EMBA 512
Assessing Business
Opportunities
EMBA 512
Assessing Business Opportunities
October Sessions
Preview
Concepts
•
•
•
•
•
•
Financial
Reporting
Demand
Microeconomics
Budgeting
Sales Forecasting
Tax
Connection
Application Tools
Foundation Skills – Part 1
•
This course provides an integrated foundation in
accounting, economics, finance, marketing, operations
management, strategic planning and interpersonal
dynamics in the context of assessing business
opportunities.
•
•
Financial
metrics
Microsoft Excel
Intuitor,
Thinker, Feeler,
Sensor Analysis
EMBA 512
Assessing Business Opportunities
October Sessions
Preview
Concepts
•
•
•
•
•
•
Financial
Reporting
Demand
Microeconomics
Budgeting
Sales Forecasting
Tax
Connection
Application Tools
Foundation Skills – Part 1
•
This course provides an integrated foundation in
accounting, economics, finance, marketing, operations
management, strategic planning and interpersonal
dynamics in the context of assessing business
opportunities.
•
•
Financial
metrics
Microsoft Excel
Intuitor,
Thinker, Feeler,
Sensor Analysis
512 Course Routine
 Pre/post
work allocation
– time budget for the month between sessions
» two weeks immediately prior to face-to-face
sessions dedicated to prework (40 hours)
» two weeks following face-to-face session dedicated
to post session assignments (40 hours)
(from Syllabus, page 5)
(from Syllabus, page 6)
The Culminating Project
 An
integration exercise
– identify a future opportunity
» a new product, market, line of business
» acquisition of another company
» etc.
– assess the feasibility of this opportunity
» what information will you need?

how will you deal with insufficient data?
» what analyses must you perform?
– present your results to the faculty
Culminating Project Details
 Described
in full in session 25 syllabus
step 1—each member identifies an opportunity
» write up a short summary
step 2—team discussion (flex time, Oct, Nov)
step 3—team selects one as its project
» approved by faculty (session 17—Saturday, Nov. 16,
PM )
step 4—team presents project during session 25
(Sat., Dec. 14)
The Culminating Project
 Presentations
are limited to 20 minutes
– at least two group members speak
A
wide range of topics in this course
– don't try to weave all of it in
– incorporate what makes sense
 No
paper is required
– are free to develop handouts containing your
PowerPoint slides or other supporting materials
The Culminating Project
A
tips for success
– think carefully about scope?
A
recurring issue
– dealing with inadequate data
» how will you assess the feasibility?
» what information will you need?
EMBA 512
Assessing Business
Opportunities
Financial Reporting Module
Financial Reporting Module
 Objective
– assist you in becoming more sophisticated in
your understanding and use of financial
statements
» what’s the link to opportunity assessment?

financial accounting provides much of the information by
which prospects are measured
 Complex
area
– focus of a semester long course
The Accounting System
 Provides
information for many financial
decisions
– internal users (managerial accounting)
» planning
» control
– external users (financial accounting)
» investing
» lending
» customer/supplier negotiations
» labor negotiations
The Financial Statements
 Balance
Sheet
– statement of financial position (moment in time)
» assets--the valuable resources of a company

subject to GAAP measurement conditions
» liabilities--the claims of outsiders to the resources

subject to GAAP measurement conditions
» equity--the residual that belongs to the owners
Fundamental asset characteristics:
• a future benefit
• controlled by the company
• flowing from a past transaction
Google, Inc.’s
Balance Sheet
All numbers in thousands
December
December
31
31
2012
2009
2011
2008
$10,198
14,287
3,846
836
29,167
129
4,845
5,677
679
$40,497
$ 8,657
7,189
2,928
1,404
20,178
85
5,234
5,837
434
$31,768
$2,463
285
2,748
1,745
4,493
$ 2,002
300
2,302
1,227
3,529
15,922
20,082
36,004
$40,497
14,677
13,562
28,239
$31,768
Assets
Current Assets
Cash and cash equivalents
Short term investments
Net receivables
Other current assets
Total Current Assets
Long term investments
Property, plant and equipment
Intangible assets
Other long term assets
Total Assets
Liabilities
Current Liabilities
Accounts payable
Other current liabilities
Total Current Liabilities
Long-term liabilities
Total Liabilities
Stockholders' Equity
Common stock
Retained earnings
Total Stockholders' Equity
Total Liab. & Stockholders' Equity
The Financial Statements
 Income
Statement (P&L)
– summarizes performance for a past period
» revenues--asset inflows from operations
» expenses--asset outflows for operations
» gains--net inflows from nonoperating items
» losses--net outflows for nonoperating items
Google, Inc.’s
Income Statement
Years Ending December 31
Total Revenue
Cost of Revenue
Gross Profit
Operating Expenses
Research Development
Selling General and Administrative
Total Operating Expenses
Income from Continuing Operations
Total Other Income/(Expense)
Earnings Before Interest and Taxes
Interest Income
Income Before Tax
Income Tax Expense
Net income
All numbers in thousands
2012
$23,650
8,844
14,806
2011
$21,796
8,622
13,174
2,843
3,651
6,494
8,312
0
8,312
69
8,381
1,861
$ 6,520
2,793
3,749
6,542
6,632
(1,094)
5,538
316
5,854
1,627
$ 4,227
The Financial Statements
 Statement
of Cash Flows
– summarizes flows for the period by type
» operating

typically prepared indirectly
» investing

purchases and sale of ‘capital’ investments
» financing

transactions with creditors and owners
Google, Inc.’s
Statement of Cash Flow
All numbers in thousands
Years Ending December 31
Operating Activities
Net Income
Depreciation
Adjustments To Net Income
Changes In Accounts Receivables
Changes In Liabilities
Changes In Other Operating Activities
Net Cash Flow From Operating Activities
Investing Activities
Capital Expenditures
Investments
Other Cashflows from Investing Activities
Net Cash Flow From Investing Activities
Financing Activities
Sale/(Purchase) of Stock
Other Cash Flows from Financing Activities
Net Cash Flow From Financing Activities
Effect Of Exchange Rate Changes
2012
Change In Cash and Cash Equivalents
2011
$6,520
1,524
785
(504)
511
480
9,316
$4,227
1,500
1,799
(335)
183
479
7,853
(810)
(7,101)
(108)
(8,019)
(2,358)
359
(3,320)
(5,319)
143
90
233
11
(72)
159
87
(46)
$ 1,541
$2,575
E3.13
1. financing
2. operating
3. investing
4. noncash event
5. financing
6. financing
7. operating
8. noncash event--requires disclosure
9. financing
10. operating
P3.26
The Accrual Model
 Financial
statements are built from a
company’s transactions
– record assets and liabilities
» revenues and expenses from the changes in them

The ever present accounting equation
A = L + SE
P2.23
Capital
Stock
Ret.
Earn.
E2.16
a. I/S
b. B/S
c. I/S
d. B/S
e. I/S
f. B/S
g. I/S
h. B/S
i. B/S
j. I/S
E
A
E
A
E
A
R
L
A
E
j. B/S A
k. B/S A
l. B/S L
m. I/S E
n. B/S A
o. B/S SE
p. I/S E
q. I/S E
r. B/S A
E2.17 (asset/expense challenges)
Key Accounting Method Choices
 Can
–
–
–
–
dramatically impact reported results
inventory
depreciation
research and development
consolidations (business combinations)
Inventory Cost Flow Example
 ABC
Company’s inventory transactions:
– 1/01/x1--buys 1 unit @ $10
– 1/12/x1--buys 1 unit @ $12
1/21/x1--sells 1 unit @ $20
 ABC
Company’s Performance:
FIFO
inventory (B/S)
1 @ $12 = $12
CGS(I/S)
1 @ $10
LIFO
1 @ $10 = $10
1 @ $12
Inventory Method Choice Summary
Method
FIFO
LIFO
Inventory(B/S)
current prices
old prices
Cost of Goods Sold(I/S)
old prices
current prices
Financial Statement Impact (assuming rising prices)
Balance Sheet
Inventory
FIFO > LIFO
Income Statement
Cost of Goods Sold
FIFO < LIFO
Net Income
FIFO > LIFO
Depreciation of Property, Plant
and Equipment
 Process
of allocation, not valuation
» charge a portion of the cost to expense during each
year of an asset’s useful life
income statement shows depreciation expense
 balance sheet shows accumulated depreciation

 Amount
of depreciation taken depends on:
» cost
» method (straight-line, accelerated)
» salvage value
» life
Why Might Depreciation Vary
Across Companies?
 Method
differences
– most U.S. firms use SL
» can convert SL to accelerated (MACRS) using
income tax footnote
 Life
differences (for companies using SL)
average life =
gross PP&E ÷ annual depr. exp.
 Age
differences (for companies using SL)
average age =
accumulated depreciation ÷ annual depr. exp.
Research and Development
 Activity
directed at developing new
knowledge
– translate into
» products
» services
» processes
 Sometimes
successful, often not
– tangible evidence of success
» patents
» trademarks
» profits!
The Challenge of R&D
 When
money is spent up front, how do we
evaluate it’s future success?
 Necessary in order to
– capitalize (record as asset) the successful
– expense (write off) the rest
 GAAP’s
solution
– expense all R&D
» conservative
The Conservatism Paradox
Assume:
1. R&D spending is constant @ $10,000/year
2. Creates benefits lasting 5 years
3. Company has $100,000 of assets and $25,000
of income, both before considering R&D
Required:
–
Evaluate the impact of expensing R&D on
Return on Assets (ROA)
The Conservatism Paradox
Analyzing R&D Firms
 Need
to exercise care in interpreting
profitability
– especially when level of R&D expenditures is
changing
Financial Statement Analysis
 For
what purpose?
– price arbitrage
–
–
–
–
–
lending
customer/vendor evaluation
labor negotiations
government regulation
litigation support
Financial Statement Analysis
 What
are we looking for?
Positive investment returns!
Where Pt = Share price at end of period,
Dt = Dividends received during the period,
Pt-1 = Share price at beginning of period
 What
are we worried about?
Risk!
E1.29
GE’s r = ($34.50 – $32.01 + $.86) ÷ $32.01
Competition
Bargaining Power
Financial Statement Analysis
 Factors
affecting corporate performance
– industry characteristics (Porter’s five forces)
» buyer power (price sensitivity)

costliness, competing products
» supplier power

scarcity, quantity
» rivalry among firms
» threat of new entrants

capital intensity, government regulation, rate
technological change
» threat from substitute products
Financial Statement Analysis
 Factors
affecting corporate performance
– industry characteristics (Porter’s five forces)
– corporate strategy
» product focus

differentiation, low cost leadership, niche ●
» location in the value chain

manufacturing, distribution, integration
» diversification (geographic or industry)
» leverage

use of financial and/or operating leverage
The Margin versus Turnover
Trade-Off
35%
Profit Margin
30%
25%
20%
ROE=10%
15%
ROE=20%
10%
5%
0%
0
1
2
3
4
5
6
Turnover
7
8
9
10 11
Financial Statement Analysis
 Factors
affecting corporate performance
– industry characteristics (Porter’s five forces)
– corporate strategy
» product focus

differentiation, low cost leadership, niche
» location in the value chain

manufacturing, distribution, integration
» diversification (geographic or industry)
» leverage

use of financial and/or operating leverage
Operating Leverage Illustration
ABC Company plans to sell a new product this year
that can be sourced two ways:
1. subcontract to Asia for a cost of $1.50 each.
2. produce in a refurbished company owned facility at a
variable production cost of $1/unit and facility operating
costs of $275,000/year
What is product cost?
Option 1
• at 500,000 units $750K ($1.50/unit)
• at 800,000 units $1,200K ($1.50/unit)
Option 2
$775K ($1.55/unit)
$1,075K ($1.34/unit)
48
Financial Leverage Illustration
 Company
has $1,000 asset earning $150
(15%) before financing
 asset financed as follows:
» $300 by long-term debt (10% interest cost)
» $700 by equity
ROA = (150 ÷ 1,000) = 15%
ROCE = (120 ÷ 700) = 17%
Assets provided by creditors:
Return generated $300 x .15 = $45
Financing cost $300 x .10 = $30
$15 excess to equity
49
Gauging Performance
 Ratios
are popular
– performance measurement
» ROA, ROCE
– risk assessment
» extent to which current profits may be different that
those in the future
liquidity
 solvency
 turnover
 leverage (operating, financial)

Identify the Company
K
BB AF HP PG du
Mc
OM
HS
M
NI
BC
PG
AS
Complications
 Financial
Statements tell us…
– only part of the story
» hard to predict the future

fundamental challenge of analysis
» limitations in GAAP
substantial latitude in preparing information
– discretionary accounting choices
 important information left off the statements
– ‘off-balance-sheet’ financing

Psychology of Reporting
 Management’s
natural desire to cast things
in a favorable light
– management vs. manipulation
» why we have
GAAP
 audits

– millennium scandals
» why we now have
Sarbanes/Oxley Act
– 404
 PCAOB

Financial Statement Analysis
 Performance
measurement framework
– profitability (Dupont Model—see p. 131)
» ROA
profit margin
 asset turnover

» ROE
ROA
 financial leverage

– risk
» solvency risk
» operating leverage
» financial leverage
see ratio list
Financial Statement Analysis
 Our
focus is on the future
– to predict well we need to consider
» current economic conditions and forecasts
» industry characteristics
» company strategy
Measuring Earnings

Need to evaluate the components of GAAP
income
– permanent earnings (recurring, persistent)
– transitory earnings
Finding the Nonrecurring
(Transitory) Earnings
Sales
-Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+ Other revenues/gains
- Other expenses/losses
Income before taxes
- Income tax expense
Net Income
Finding the Nonrecurring
(Transitory) Earnings
Sales
-Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+ Other revenues/gains
- Other expenses/losses
Income before taxes
- Income tax expense
Net Income
Nonrecurring Earnings
 Other
Revenue/Gains
– gains from peripheral activities (e.g., the sale of
PP&E, investments)
 Other
Expenses/Losses
– losses from peripheral activities (e.g., the sale
of PP&E, investments)
– restructuring charges
– impairment losses
Other Sources of Nonrecurring
Earnings
Sales
-Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+ Other revenues/gains
- Other expenses/losses
Income before taxes
- Income tax expense
Income before …
Special Income Statement Items
 Discontinued
Operations
 Extraordinary Items
Discontinued Operations
 Results
from disposal of segment
– a sizable component of operations
 Reported
in two separate components
– income/loss on operations
– gain/loss on disposal
 Both
components reported net of related tax
effects
O’Sullivan Corporation
 Manufacturer
of flexible vinyl sheeting
– automotive, industrial, medical
– sold consumer products business in 2005
Income b/4 Disc. Operations
Loss from operations (net of
$428,489 in tax benefits)
Loss from disposal (net of
$1,825,954 in tax benefits)
Net Income
2005
8,813,858
- 593,593
-3,674,046
4,546,219
Extraordinary Items
 Both
unusual in nature and nonrecurring
– fire, flood and other casualties
 Reported
net of related tax effects
flood loss 1,000,000
tax effect (400,000)
net loss
600,000
E3.19
operating cash flow
$9,606
share price
$3.80
$(20,908) $(27,411)
$10.40
Other Earnings Reporting Issues
 Restatements
– change amounts in financial statements for
prior years (comparative statements)
– used for
» correcting errors

on prior years’ income statements
» reporting changes in accounting principles

retrospective method
» changes in the entity (acquisitions, divestitures)
Other Earnings Reporting Issues
 Restatements
– change amounts in financial statements for
prior years (comparative statements)
– used for
» correcting errors

on prior years’ income statements
» reporting changes in accounting principles

retrospective method
» changes in the entity (acquisitions, divestitures)
Restatement Example
 XYZ
Co. began operations in 2008
– in 2002 recorded cost of a $100,000 building as
a purchase of land.
– error not detected until this year (2012)
– building has a 20 year life and $0 salvage
value.
– company uses straight-line depreciation.
– tax rate = 40%
Restatement Example (Cont.)
Income Statement 2008 2009
depreciation taken
0
0
correct depreciation
5
5
gross effect on inc. - 5
-5
taxes (40%)
+2
+2
net effect on inc.
-3
-3
2010
0
5
-5
+2
-3
2011
0
5
-5
+2
-3
2012
0
5
-5
+2
-3
Corrections on Income Statement:
NI (as prev. reported) 28
35
error
-3
-3
NI (corrected)
25
32
41
-3
38
45
-3
42
--47
Corrections also flow through balance sheet:
accumulated depreciation, retained earnings, tax liability
Overcoming GAAP Limitations
 Many
accounting standards provide
opportunities for
– managing income
– off-balance sheet financing (OBSF)
 Why
would managers want to do this?
– basic economics
» we are all self interested agents

 Why
this?
agency costs
Q3.6
Q1.13
would GAAP permit managers do this
PEAP, POOP, WYWAP
Not GAAP but…
 Politically
Expedient Accounting Principles
– Concessions, concessions, concessions!
» Footnote reporting of option expense
» Pensions (triple smoothing of volatility)
 Whatever You
Want Accounting Principles
– GAAP allow lots of choices
» FIFO/LIFO
» Accelerated/St. line
Not GAAP but…
 Pitifully
Old and Obsolete Principles
– Many old standards still around:
– Treasury stock (1934)
– Depreciation (1946)
– LT contracts (1955)
– Stock splits (1941)
– Inventory (1947)
– Quarterly reporting (1934)
Fixing Up Poor GAAP
Measurement
 Major
problem areas
– investments (smoothing)
– leases (OBSF)
– retirement benefits (smoothing, OBSF)
Details forthcoming in our next session
(February 2014)