Define Transaction and Financial Analysis Read Chapter2( text book ), write a journal. The journal must include the following: Define transaction and fi

Define Transaction and Financial Analysis Read Chapter2( text book ), write a journal.

The journal must include the following:

Define transaction and financial analysis


Transactions as an event

Record keeping tools

Data for finance statements

Varieties of data

Business activity

Compiling finance statements


Financial statements as scorecards. The Wharton Executive Essentials Series
The Wharton Executive Essentials series from Wharton Digital Press brings the ideas
of the Wharton School’s thought leaders to you wherever you are. Inspired by
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Customer Centricity: Focus on the Right Customers for Strategic Advantage, by Peter
When Roger Enrico took over as CEO of PepsiCo, he reported mixed news in his first
letter to shareholders in the 1996 Annual Report. On the one hand, PepsiCo as a
whole reported record sales of $32 billion and record cash flow as well. On the other
hand, profits weren’t growing and not all of their segments were doing well. In fact,
their beverage segment, the heart of their business, was doing poorly outside the
United States, losing market share to archrival Coca-Cola. PepsiCo had invested
billions of dollars in their restaurant segment (Pizza Hut, KFC, and Taco Bell) over
the prior five years, yet the return they were achieving was disappointing.
After conducting a thorough analysis of its financial performance, Pepsi began
making significant changes to its corporate strategy. They spun off their restaurants
into a separate company, Tricon Global Restaurants (now called Yum! Brands) so they
could concentrate on their snack and beverage segments. But they didn’t stop with
that change; the process of evaluating and revising strategy is an ongoing one. Shortly
thereafter, they acquired Tropicana and Quaker Oats (who also owned Gatorade).
They have continued to make changes to their segments and product lines, and as
recently as 2010, they reacquired control of two of their largest bottlers. By 2010,
through this series of strategic shifts, PepsiCo’s revenue had skyrocketed to nearly
$60 billion. Their earnings and their stock price performance have both substantially
outperformed the S&P 500 over the period from 1997 to 2010.
These are major corporate-level changes, but the same principles apply at all levels of
the organization. Managers must constantly evaluate their firms’ strategies to assess
how their decisions have been performing, to modify these strategies as conditions
change, and to devise new strategies to boost performance in the future. Which
activities should we devote more resources to and which should we cut back on?
Which resources are not being used effectively? Should we outsource an activity or
continue to perform it ourselves? Business decisions like these need to be based on
information, and financial statements are a major source of this information.
But many managers don’t have a background in accounting and finance, so they don’t
have the tools they need to answer these questions. They don’t understand the reports
they are given to help them make these decisions. They either ignore the information
completely, they misinterpret what the numbers mean, or they aren’t even aware of
what isn’t in the numbers at all. All of these behaviors are dangerous to your firm’s
financial health. They are like trying to fly a plane with no instruments and with the
windshield fogged up.
The goal of Financial Literacy for Managers isn’t to teach readers how to compile the
financials. Leave that to the accounting and finance staffs, the CPAs, and the CFOs;
they know all the rules and regulations. Instead, my goal is to teach you how to use
and interpret the data they give you. Whether you are an experienced manager,
executive, or leader at a public company or private business, and regardless of size,
mastering financial statements can help you make better decisions and make you more
valuable to your firm.
Although accounting statements are filled with numbers, in many ways, accounting is
more like a language. Accounting rules provide the mechanism by which business
transactions and economic events get translated into numbers. What do the words
attached to the numbers mean? Like every field, finance and accounting have their
own jargon, and an important part of being able to understand and communicate is
learning this vocabulary or language. Income is different from cash. Depreciation
doesn’t mean how much an asset’s economic value has gone down. Liabilities can be
good things. Too much cash can be bad. GAAP, NPV, ROA, EBITDA, WACC,
leverage . . . What do these terms mean?
Many people are also surprised to learn that financial statements carry a large degree
of ambiguity and subjectivity. Just as English majors argue about the interpretation of
a soliloquy in Hamlet, managers and accountants can disagree regarding the best
measure of a company’s performance or financial status. The reason for this
subjectivity is that accounting statements have to be put together while much is still in
process. Although we could eliminate this ambiguity if we waited until the end of the
firm’s life before we tallied up its profits, this information would be too late to help
with decisions that have to be made while the firm is still operating.
To provide more timely and useful information, accounting statements do not just
look backward and tell you what happened in the past; virtually every number on a
balance sheet or income statement is based in part on estimates of what will happen in
the future. Unfortunately, future cash flows and events are never known for sure. This
is what opens the door for manipulation by unscrupulous management. Even wellmeaning managers are often overly optimistic about their firm’s future prospects. To
deal with these potential problems, restrictions are placed on what kind of information
about the future is permitted to be transmitted through the financial statements.
Auditors and other checks and balances exist to limit management’s ability to
misrepresent the firm’s performance, but these elements don’t work perfectly because
they don’t have a crystal ball into the future either. In this book, you will learn how
this subjectivity and judgment affects the numbers and about what aspects of the
future are incorporated and what others aren’t. This will help you learn to read
between the lines of financial statements and know when to be skeptical.
Once you better understand accounting and finance, you will also begin to see that the
numbers that your firm supplies to external parties (like shareholders or tax
authorities) aren’t the numbers you want to use to run your firm—and no, the reason
doesn’t have anything to do with cheating or misrepresentation. At a minimum, you
will want more detail about the performance of the individual parts of your company
than annual reports and tax returns can provide. In addition, you want data that help
you predict how costs and revenues will change if you make different decisions.
External reporting systems typically sort items only by their type (for example,
production costs are separate from marketing costs), but you would like information
within each category to help you understand how your costs behave: what costs are
fixed versus variable, what costs are sunk or committed to, what costs are direct
versus allocated, and so on.
Finally, the reports provided to external parties like shareholders and creditors are
compiled using rules that are regulated by standard-setting bodies. Given that the
company already has to compile numbers in a particular way to satisfy these external
regulatory demands, many companies choose to use these exact same numbers for
internal decision-making purposes also (because it’s cheaper than coming up with an
additional reporting system). Be careful. These rules are often designed for simplicity,
to be conservative, or to achieve other objectives—not to measure your performance
or financial position as accurately as possible. I will discuss some of these problems
and how they can distort your performance measures.
Another important reason for managers to learn accounting and finance skills is to
help them become more valuable participants in discussions of corporate strategy and
to be more effective in championing their own ideas. Ultimately, an important part of
these decisions is based on what they will do to “the numbers.” Many investment
proposals involve spending money now on something that will (hopefully) yield
benefits in the future. Therefore, investment decisions are based on predictions about
the future and on how these predictions will manifest in term of future cash flows and
Here it is vital to understand what accounting and finance skills can do and what they
can’t do. Accounting and finance skills can’t tell you whether an investment in a
proposed research and development plan will yield a drug that the FDA will approve.
Accounting and finance can’t tell you whether consumers will like the new product
you’re thinking of introducing (like New Coke). Accounting and finance can’t tell you
whether an acquisition whose success requires blending two completely different
corporate cultures (like AOL and Time Warner) will work. Experience and gut
instincts are invaluable skills to managers in trying to make these judgments.
What accounting and finance skills can tell you is how big the probability of success
needs to be and how big the benefits need to be if things work out in order for the
investment to be worth the costs. More generally, accounting and finance provide an
economic framework for comparing alternative strategies for how to invest your
money in terms of how much value they add to the company. They can help you
assess what an acceptable rate of return is. They can tell you how it depends on the
riskiness of the strategy. They can tell you how much more a strategy that won’t pay
off for many years has to earn compared to an investment that generates its return
more quickly.
Moreover, by forcing you to tie your forecasts of future events into income
statements, balance sheets, and cash flow statements, the framework of accounting
and finance adds discipline to the process. Often managerial projections are fueled
more by ego or hope than by reality. Accounting and finance techniques give you an
opportunity to assess the reasonableness of the assumptions underlying the predictions
and the sensitivity of the predicted results to changes in the assumptions. By forcing
you to construct projected income statements, balance sheets, and cash flow
statements that are internally consistent, these skills also reduce the risk of leaving
something significant out of the analysis completely.
In this book, I will explain:
The role of balance sheets, income statements, and cash flow statements
How these financial statements relate to one another
Financial reporting concepts, such as revenue recognition, inventory costing,
depreciation, and taxes
How to dissect an income statement and balance sheet to understand the drivers
of profitability
How your capital structure—the mix of debt and equity you use to finance your
assets—influences your profits and your risk
How you can identify and estimate the relevant costs for decisions
How to evaluate investment strategies and conduct discounted cash flow analysis
How to put all of this together to develop a coherent business strategy
Finances affect every aspect of business. Once executives and managers understand
the rudiments of financial statements and the tools of financial analysis, managers can
understand what is driving revenue, pinpoint where the organization is doing well,
and analyze why performance isn’t living up to expectations. Gaining a better grasp of
financials helps managers know what questions to ask and what to focus on,
determine what’s most important, and know what to avoid and what to pay attention
to. Fueled by better understanding of the drivers of performance, leaders can make
better strategic decisions, make changes in the business, and better gauge what to
acquire or sell. It’s the synergies that arise from merging managerial experience with
finance and accounting skills that can generate the most value to you and to your
organization. Hence, boosting your own financial knowledge makes good business
Chapter 1: Your Company’s Financial Health and
Performance: What Financial Statements Can Tell You
In this chapter:
The 3 fundamental financial statements
How the 3 financial statements relate
When Krispy Kreme went public in 2000, it was hard to resist its sugary doughnuts or
its stock. America is well known for having a sweet tooth, and investors figured
consumers would keep buying those sugary sweets the way they kept digesting Big
Macs. By the summer of 2003, the stock had skyrocketed to $50, more than double its
initial offering price. By the end of 2003, Krispy Kreme had opened 357 outlets,
including some stores overseas. Revenues rose from $300 million in 2000 to $649
million in 2003. But by the summer of 2004, a slew of low-carbohydrate diets were in
vogue that made doughnuts a no-no. America’s tastes had changed, and those
doughnuts and its stock began to turn stale.
Krispy Kreme’s aggressive expansion was funded in part by sharply increasing their
debt load; long-term debt rose from a modest $3.5 million at the end of 2000 to $56
million in 2002 to $137 million in 2003. Accordingly, interest costs rose sharply. As
revenues started to drop, profits declined even more sharply. By 2005, the stock had
slid to $6, and the company started closing stores. Revenues in 2010 were only $362
million, compared to $649 million in its heyday in 2003. However, their stock price
bounced back slightly in 2011.
Understanding Krispy Kreme’s opportunities and risks as it grew demanded reading
and understanding its income statement, cash flow statement, and balance sheet. In
this chapter, we’ll discuss the importance of each of those financial statements and
cover the following topics:
How the balance sheet represents a snapshot of the company’s resources (assets)
at a fixed period of time and also provides information about the firm’s capital
structure and its riskiness
Income statements, which measure a company’s revenues, expenses, and
Cash flow statements, which provide information about liquidity and the sources
and uses of cash, the lifeblood of the company
How income statements and cash flow statements differ
The 3 Fundamental Financial Statements
The financial statements—the balance sheet, income statement, and cash flow
statement—are an important means by which timely information is provided to
managers as well as to investors, creditors, and other users of financial statements.
Each statement furnishes a different type of information. Each is useful in its own
right; however, understanding how the three are linked is vital to assessing a
company’s strengths and weaknesses. Together they provide a fuller picture of a
company’s current financial status and offer a glimpse into its future. In this chapter,
we will describe what each statement does and how they are interrelated. An example
of a set of financial statements is contained in chapter 2.
What distinguishes the three statements? The balance sheet lists the resources (assets)
the firm has acquired and still retains, as well as the nature of the claims on these
assets (liabilities and owners’ equity). The balance sheet is analogous to a snapshot; it
represents the financial position of the firm at a specific point in time (for example, at
the end of the quarter or year). Income statements report the profitability of the firm
during the period. Cash flow statements provide information about the inflows and
outflows of cash during the period. These latter two statements therefore help provide
information about how and why the firm’s financial status has changed since the end
of the prior period. Profitability (value generated) and liquidity (cash generated) are
not the same thing, however, which is why we have two different statements.
Balance Sheet
The phrase “balance sheet” comes from a relation that financial statements must
always preserve:
Assets = Liabilities + Owners’ Equity
This equation simply states that the assets or resources of the firm have to be claimed
by someone. If it is not someone else (the liability holders or creditors), then it is the
owners. A simple example from personal finance illustrates: if you have a house that’s
worth $500,000 and have a mortgage with a balance of $300,000, your owners’ equity
in the house is the difference, $200,000. Although the concept might look simple, we
will see that this relationship has important implications for understanding how to
interpret financial statements and also for understanding how balance sheets and
income statements are related. The fact that balance sheets always balance to the
penny is one of the factors that contributes to the illusion of exactness in accounting.
A balance sheet that balances does not mean there are no errors, and it does not mean
that everything is valued correctly. If we misvalued our house at, say, $700,000, we
would similarly mismeasure the value of our equity at $400,000. Everything still
balances, but the economic picture presented is distorted relative to reality.
A company’s balance sheet starts with its assets. Assets are the keys to sustaining the
company. Assets represent the resources a company has available to use to generate
profits or provide other future economic benefits, such as the ability to pay back debt.
Assets include the following types of resources:
Financial assets: cash, notes and accounts receivable, marketable securities,
derivative instruments
Physical assets: inventories, plant and equipment, real estate
Intangible assets: patents and copyrights, other contractual rights, goodwill
Assets are grouped on the balance sheet into two categories, current and noncurrent.
Current assets are those expected to generate their benefits within one year; examples
include cash, accounts receivable, inventories, and many types of marketable
securities. Noncurrent assets are expected to take longer than a year and include
property plant and equipment, long-term investments, and most intangibles.
Valuing Assets
All of the assets, liabilities, and owners’ equity accounts are expressed in dollars. How
do we place a value on them? Accountants have traditionally used historical cost for
most assets. The historical cost is the amount that was paid for the asset when it was
acquired. The virtue of historical cost accounting is that the numbers are objective and
reliably measured. Unfortunately, historical costs can become out-of-date and lose
their relevance over time.
To address this problem, an alternative basis for valuing assets termed “fair value”
was developed. If you have heard the phrase “mark to market,” this is what fair value
tries to do—to estimate what the current market value of the asset is. Unfortunately,
this is often not easy to do with any precision, which leads to questions about the
reliability of these values. The virtue of fair-value accounting is that values are more
up-to-date, so they are, in principle, more relevant to decision making. The “relevance
versus reliability” debate regarding which valuation method is better has gone on for
many decades, and it will continue far into the future. When an asset is newly
acquired, its historical cost and market value are usually the same thing. It is only
after the asset is acquired that the two values diverge.
For financial assets, obtaining reliable values is often easier to do because there are
actively traded markets for many of them (e.g., the stock…
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