Financial Decision Making

and the Techniques Used

in
Financial
Analysis
Learning Objectives
By the end of this chapter, you should be
able to:
Discuss the financial analyst's role in an orga-
nization.
List at least six financial analysis topics.
Describe the three main financial manage-
ment decisions.
Identify five forces that influence the average
profitability of an industry.

List the four balanced scorecard perspec-
tives.
The accounting function quantifies the economic relationships of an enter-
prise; the finance function, on the other hand, manipulates those relation-
ships in order to optimize the company's liquidity and profitability. The
accounting model may be viewed as a set of specific rules and conventions,
the purpose of which is to record, analyze, and report the historic experience
of all aspects of a firm's operation. The financial model is a diverse set of
techniques that are used to analyze and manage the future direction of the
firm's investments and financing. The purpose of this course is to acquaint
the student with the various financial techniques within the construct of the
accounting framework.
Managers at every level must make difficult financial decisions continu-
ously. Analytical tools or techniques are important in decision making, analy-
sis, planning, and control. Aspects of financial management are performed
by most managers today, and it is important that managers be able to apply
analytical techniques to their specific financial problems or decisions. It is
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1
impossible to say which of the various techniques of financial analysis is the
best. They are all tools to be used in decision making and, as such, should
be applied according to the situation.
FINANCIAL ANALYSIS
Financial analysis is part of the financial decision making process. Financial
decision making involves analyzing the financial problems that the company
faces and deciding which course of action should be taken. In order to make
financial decisions, you must be able to identify potential financial problems
and analyze the effects of alternative courses of action. Thus, as a decision
maker, you must be able to use the analytical techniques of financial analysis.
The role of financial analyst may be assumed by any manager. Those managers
who are involved in financial decision making but who may not perform the
actual financial analysis should know the techniques and tools used to arrive
at the recommendations the analyst makes. This course is for both those
managers who want to do their own financial analysis and those who delegate
this responsibility but nonetheless use the findings of financial analysis in
their decision making. Financial analysis topics are listed in Exhibit 1-1.
THE ROLE OF THE FINANCIAL ANALYST
Although this course is directed primarily toward those managers who will
perform their own financial analyses, an overview of the role of the financial
analyst in a large company will provide any manager with some insights on
the importance of financial analysis. The position of the financial analyst in
the corporate structure and the scope of his or her work are interdependent.
Presumably, the needs of the enterprise govern the analyst's role and position
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in the company. Our first step, then, is to describe the analyst's mission, and
our next step is to place the analyst where the objectives of that mission can
best be attained.
Definition of the Analyst's Job
The financial analyst is a staff member who diagnoses the monetary effects
of management's proposals and decisions for executives. Acting as an internal
consultant, the financial analyst conducts studies on, interprets information
concerning, and designs controls for profitability, cash flows, and diverse
fiscal matters. The analyst does these tasks on behalf of decision makers; he
or she does not usually make decisions. The analyst's role, therefore, generally
ends at clarifying and evaluating options.
Typical Assignments
The purview of financial analysis for a company depends on its perceived
needs and the types of decisions its management makes. Companies' needs
differ, but the areas of financial analysis most analysts deal with include long-
range planning, profit planning and budgeting, capital investment decisions,
operational auditing, mergers and acquisitions, and the administration of
temporary corporate investments.
There are many projects that financial analysts must perform periodically.
These activities include analyzing the company's liquidity, performing opera-
tional audits, and supervising the company's day-to-day financial activities.
In addition, the analyst has annual or semiannual duties, including conducting
a sales analysis, analyzing the company's debt structure, developing the finan-
cial statements and ratio analyses, and analyzing the investment of liquid
reserves.
Similarly, the analyst does specific projects that are either self-initiated
or, as usually happens, requested by others. For example, if a financial analyst
sees a marked decrease in a particular financial ratio, he or she may analyze
the factors that would cause such behavior. Also, the analyst might analyze
how the economic environment affects the company or, more specifically, how
various tax policy changes will affect the company. However, most of the
analyses conducted by the financial analyst are situation specific and usually
are requested by other departments . For example, management may want to
know whether a certain asset should be leased or bought; or the company
may be considering purchasing land and therefore need a location analysis.
The analysis may be company-wide or may just pertain to a division within
the company.
Planning plays an important part in most assignments undertaken by
financial analysts. By planning, we mean both short-term objectives as well
as long-term strategic goals. Financial analysts must integrate the goals and
objectives of their companies in their analyses. Consequently, most of a finan-
cial analyst's assignments implicitly or explicitly include aspects of com-
pany plans.

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The Analyst's Position in the Corporate Structure
The position of the analyst in the corporate structure varies with the nature
of the company and its administrative organization. In smaller firms, a single
individual may handle all financial activities, including any necessary financial
analyses. In larger fnms,there generally is a staff of financial analysts reporting
to a financial manager, who in turn reports to the controller,who is supervised
by a vice-president of finance or chief financial officer. Financial analysts may
be at the corporate or divisional level.
The analyst's position within the company is important, because the
topics of financial analysis are used to help improve the value of the company -
frequently, they are also sensitive, conflict-provoking subjects. For instance,
after conducting a financial analysis, an analyst might recommend the dissolu-
tion of a certain division or department.To say the least, this recommendation
would not be popular with the members of the department or division in
question. Centralizing the position of the financial analyst indicates that the
role is a service and is different from the operational units for which most
of the analyses are performed. The advantages of placing the position in a
central service unit include: (1) it allows the grouping of financial analysts,
thereby pooling expertise and encouraging cooperation among analysts; (2)
it promotes flexibility and accommodates departments that do not need an
analyst full-time; (3) it facilitates multidepartmental assignments; and (4) it
increases the neutrality and objectivity of analyses.
There are also advantages to placing the financial analyst in a decentral-
ized position in the company,with financial analysis attached to and integrated
with operating units. A decentralized positioning is favored when: (1) the
analyst's role is to help and advise locally rather than to try to control from
the corporate office; (2) the operating unit needs full-time analysts and the
management of the unit is receptive to analytical services; or (3) the operations
of the unit are highly complex and much research is necessary before financial
analysis can be done.
The nature of a company signals which position-centralized or decen-
tralized-maximizes the benefits from financial analysis. Some companies
even mandate that a financial analyst work at a centralized corporate level
and at a decentralized division level prior to being eligible for an advanced
position. The rationale behind this rule is that the analyst will gain broader
experience and familiarity with the company's products, policies, and proce-
dures. In this course, the most importantpoint is not the position of the analyst
within the company, but rather the uses and benefits of financial analysis.
FINANCIAL MANAGEMENT AND
FINANCIAL ANALYSIS
The financial manager and the financial analyst may or may not be the same
individual. As we mentioned earlier, one major difference in their roles is
that the managers make the financial decisions while the analysts recommend
the best alternatives. The influence of the financial manager (and financial

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management in general) has increased substantially in recent years. Once,
the manager's responsibilities were confined mainly to preparing financial
statements, managing the company's cash position, and providing the means
for paying bills and procuring additional funds. Now, financial management
includes: (1) investing idle cash and liquid reserves; (2) synchronizing cash
receipts and disbursements; and (3) procuring financial sources of funds.
Furthermore, the financial manager should be cognizant of external and
internal user needs.
External users are primarily concerned about the liquidity, operating
profits or losses, and business risk of the company. Business risks pertain to the
relative volatility of the firm's expected net operating earnings. For example, a
paper company experiences a business risk when its forests are exposed to
losses due to fire or diseases. Internal users are not only concerned about
the day-to-day liquidity and profit/loss record from operations, but are also
concerned about financing sources and the accompanying financial risk. A
financial risk pertains to the likelihood of default on financial obligations.
The evolution of financial management and the increased use of financial
analysis have been furthered by the availability of computers at every level
in a business enterprise. Accordingly, the application of computers as analytical
tools enables managers at every level to use sophisticated financial models
and techniques in their decision making.
ACTIVITIES AND FINANCIAL
STATEMENTS
Companies use physical and financial resources to implement their business
strategies. What a business does is the result of its business activities -its
operating activities (e.g.,producing and selling goods), its investment activities
(e.g., acquiring and selling plant and equipment assets), and its financing
activities (e.g., issuing and retiring long-term notes). These activities are
reported in summary form in the financial statements through the company's
accounting system. Financial reports are prepared on an accrual basis rather
than on a cash basis. Accrual accounting recognizes revenue when it is earned
and expenses when they are incurred, regardless of whether cash is received
or paid. Accrual accounting, in contrast to cash-basis accounting, reports the
full economic consequences of business activities.
Accrual accounting necessitates assumptions and estimates in reporting
financial information. While managers have the most knowledge to make
these assumptions and estimates, they also have some incentive to manipulate
financial data for the company's benefit. Management's discretion is reduced
by the requirement to follow Generally Accepted Accounting Principles
(GAAP). Such limitations can have both good and bad effects. Similarly, the
verification of the preparation of financial statements on the basis of GAAP
by independent auditors can be both beneficial and not beneficial.
Managers still have discretion to tell their story; GAAP does not eliminate
choice completely. Managers have discretion to disclose as much information
as they like. Managers want to provide information so that investors and
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creditors can understand the business. On the other hand, they do not want
to disclose information that may hurt the firm competitively or that might
indicate that the firm is performing poorly if such information can be hidden.
The role of the financial analyst is to understand the reality of the business
despite shortcomings in the reporting process.
BUSINESS STRATEGY
A company must have a strategy to create and sustain a competitive advantage.
One strategy is to differentiate a product or a service to make it unique
because of its high quality or technological capabilities. Another strategy is
to focus on costs by concentrating on product efficiencies, or purchase dis-
counts, or by outsourcing. Lower costs lead to high sales volume through
lower prices. Such operational efficiencies can be easily imitated, resulting in
nobody having a clear advantage over others. Most companies try to imple-
ment both strategies.
Porter (1996) notes that competitive strategy means being different-
either performing different activities or performing activities differently from
other companies.A company may specialize in producing just a few products,
or providing just a few services, or on meeting the needs of a select group
of customers. Strategic positioning means choosing activities that differ from
your competitors'. The same activity set cannot be everything to everyone.
To sustain a strategic position, trade-offs are required. But what activities is
the company going to forgo? The whole system is important. We must not
speak of key or critical success factors. One activity affects another. It is harder
to imitate a whole integrated system than a single activity.
In its 1997 annual report, William C. Foote, Chairman and Chief Execu-
tive Officer of USG Corporation, states the company's strategic objectives:
1. Increase operational excellence (core values-safety, quality, service, low
cost, integrity).
2. Invest for growth (being a low-cost producer so as to maintain profitability
throughout the economic and construction cycle).
3. Improve financial flexibility (achieving debt reduction, eliminating collat-
eral on debt obligations).
4. Build the USG team (enhancing the team's effectiveness by increasing
diversity).
COMPETITIVE
ENVIRONMENT
Porter (1985) writes that the average profitability of an industry is influenced
by five forces. The first three-rivalry among existing firms, threat of new
entrants, and threat of substitute products-relate to the degree of actual and
potential competition. The fourth and fifth-bargaining power of buyers and
bargaining power of suppliers-determine whether or not the potential profits
are kept by the industry.
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The degree of competition depends on factors such as the following:

growth of the industry (whether rapid or stagnant)

number and size of firms in the industry

differentiation among products
existence of economies of scale
amount of research and development needed
amount of brand advertising needed
existence of entrance and exit barriers
distribution networks established
threat of substitute products
The bargaining power of buyers is important, because if the buyers are
economically powerful compared to the company selling the product or ser-
vice, prices can be kept low; therefore, the selling company's revenues are
not as high as they could be. Similarly, if the bargaining power of suppliers
is high compared to the company selling the product or service, input prices
are higher; consequently, the selling company's costs are higher than they
could be.
Different industries have different competitive environments. Exhibit
1-2 presents the competitive environments in the personal computer and
cereal industries.
THE APPLICATION OF ANALYTICAL
TECHNIQUES FOR SPECIFIC PROBLEMS
Financial management may be broken down into three main decisions: the
investment decision, the financing decision, and the dividend decision. The
applications of the various financial analytical techniques likewise may be
broken down into these decision units.
The use of a specific analytical model, such as net present value or
internal rate of return, depends on the question being asked. Many problems
in financial management can be dealt with by employing more than one
financial analysis technique. The purpose of applying an analytical technique
is not necessarily to calculate a definite answer; rather, the purpose of a
technique is to provide a more informed basis on which to make a decision.
An important consideration in financial analysis is timing. The timing of
various financial policies is important in terms of interest rates, inflation,
taxes, and the capital market. Most of the techniques used in financial analysis
involve a time element. For example, when evaluating a capital investment
proposal, the manager must be fairly certain of the times involved for ordering,
installing or building, and starting up a new investment. In the following
sections we will discuss how specific techniques can be used under certain
circumstances and describe how we arrived at a financial decision.
Investment Decisions
Investment decisions are perhaps the most important of the three types of
financial decisions, because the outcome of these decisions determines the
amount of cash flows in future periods. Investment decisions in this context
refer to both short- and long-term reallocations of corporate funds. Short-
term investment decisions include the level of current assets (cash, accounts
receivable, and inventories) necessary for day-to-day operations; whereas
long-term investment decisions refer to fixed asset purchases, mergers, acquisi-
tions, and corporate reorganizations.
Different techniques are used for effective management of short-term
cash and accounts receivable than for purchases of long-term fixed assets. In
order to gauge the proper level of cash, an analyst may develop a cash budget,
use ratio analysis to determine the trends or variations of current assets and
liquidity, or use pro forma income and balance sheets to plan income, funds
flow, and cash flows. These various analytical tools are interrelated and should
be used together to manage current assets.
Capital investment -a major aspect of the long-term investment deci-
sions the allocation of capital to investment proposals that will realize
benefits in the future. Investment proposals necessarily involve risk, because
future benefits are uncertain. Consequently, investment proposals should be
evaluated both for their expected return and for their risk to the company.
Capital investment proposals include both investment in new assets and the
relocation of capital and assets within the company.
The evaluation of capital investment proposals involves a number of
different techniques and types of financial analysis, all of which are interre-
lated. A risk analysis determines the investment's risk as compared to the
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company risk. A cost of capital analysis determines the correct discount rate to
use in the cost analysis. A cash flow analysis determines the expected net cash
flow from a new investment. The determination of a predicted cash flow could
involve a sales analysis to predict future sales from the investment, an economic
analysis to study future trends, or a financial forecasting analysis to determine
cash income and expenses. Once the cash flow analysis has been completed,
it is necessary to conduct a cost analysis to determine the returns of the new
investment or the allocation of capital. The areas commonly studied in cost
analysis include: net present value, internal rate of return, cost-benefit ratio, and
the payback period. Upon completion of this evaluation,a sensitivityanalysis to
test the validity of the analyst's original basic assumptions is justifiable.
If mergers and acquisitions or failures and reorganizations are the subject
of analysis, the analytical techniques used would include: determining certain
financial ratios such as the price-earnings ratio, determining the exchange
ratio, and analyzing the possible negotiation range for mergers and acquisi-
tions. Also, the net present value technique could be used once the cash flows
with either a merger or a reorganization has been predicted.
Financing Decisions
The financing decision varies depending on the size of the firm, the financing
options available to the firm, the needs of the firm, and the location of the
firm. Small firms generally do not have the same financing options that larger
firms have; consequently, small firms are more likely to experience difficulties
financing growth and/or avoiding bankruptcy.
Large firms are more likely to be able to obtain bank financing and to issue
stock. Furthermore, large, established firms may have the opportunity to issue
commercial paper. Small firms, on the other hand, usually depend heavily on
family, friends, and supplier financing for start-up and working capital.
When making financial decisions, the manager must determine the best
financing mix or capital structure for the company. In this sense, the best
choice is the capital structure that allows the optimal valuation of the company
for the shareholders.The important elements to consider in making financial
decisions include: (1) the nature and riskiness of the business operation;
(2) the capital structure (debt-to-equity ratio) desired; (3) the length of time
the assets will be needed; and (4) the cost of alternative financing.
There are a number of pertinent analytical tools to use when the subject
of analysis is the optimum capital structure of the company. A financial
leverage analysis determines the company's financial leverage and how it can
use financial leverage in its capital structure. Trend and historical analyses
examine the company's past capital structure. Ratio analysis determines the
current financial structure and other financial indicators. In addition to con-
ducting the above analyses, the analyst could perform an analysis to determine
the current cost of capital and ways to decrease this by changing the financing
mix. All these analyses are concerned with the total valuation of the company.
Alternative sources of financing are an important subject of analysis, also.
Businesses need short-, medium-, and long-term financing at various times
to remain liquid and profitable. To analyze sources of short-term financing,
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the analyst must study the costs of each source, applying techniques such as
present value analysis, compounding analysis, and interest factor analysis.
To evaluate alternative sources of long-term financing, security markets,
types of securities (such as debt or preferred stock), and common stock values
and sales should be analyzed. An analysis of sources of long-term financing is
linked to the capital structure analysis. Any analysis of a source of long-term
financing would have to include a study of the effect of the financing on the
company's capital structure as well as the costs and benefits of the financing.
Other forms of financing that could be the subject of financial analysis
include term loans and lease financing. For either form, the analytical tech-
niques used would include a comparison of that type of financing's present
value costs or benefits with the present value costs or benefits of the alter-
natives.
Dividend Policy
The dividend policy that the company chooses is also a subject of analysis in
financial management. The three standard dividend alternatives -the stable
dividend policy, the constant payout ratio, and the regular low dividend policy
plus extra-must be evaluated according to the company's specific situation.
In addition, the repurchase of the firm's outstanding common stock must be
considered. The aim of the analysis would be to determine which type of
policy would maximize the value of the company's stock. To determine this,
the analyst would compare the effects of different policies on the company's
valuation. Choosing the dividend policy is a strategic decision, usually made
by senior-level managers, with final approval subject to the board of directors.
PRIMARY GOAL OF FINANCIAL ANALYSIS
Criteria used in financial decision making should be based on the anticipated
benefits to the present owners of the company. Theprimary goal is to increase
the owners' wealth. The way to increase the owners' wealth is to increase
the market value of their investment (equity) in the enterprise. Conse-
quently, the decision criteria used in this course are those that maximize the
market value of the shareholders' equity.
An immediately obvious question is what criteria to employ for companies
that do not have an observable market price. The answer lies in the characteris-
tics that cause any earning asset to have value. The rule, then, is to optimize
the expected return and to minimize the risk of the equity. Such optimization
refers to the balancing of the risk and the return in an attempt to maximize
what the decision maker believes would be the market price of the owners'
equity if it were traded in the market.
LONG-RANGE VERSUS
SHORT-RANGE GOALS
It is important to note that decisions are analyzed differently, according to
the decision maker's point of view. Different levels of management treat
financial decisions in different ways. For example, the board of directors or
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top management has a long-range view of the company and, therefore, of
the effects of various decision alternatives on the company. Generally, top
managers are more concerned with long-range strategic planning, and their
decision criteria reflect this. Consider the dividend decision, which usually
is made by the board of directors or top management. Their overriding
consideration in choosing a dividend is the dividend's long-range impact on
the company's stock price.
In comparison, the managers at the operating level of a company generally
are more concerned with short-term goals and the short-term effects of various
decision alternatives. For example, operating management is concerned with
cash management decisions. Short-term objectives, such as cash liquidity and
inventory control, are of primary concern in the financial analysis of cash
management decisions.
THE BALANCED SCORECARD
Long-range strategy can be linked with short-term actions through the imple-
mentation of the balanced scorecard. Combining financial and operational
measures, the balanced scorecard gives management a comprehensive view of
the business. According to Kaplan and Norton (1992), the balanced scorecard
provides answers to four basic questions that enable management to focus
on the most critical measures.
How do customers see us? (a customer perspective)
What must we excel at? (an internal perspective)
Can we continue to improve and create value? (an innovation and learn-
ing perspective)
How do we look to shareholders? (a financial perspective)
The balanced scorecard represents a fundamental change from traditional
performance measurement systems by putting strategy, rather than control,
at the center. Everyone in the company should be moving along the path
toward the overall vision of the company.
Kaplan and Norton (1996) write that four management processes link
long-term strategies with short-term actions:
1. Translating the vision into an integrated set of agreed-upon objectives
and measures that are stated in meaningful terms.
2. Communicating management's strategy and linking it to departmental and
individual objectives.
3. Through business planning, integrating business and financial plans and
moving the company toward management's long-term strategic objectives
by selecting measures of progress from each of the four balanced scorecard
perspectives (listed above) and then setting targets for each of them.
4. Enabling a company through feedback and learning to see whether it and
its components have met their financial goals and evaluating strategy in
light of recent performance.
The balanced scorecard allows strategy to not only be implemented but also
to evolve in response to competitive and technological changes.
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TECHNIQUES PRESENTED
IN THIS COURSE
In this course, we will present several specific financial analytical techniques.
In Chapters 2 , 3 , and 4 financial statement analysis and the use of ratio analysis
are explained Chapter 5 provides a discussion of current asset and liability
management. Chapter 6 describes several different techniques used to evaluate
capital investment proposals. In Chapter 7, we will discuss business and finan-
cial risk and optimum capital structure. Chapter 8 explores mergers and acqui-
sitions.
In this chapter, we discussed the role of the
financial analyst, the criteria for financial deci-
sion making, the various financial decisions
recap
that most managers must make, and the spe-
cific analytical techniques that managers can
use to make more informed financial decisions.
Some techniques for analyzing three different
financial decisions (investment, financing, and
dividend) were explained. Also discussed were the interrelated topics in finan-
cial analysis.
The scope of financial analysis and its location in the organization varies.
Financial analysis is fiscally- and economically-oriented staff work. Financial
analyses are done not only by financial analysts but also by all managers who
must make financial decisions. The topics covered in this course are just a
few in the scope of financial analysis; however, the subjects and the specific
analytic approaches presented are the basics upon which managers may expand
their decision-making capabilities.
A company's strategy creates and sustains its competitive advantage.Most
companies try to differentiate their products or services from their competitors
and to control their costs. Profitability in an industry is a function of the
rivalry among existing firms, threat of new entrants, threat of substitute
products, bargaining power of buyers, and bargaining power of suppliers.
This course will enable managers to use financial analysis in a number
of specific areas. More importantly, it presents sound financial analysis tech-
niques that may be applied to most financial decision-making processes.
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1. An advantage of placing the role of financial analysis in a decentral-

1. (d)
ized position is:
(a) it increases the objectivity of analyses.
(b) it pools expertise and encourages cooperation among analysts.
(c) it facilitates multidepartmental assignments.
(d) it allows for necessary research to be conducted for a unit's
operations that are highly complex.
2. Financial management is not concerned with:

2. (d)
(a) increasing the overall valuation of the company.
(b) the investment of funds in capital assets.
(c) obtaining the best mix of financing.
(d) preparing financial statements.
3. The main decisions in financial management do not include:

3. (c)
(a) the investment decision.
(b) the dividend policy.
(c) the personnel policy.
(d) the financing decision.
4. A company's operating activities include:

4. (a)
(a) producing goods or services.
(b) retiring long-term notes.
(c) acquiring plant and equipment.
(d) following GAAP.
5. Whether or not potential profits are kept by the industry is partly

5. (c)
determined by:
(a) threat of new entrants.
(b) rivalry among existing firms.
(c) bargaining power of buyers.
(d) threat of substitute products.