Financial Analysis

A Controller's Guide

Steven M. Bragg

• Publisher: Wiley
• Year: 2012
• ISBN:
  9781118428924
• Edition: 2
• Topic: Commerce
• Subtopic: Comptabilité de gestion

"The latest edition goes beyond ho-hum analysis techniques and provides concrete problem solving. The text is sprinkled with real-world problems (and the analytical tools to solve them) that will be familiar to accounting professionals everywhere. A must-have for anyone looking to improve their company's decision making... and their own role in it."
—George R. MacEachern President, Grosvenor Financial Services

"Steve Bragg has presented yet another comprehensive reference tool for the finance professional. Financial Analysis: A Controller's Guide is the perfect reference guide for today's controller, presenting not only traditional financial analysis information, but also various types of analyses that will benefit any type of organization. This book is a must-have for any financial professional desiring to make a relevant contribution to his/her organization."
—Jodi Nefzger, CPP Director of Finance, Masonic Home of Missouri

Today's proactive controllers can soar past their mundane responsibilities and become active participants in their corporation's success with the visionary tools found in Steven Bragg's Financial Analysis: A Controller's Guide, Second Edition.

Now updated to include analyses of intangible asset measurement and performance improvement as well as evaluation methods to determine which products and services should be eliminated, Financial Analysis: A Controller's Guide, Second Edition helps financial managers upgrade their skills so they can answer their organization's call for company operations reviews, investment evaluations, problem reporting, and special investigation requests. Controllers prepared to address this growing need for more innovative financial analysis will open doors to a variety of promotions and high-level interactions with other departments.

Become a highly valued member of your company's infrastructure with the indispensable tools found in Financial Analysis: A Controller's Guide, Second Edition.

PART ONE

OVERVIEW

Chapter 1

Introduction

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Chapter 2

The Role of Financial Analysis

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

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

• Target measurements. There is no need to create and continually recalculate a vast array of measures that will track every conceivable corporate activity. Instead, it is best to carefully review operations, with a particular view of where problems are most likely to arise, and create a set of measurements that will track those specific problems.
• Revise measurements. No measurement will be applicable forever. This is because a company’s operations will change over time, which calls for the occasional review of the current set of measurements, with an inclination to replace those that no longer yield valuable information with new ones that focus on new problems that are of more importance in the current operating environment.
• Educate management about the measures used. Though most financial analysis measurements appear to be very straightforward and easily understood, this is from the perspective of the accounting staff, which has been trained in the use of financial measurements. The members of the management group to whom these measurements are sent may have no idea of the significance of the information presented. Accordingly, the controller should work hard not only to educate managers about the contents of financial analysis formulas, but also to keep reeducating them to ensure that explanations do not fade in their memories.
• Add commentary to measurements. Even a well-trained management team may not intuitively understand the underlying problems that cause certain measurement results to arise. To forcibly bring their attention to the key measurements, a controller should add a short commentary to any published set of measurements. This is an excellent way to convert a numerical report into a written one, which many people find much easier to understand.

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

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

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

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

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

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

• What would happen to sales if credit levels were tightened?
• What would happen to the accounts receivable balance if credit levels were loosened?
• What would happen to the raw material turnover rate if purchases were made in weekly increments instead of monthly?
• What will be the inventory investment if the company adds one distribution warehouse?
• What will be the savings if the company passes through freight costs to customers?
• What will happen to the total gross margin if the price of one product is cut by 10 percent?
• What will happen to the corporate medical expense if the company requires employees to pay an extra $10 per month on their medical insurance?

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

• Clarify the question. There is nothing worse than trying to remember the question asked by a requestor; making an assumption about what is being asked, rather than confirming with the requestor; and then finding later on that the resulting financial analysis answered the wrong question. To save a great deal of wasted effort, one must always write down the request at once, read it back, and clarify any points before beginning the analysis.
• Verify assumptions. There are some assumptions built into any financial analysis. For example, what is the cost of capital to be used for a discounted cash flow analysis? What is the assumed rate of customer retention if prices are dropped by 10 percent? Rather than guess at an assumption that will be an integral part of a financial analysi...