23:
B24:
B25:
B27:
B28:
B30:

=B4-B5 “Gross Profits” equals “Total Operating Revenues” minus “COGS.”
=SUM(B8:B11) This command adds entries in cells B8:B11.
=B6-B12 This term is also known as “Net Operating Profits.”
=B13+B14
=B17+B18
=B15-B19 Also known as “Net Profits (or Earnings) before Taxes.”
=B24-B22 “Deferred Tax” equals “Total Tax” minus “Current Tax.”
=0.40*B20 “Total Tax” equals 40% of EBT.
=B20-B24 Also known as “Net Profits (or Earnings) after Taxes.”
=B25-B26
=B27/100000 Per share value is based on 100,000 shares.
=B27-B29


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