ENT 470/570 2009 PRESUMMER - 04

The Business Plan for Executing Innovations:

Concepts, Theories, Models and Strategies
Ozzie Mascarenhas SJ, PhD.
May 13, 2009

From an academic point of view, a business plan is a roadmap, a statement of strategy, an operational
model, a business forecast or some other conceptual label. From an entrepreneurs viewpoint, a business
plan is a selling document, a sales pitch you give to prospective venture capitalists and banks. A business
plan does not sell a product or a service or a work environment, it sells an entire innovation project, the
entire business venture or your new company. If you are really excited about and believe in your project
or your new company, it should reflect in the business plan. Excitement, however, is not based on puffery
or exaggeration. It is based on supporting evidence in the form of solid research and experience. The
innovation, new product or service idea that you sell or form a company about should be real, credible,
convincing, promising, attractive, demonstrable, and worth investing to your stakeholders. Hence, have a
clear purpose, content, audience and expected outcome for your business plan. These will generate a
sense of commitment, focus and realism to your document.

Why should you write a Business Plan?

A completed business plan is a guide that illustrates where you are, where you re going and how to
get there (Charles J. Bodenstab). A business plan may tell you by the time you are done that this is not a
profitable business. If you go into the business world without a path to walk down, without some sort of
guidelines, you are in trouble (Geoff Walsh). The business plan could be the most useful and important
document you, as an entrepreneur, ever put together. The plan keeps you thinking on target, keeps your
creativity on track, and concentrates your power on reaching your goal (Megginson, Byrd, Scott and
Megginson 1994: 138).

A properly developed and written business plan serves as an effective communication tool to convey
ideas, research findings and proposed plan to potential investors. The business plan is the basis for
managing the new venture. It also serves as a measure to gauge progress and evaluate needed changes.

Gumpert (1997: 120-147) provides eight reasons for writing a good business plan:

1. It is a sanity check for you. Write your plan and run it through others for their response and
reactions. Not all would agree with you and your plan. Nevertheless, agreements and
disagreements will help you to focus better, sell yourself more credibly, and revise your
assumptions and presuppositions.
2. To obtain Bank Financing: Getting bank finance is tough, and you will have to make a clear
persuading case to your prospective bankers. Currently, (given the bank failures of the late 1980s
and early 1990s), banks are under great scrutiny by federal regulators and, consequently, require
entrepreneurs to include a business plan with any request for loan funds.
3. To obtain Investment Funds: A written plan endorses your belief and commitment to your
business idea. Investors and the Securities Exchange Commission (SEC) want written business
plans than mere oral presentations.
4. To arrange Strategic Alliances: Small and large companies need others and each other. Small
companies need financial support and big companies need innovation. Besides obtaining funds,
your business plan could ground joint research for developing your core product and
competencies (front-end innovations) and joint marketing for bundling, promoting, retailing and
servicing (backend innovations) your product.

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 5. To obtain large Contracts: Your major buyers will not contract with you until they are convinced
that your product meets with quality standards, and that you will stay in business for at least
three to five years. A formal written business plan should convince them about these concerns.
Today, big corporations are looking for long-term supplier chain management (SCM)
relationships.
6. To attract key Employees: Best talent normally looks for stable large companies. Hence, as a small
business, your business plan must be able to attract good executive, engineering and blue-collar
worker talent to your fledgling company. Good executive and engineering talent, tired of
convoluted bureaucracies of large corporations, are seeking personalized, ethical, and
empowering morale and climate of small companies.
7. T complete Mergers and Acquisitions: If your business plan intends a merger, acquisition,
divestiture, technical collaboration, cross-licensing, strategic alliance or a joint venture, then your
prospective business partner would like to know more about you and your venture from your
business plan.
8. To motivate and focus your Management Team: A written business plan with clear short-term and
long-term goals and strategies will enable your executives, engineers, marketers and workers to
stay focused, motivated and productive.

The Structure of your Business Plan

A business plan has usually three parts:

a) A Summary Business Plan (< 5 pages) containing executive summary on all the key points of
your full business and operational plan.
b) The Full Business Plan (10-20 pages) covering topics 1-14 below, and
c) The Operational Business Plan (25+ pages) covering materials, purchasing, product design,
production, inventory, sizing, packaging, bundling, costing, pricing, distribution, promotion
and advertising, business forecasts, cash flows, and profitability.

The length, depth, breadth and technicality of your business plan would depend upon several factors:

1. Nature of your business (its size, growth, complexity, newness);

2. The domain of your business (local, statewide, regional, national, international, global and
online);
3. Size of the bank loans needed;
4. Size of investor commitment expected;
5. Size of your collateral; what you bring to the table;
6. Strategic business partners (mergers versus acquisitions versus joint ventures versus alliances);
7. Your credibility and fame as a seasoned and successful entrepreneur;
8. The nature of your innovation (radical versus incremental);
9. The nature of your breakthrough idea (market versus technological breakthroughs);
10. The nature, complexity, cultural diversity, rarity and cost of the skills required for your
business;
11. The nature of the target markets (old versus augmented versus new markets),
12. The size, stability, volatility, potential and accessibility of your target markets;
13. The risk, uncertainty and ambiguity of your products and target markets; and
14. The legal implications of your products or services (e.g., safety, security, privacy, unions, patents,
intellectual property, and OSHA, CAF, EPA, USDA, SEC, CPSC or WTO regulatory
requirements).

The Basic Content of a Business Plan

1. Cover page: Name of the company, address, name of the president or contact person with phone,
Website and email details. The cover page should also include copyrights.

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2. Table of Contents: Provide Contents in brief, and Contents in details. Some bankers read portions of
your business plan picking items from the Table of Contents.
3. Executive Summary: This is the business plan in miniature. It should catch the excitement and
essence of the business. This is the single most important section of your business plan because most
of your target audience will start reading the summary first before digging into the Business Plan
proper. Your executive summary has to keep potential investors, bankers or venture capitalists
interested. If you lose them here, you lose them forever. It should rarely exceed two pages of bullets.
You may write this first before you start working on the business plan, or you may do it at the end.
In any case, this piece of the business plan should get your best attention, skills, drives and passion.
4. The Company: What is your corporate identity? Provide your companys history in brief, your
start-ups, your current business strategy, management team, and a record of accomplishment of past
products and successes (and failures). In describing your business strategy, tell the audience what
you plan to do, but follow it carefully in the subsequent documents. Make your business strategy
relevant, credible, doable, believable, and logically consistent. In this connection, analyze your past
successes and problems as honestly and objectively as possible, with both its positive and negative
aspects, describe your current status (e.g., its feasibility, viability, sales and earnings trends, your
product and marketing mix, significant changes and profitability. Thirdly, outline your future goals,
how they continue or depart from the past, why, and with what success. Describe your management
team and how it is geared to realize your future goals.
5. The Market: Who are your target market or potential buyers? How and why did you identify them?
What was your market scanning, market research, and market forecasting on this? What is your
customer base, customer prospects, and how best can you reach them. What are your target market
demographics and possible demographic shifts? Detail on the size, accessibility, stability, buying
power, volatility of the target market. What will make the market believe and buy- in your product?
Is your market growing or shrinking, stagnant and stale? How do you plan to protect this market by
suitable and ethical market entry barriers?
6. The Product/Service: What are you selling? To whom? Why? How? When? Where? Through
whom? How often? Describe your creation/innovation/invention/discovery product or service with its
essential features and attributes, values, costs and benefits, quality and utility to the target markets.
How can your product fulfill unmet needs, wants and desires of your target customers? What
convenience and saving (of time, money, energy, effort, anxiety, space and pace) does your product
provide that your competition does not? Quantify your costs and benefits to the prospective
customer.
7. The Production Phase: Describe the essential ingredients, materials, components and parts required
for the production of your product/service. Describe your suppliers, your purchasing strategies,
your materials inventory, your in-process inventory and your finished goods inventories. Foresees
problems and resolution of design, manufacturing, platform technology, patents and intellectual
property, scale and scope economies, sizing, bundling, packaging, transportation logistics, costing
and pricing, and other factory problems.
8. Sales and Promotion: Detail on your marketing, advertising, promotion and distribution plan and
strategies. In-house versus external marketing consultants. Detail your promotion tools such as
price bundling, product bundling, price and product hybrid bundling, warranties, guarantees,
discount pricing, rebates, credit, financing, product expansion and updates, and refund and recall
policies. What are your plans for Web-marketing, Website designs, Web-auctioning, Web-
personalizing, and other modern Internet marketing strategies? What are your selling plans, costs
and strategies? What are your retailing plans, costs and strategies? What are complaint handling
and redress strategies? How will you motivate your distributors, retailers and sellers? How will
your corporate advertising, PR, brand image building, product preannouncements, and brand
community-building supplement and support your selling, retailing and distribution strategies?
9. The Competition: Unless your product is absolutely new to the world, it will have competing brands,
substitutes and surrogates. Examine and assess them. Who are your competitors, their products or
services, their quality and brand equity, their price and rebate offerings, their price and product

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 bundling, their warranties and guarantees, and their credit and financing strategies? Be sure, you
cover international and global competition if relevant. How would your establish sustainable
competitive resource advantage (SCRA) against this competition? How would you establish your
sustainable competitive quality advantage (SCQA) against this competition? How would you
establish your sustainable competitive marketing advantage (SCMA) against this competition?
10. Finances: What are your costing, pricing, break-even and mark-up plans? What are your premium,
penetration and competitive pricing strategies? Based on your business forecasts, project your cash
flows, cash outflows, cash inflows, net cash flows, for the first, second, third, fourth and fifth years.
Study your cost of goods sold (CGS), selling and administrative costs (SAE), capital expenditures,
interest expenses, owning versus leasing versus renting expenses, depreciation, wage payrolls, taxes,
gross margins, contribution margins, net earnings, retained earnings and dividends. Hence, also
project ROQ, ROS, ROM, ROE, ROI, ROA, and EPS, P/E, and TSR if publicly traded.
11. Concluding Remarks: Summarizes your strengths and weaknesses, threats and opportunities, unique
features and attributes, great values and benefits to make a final and brilliant pitch to your reader
audience.
12. Appendices: This is the place for executive and team rsums, product literature, patent literature,
endorsement letters from suppliers and customers, and the like.

Table 4.1 summarizes the content of a business plan and the relevant questions you should ask under each
item.

Before you write a Business Plan:

Before embarking on any business project, it is critical that you ask the right questions and explore
focused answers on several key issues. For instance, examine your current financial position by
answering some simple questions (Blaney 2002:57):

a) Where are you now? Do you have the money to start this business? Do you need to borrow from
banks? Do you want to attract venture or angel capitalists to your project? What is your current
business status: Are you insolvent: that is, can you pay all your bills and debts when they are due?
Do you have sufficient cash for the immediate near future? Will the banks (assuming you have bank
borrowing capacity such as overdraft) bail you out?

b) How did you get here? What brought you to your current business status? Do you have in the
immediate any negative net cash flows? What was your business performance record of
accomplishment with immediately past innovations and new product introductions?

c) Where are you going from here? What are your longer-term cash, sales, profit and loss, balance and
security forecasts? How did you forecast? How objectively and realistically did you forecast?
Presumably based on your forecasts, how and why did you set your targets?

d) How do you know now that you will reach there (your targets)? How would you know that you have
reached there? What are your metrics to gauge your performance? If you do not reach your
forecasted targets, what is your risk? What is the impact of such a risk on your profits and financial
performance ratios?

If you are in a cash crisis (first question), then you should not worry about the past (second question)
or about your future (third and fourth questions). Your business plan should address all four questions:
with sales, CGS, receivables, payables, inventory, cash, cash cycle, cash flows, cash flow forecasts, cash
flow statements, cash flow management, cash budgeting, harvesting cash, and anything about cash that
will help you answer the first and the third questions and get you out of a cash crisis. The single most

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important tool for building new companies or saving dying ones is the deft management of cash flow
(Wexler 2002).

Often, new products turn out to be cash traps. Bruce Henderson, the founder of the Boston
Consulting Group, warned managers over three decades ago: The majority of products in most
companies are cash traps. They will absorb more money forever than they will generate. Most new
products (almost 5 to 9 out of ten products) do not generate enough cash or enough financial returns
despite massive investments in them. For instance, Apple Computer stopped making the striking G4
Cube less than a year after its launch in July 2000 as the company was losing too much cash on the
investment. Proctor & Gamble in 2002 made half of its sales and even a bigger share in profits from just
12 of its new 250-odd products of that year (Andrew and Sirkin 2003: 77). Creativity and innovation are
not enough. There is a big difference between being innovative and an innovative enterprise: the former
generates many ideas; the latter generates much cash (Levitt 1963). A failing company needs innovations
that turn into good markets and good markets that turn into good cash and financial returns this is the
innovation-to-cash chain (Andrew and Sirkin 2003: 78).

The Fundamental Finance Principle

A key question we ask before any business decision or undertaking is: Will the decision create value
for the firms owners? The fundamental finance principle responds to this question stating: A business
proposal (e.g., new investment, acquisition, merger, a restructuring plan) will raise the firms value only if
the present value of the future stream of net cash benefits the proposal expects to generate exceeds the
initial cash outlays required to carry out the proposal (Hawawini and Viallet 2002: 5).

The present value of the future stream of net cash benefits the proposal expects to generate is the
amount of dollars that makes the firms owners indifferent between receiving that sum today and getting
the expected future cash-flow stream. For example, if the firms shareholders are indifferent between
receiving cash dividend of $100,000 today and getting expected cash dividend of $110,000 next year,
then $100,000 is the present value of $110,000 expected next year. That is, the shareholders expect to
receive a return of 10 percent from the project, which is called the discount rate (the rate at which the
future cash flow must be discounted in order to find its present value). A proposals appropriate discount
rate is the cost of financing the proposal. By the fundamental finance principle, a project is undertaken if
its net present value (NPV) is positive (i.e. it creates value for the firms owners), and is rejected if its
NPV is negative (since it destroys value for the firms owners). This is called the Net Present Value Rule.

Only Cash Matters

The fundamental finance principle requires that the initial investment needed to undertake a proposal,
as well as the stream of net future benefits it expects to generate, be measured in cash. Only cash matters
to the investors, whether they are shareholders (providing equity capital) or debt-holders (leveraging debt
capital) because all they have invested is cash in the firm and are expecting cash returns in the future.
[Note that the cash benefits of a project are not the same as the projects net profits the latter are
accounting measures of benefits, not of cash returns].

In 1993, Dell experienced a serious liquidity problem. Dells rapid growth coupled with poor
working capital management was rapidly stifling their ability to grow in the future. In order to remedy
the problem, Dell institutionalized a working capital program that focused on cash flow and a more
efficient cash management process. Today, working capital management is part of the Dell fabric and
DNA for growth (Hartman 2004: 150).

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 How to use cash is the biggest issue in an ongoing restructuring plan. Debt and cash are two top
priorities in troubled organizations, especially those that have no choice but restructure. Some
corporations use cash to buy back their own stock, especially if there is no other better investment
opportunity. Others pay dividends giving cash back to shareholders and assuring them that they can think
of no better investment for their money. If you restructure your balance sheet to reduce your debt in
profitable times, you prepare yourself for times you will need to raise the debt. Excessive debt creates
unremitting pressure from financial and trade creditors. Financial creditors harass management about
delayed interest payments, violated debt covenants, sinking fund obligations and early repayment
schedules, and may even threaten to deny the company further credit. Trade creditors warn the struggling
company about overdue balances and may threaten to withhold further shipments. Controlling your cash
and cash flows are very important in satisfying both your financial and trade creditors (Pate and Platt
2002: 92-3).

We can view a satisfied customer as an economic asset that yields predictable future cash flows
(Fornell 2002: 41). Satisfied customers are more loyal and increase their level of purchasing over time
(Anderson and Sullivan 1993; Reichheld 1996), are more receptive to cross-selling efforts (Fornell 1992),
are less likely to switch to competing brands despite their alluring lower prices (Fornell et al. 1996), and
generate positive word-of-mouth patronization (Anderson 1996). All these factors contribute to steady
and enhanced future cash flows that ensure higher shareholder value.

Some Basic Terms and Definitions of Cash Flow Management

Cash Flow Management:
In order to appreciate fully the critical importance of cash and cash flows to any business, we first
define some major terms involved such as cash, cash flow, cash flow management, cash flow time line,
operating cycle, cash cycle, cash flow management measures and cash flow statements. Most of these
terms follow generally accepted accounting principles (GAAP).

Cash: Definition and Measurement

Most familiar to us as the term cash is, it is a surprisingly imprecise concept. From a bankers
viewpoint, cash is money or any medium of exchange that a bank accepts at face value. Cash includes
currency, coin, and funds on deposit that are available for immediate withdrawal without restriction. Cash
is the first current asset listed on the balance sheet of most companies. A balance sheet lists all assets in
relation to their degree of liquidity. Cash obviously tops the list in the balance sheet as being the most
liquid monetary asset of the firm. The cash account on the balance sheet is the amount of liquid assets
available for the companys day-to-day uses.

The economic definition of cash includes currency, money orders, certified checks, cashiers checks,
personal checks and bank drafts, checking account deposits at commercial banks, and un-deposited
checks. Financial managers use the term cash also to include short-term marketable securities. Short-
term marketable securities are short-term investments with a maturity not exceeding one year.

One property of liquidity is divisibility, that is, how easily an asset can be divided into parts (Ross,
Westerfield and Jaffe 2002: 771). The economic definition of cash is based on liquidity: currency,
checking accounts at commercial banks and un-deposited checks are highly divisible into small units and
usable to pay bills. As the most liquid of all assets, cash is also the medium of exchange for assets and
liabilities. It serves as a basis for measuring the value of all assets and liabilities.

Cash Equivalents

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 The balance sheet term cash or cash equivalents reflects the amount of money or the currency the
firm has on hand or in bank accounts. Cash equivalents are short-term and highly liquid investments
readily convertible into known amounts of cash and close enough to maturity. Typical cash equivalents
are short-term marketable securities such as short-term U. S. Treasury bills issued by the government,
certificates of deposit issued by the banks, commercial paper issued by corporations with good credit
ratings, shares in money market funds, and repurchase agreements. The balance sheet item cash
usually includes cash and cash equivalents. Net working capital includes both cash and cash equivalents.
Cash equivalents are highly liquid; that is, one can easily sell or convert them to cash with minimal
change in value.

How is cash amount measured? If cash consists exclusively in US dollars, the balance sheet account
reflects the historical amount of net dollar units arising from past transactions. Since cash is very liquid,
this historical amount of net dollar units is identical to the current market value of the cash.

If a firm is multinational, and some cash is in foreign currencies, then the foreign currency units must
be translated into U. S. dollar equivalents. For some monetary assets like cash, accounts receivable and
notes receivable, the current rate of foreign exchange (in effect at the balance sheet date, and not the
historical rate of exchange that was in effect at the time of the foreign currency cash inflow) is used to
translate foreign currency into U. S. dollars. Some currency conversions involve conversion commissions
or exchange fees. Thus, this foreign portion of the cash account is carried at its current market price,
irrespective of whether it is higher or lower than the historical rate. Thus, for foreign accounts, the GAAP
measurement convention for cash is market price rather than historical cost (Revsine, Collins and
Johnson 1999: 109-110).

There are two primary reasons for holding cash:

1. For transactions such as disbursements and collections. Disbursements of cash are cash outflows
and include the payment of wages and salaries, rents, utilities, shipping, trade debts, taxes, and
dividends. Collections of cash are cash inflows and occur from selling products and services,
sales of fixed assets, income from investments, royalties from patents and licenses, and new
financing.
2. For Compensating balances: minimum cash balances are held in commercial banks to
compensate for banking services provided by them.

Since minimal compensating balances must be maintained in order to obtain banking services and not
for transactions, the cash of most firms can be thought of as consisting only cash holdings for transaction
balances. The cost of holding cash is the opportunity cost of lost interest. To determine the optimal cash
balance, the firm must weigh the benefits of holding cash against opportunity costs of lost interest and
cash-shortage. Many firms hold very large balances of cash and cash equivalents. For instance, in 1997,
the largest cash balances included those of Ford ($18.5 billions), General Motors ($10.1 billions),
Microsoft ($9.1 billions), Intel ($8.5 billions) and IBM ($6.5 billions). The reasons firms hold large
balances of cash and cash equivalents include precautionary needs such as a recession, large anticipated
spending on dividends, stock repurchases, privatization, stock options, or capital investment.

Understanding Financial Statements

Financial Statements are formal documents issued by firms to provide financial information about
their business and financial transactions. Regulatory authorities (e.g., GAAP, SEC) and stock markets, in
which their shares are traded, require such financial statements at least annually. Two primary financial
statements include: a balance sheet and an income statement (the latter is also called the profit and loss

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statement or P&L account). In some cases, regulatory authorities also require a third protocol: a
statement of cash flows, which provides information about the cash transactions between the firm and its
outside world. Financial statements are mostly meant for the investors who are the primary users of such
statements. Hence, these statements must use terms and expressions that are commonly employed in
financial accounting and must conform to general standards and rules, which in the USA are known as
generally accepted accounting principles (GAAP).

The fundamental objective of a balance sheet is to indicate the value of the net or cumulative
investment made by the firms owners (investors or shareholders) in their firm at a specific date, generally
at the end of the accounting period. The balance sheet informs what shareholders collectively own and
what they owe at the date the statement is made.

The fundamental objective of the income statement is to measure the net profit (or loss) generated by
the firms activities during a specific period called the accounting period (or the fiscal year). The income
statement informs the investors about the firms activities that resulted in increases (or decreases) in the
value of the owners investment during a given accounting period. That is, the income statement or the
net profit or loss statement is a measure of the change in the value of the owners investment in their firm
during a given accounting period. Table 4.2 presents a sample of Projected Income (Profit & Loss)
Statements 2007-2010. Table 4.3 is a sample of Cash Flow Projections 2007-2010, and Table 4.4
describes a typical Pro-forma Balance Sheet.

Further, accountants who prepare the financial statements generally provide notes that provide
additional information about the statements, such as their nature and the way they have been valued.
Also, firms prepare two sets of statements, one for financial reporting purposes and one for tax purposes.
Only the first set of statements (i.e., the balance sheet, the income statement, and the statement of cash
flows) is public. These statements are found in the annual report that the firms publish every year.
Tables 4.5 and 4.6 present financial statements, the balance sheet and income statement, of a fictitious
XYZ Manufacturing Corporation for the fiscal year ending on June 30 of 2003 and of 2002.

Owners Equity, Assets and Liabilities

As stated earlier, the main purpose of a balance sheet is to provide an estimate of the cumulative
investment made by the firms shareholders at a given point in time. This investment is known as owners
equity. Other terms used for owners equity include shareholders equity, shareholders funds, and book-
value of equity, net worth, and net asset value. Owners equity is the difference, at a particular date,
between what a firms shareholders collectively own, called assets (such as cash, cash equivalents,
inventories, receivables, equipment, buildings), and what they owe, called liabilities (such as short term
debts and long term debts owed to banks, bondholders and suppliers). That is, according to the
fundamental accounting principle of balance sheets:

Owners Equity = Total Assets Total Liabilities, or, Total Assets = Total Liabilities + Owners Equity.

The balance sheet in Table 4.5 verifies this equation for two consecutive years of reporting, 2002 and
2003, as shown in Exhibit 4.1.

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 Exhibit 4.1: Verifying the Fundamental Accounting Principle at XYZ
XYZs Total Assets Total Liabilities Owners Equity Total Liabilities +
Accounting Owners Equity
period
Ending June 30, $2,992,500 $1,855,000 $1,137,500 $2,992,500
2002
Ending June 30, $3,675,000 $2,310,000 $1,365,000 $3,675,000
2003

That is, a firms total assets must have the same value as the sum of its liabilities and owners equity.
Owners equity is a residual value that is, it is equal to whatever dollar amounts are left after deducting all
the firms liabilities from its total amount of assets. If total liabilities far exceed total assets, owners equity
is negative and the firm is technically bankrupt.

Fixed Assets and Depreciation Methods

Fixed assets or non-current assets, also called capital assets, are assets that are expected to produce
economic benefits for more than a year. Fixed assets are of two types: tangible assets (e.g., land,
buildings, machines, and furniture, collectively called property, plant and equipment) and intangible
assets (e.g., patents, trademarks, copyrights, intellectual property, long-term relationships, brand
community, brand equity and corporate goodwill).

Tangible assets are generally reported at their historical cost, that is, the price the firm paid for them
when they were bought. As time passes, the value of the fixed assets (except land) is expected to
decrease during their expected useful life. This periodic (usually, annual) and systematic value-reduction
process is called depreciation, and noted in the balance sheet as depreciation charges or simply,
depreciation. Two common methods of depreciation used are a) straight line depreciation method (assets
are depreciated by an equal amount each year of the expected lifetime of the asset), and b) accelerated
depreciation method (depreciation charges are higher in the earlier years of the assets life and lower in
the later years. The total amount that is depreciated is the same regardless of the depreciation method
used.

The value at which a fixed asset is reported in the balance sheet is its net book value. If the firm uses
historical value or acquisition cost principle to value its fixed assets, then the net book value of the fixed
asset is equal to its acquisition price minus the accumulated depreciation since the asset was bought. If
the firm uses replacement cost principle to value its fixed assets, then the net book value of the fixed
asset is equal to the price the firm must pay at the date of the balance sheet to replace that asset minus the
amount of accumulated depreciation. Exhibit 4.2 illustrates the net book value under various depreciation
methods.

In Exhibit 4.2, we assume that an asset bought at an acquisition price or historical cost of $600 has a
useful life of three years and its replacement cost the year it was bought is $750. Under the straight-line
method for depreciation, we depreciate the asset each year by $200. Under accelerated method of
depreciation, we depreciate the asset by 50% ($300) the first year, one-third the cost ($200) the second
year, and one-sixth ($100) the third year. In Exhibit 4.2, we assume the straight-line method for
depreciating the replacement cost of $750, and hence, each year the depreciation amount is $250. Under
each method, the net book value is acquisition cost (gross value) minus the accumulated depreciation.
Exhibit 4.2 illustrates that a fixed asset value reported in the balance sheet can have a different net book
value depending upon the historical or replacement cost principle and the method of depreciation used. In
comparing the financial performance of firms, therefore, one must check (from the notes) the cost

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principle and depreciation method used. Very few firms in the USA use the replacement cost principle; it
is common, however, in the Netherlands (Hawawini and Viallet 2002: 44-47).

Depreciation is a component in cash flow adjustments (CFA). CFA = Depreciation + Net cash +
Proceeds from asset sales or divestitures Capital replacement expenditures - Investment in growth
capital expenditures [see Exhibit 4.3].

Exhibit 4.2: Net Book Value under Various Depreciation Methods

Value Item Straight-Line Method Accelerated Method Replacement Cost &

Straight-Line Method
Year of Reckoning Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

Gross Value $600 $600 $600 $600 $600 $600 $600 $600 $600
(Acquisition cost)
Annual Depreciation $200 $200 $200 $300 $200 $100 $250 $250 $250
Charge
Accumulated $200 $400 $600 $300 $500 $600 $250 $500 $750
Depreciation
Net Book Value $400 $200 $0 $300 $100 $0 $350 $100 -$150

Current Assets, Current Liabilities and Working Capital Management

Assets are divided into two categories: current assets and fixed (non-current) assets. A typical
balance sheet lists its assets in decreasing order of their accounting liquidity where liquidity is measured
by the ease and speed at which you can convert assets into cash at a fair price. Thus, cash, which is the
most liquid of assets, is listed first. Land and building, the least liquid of assets, are listed last.

Analogously, liabilities are listed in increasing order of maturity, where maturity is a measure of the
time before the liability is due. Thus, short-term liabilities are listed first and long-term liabilities are
listed last. Liabilities are also divided into two categories: current liabilities and non-current liabilities.
Owners equity is listed last, as it does not have to be repaid because it represents the owners investment
in the firm.

Assets and liabilities are usually assessed and recorded according to the conservatism principle,
which states: when in doubt, report assets and liabilities at a value whereby you would be least likely to
overstate assets or understate liabilities. The recent legislation, the Sarbanes-Oxley Act of 2002, reaffirms
the conservatism principle (see Chapter One).

Current assets are cash and other assets that the company expects to convert to cash within a year.
Usually, current assets include four major items: cash, marketable securities, accounts receivable, and
inventories.

Prepaid expenses recorded on a balance sheet (e.g., prepaid rent, prepaid lease, prepaid payroll,
prepaid taxes) are payments made by the firm for goods and services it will receive after the date of the
balance sheet. A typical example is prepaid insurance, a payment for an insurance policy that will
provide protection for a period of time that extends beyond the date of the balance sheet. A typical
income statement records prepaid expenses by a key accounting principle, called the matching principle.
This principle states that expenses are recognized (in the income statement) not when they are paid but
during the period when they are consumed or when they effectively contribute to the firms revenues.

10
That is, expenses prepaid by the firm must be carried in its balance sheet as an asset until they become a
recognized expense in its (future) income statement. For instance, in Table 4.5, the prepaid rent of $5,000
for June 30, 2003 represents the rent for the year 2004 and thereafter. Often, these items are declared as
prepaid expenses for tax purposes.

Current liabilities are short-term debts or obligations that the company must clear with cash within a
year. Normally, current liabilities list four major items: accounts payable, notes payable to the banks
(also called short-term debt), accrued wages and other expenses payable and accrued taxes payable. See
Table 4.5. Short-term debts include overdrafts, drawings on lines of credit, short-term promissory notes,
and portion of long-term debt due within a year of accounting.

Working capital is current assets minus current liabilities. For XYZ it was 1,592,500 - 595,000 =
$997,500 for 2002 and 2,100,000 1,050,000 = $1,050,000 for 2003, an improvement of $52,500
(5.26%) over 2002. Thus, other things being equal, a significant increase of working capital for 2003
over 2002 indicates that XYZ is a healthy company in relation to cash flows and cash flow management.

Working Capital Management is improving working capital. Fundamentally, managing working

capital is a way to increase returns to the company; it allows one to increase cash flow used for
investment (Hartman 2004: 149). Opportunities for working capital improvement differ across
industries, but they typically involve controlling key business processes such as inventory, accounts
payable and accounts receivable. Increasing working capital, however, is not an end in itself. Some
companies that insist on JIT (e.g., Dell), payment on consignment (i.e., Wal-Mart pays its retailers only
when their products are sold and cash is realized) and cross-docking inventory systems (e.g. Wal-Mart),
may even show negative working capital, and still would have grown significantly.

Cash Flows: Positive and Negative

Cash flow represents the available cash to pay current expenses. Cash flow is a value equal to income
after taxes plus non-cash expenses. In capital budgeting decisions, the usual non-cash expense is
depreciation. The management of working capital deals mainly with cash, receivables, payables, and
inventories. A positive cash flow meets all current expenses. A negative cash flow implies more
expenses than revenues; it forces short-term borrowing to meet your current expenses. Positive cash
flows are not profits, just as negative cash flows are not losses. A positive cash flow is just cash after
paying the costs (but not after depreciation). A negative cash flow is like bleeding; it is borrowing from
Paul to pay Peter.

Mere growth in sales does not assure a steady cash flow, as much of the sales could be tied in credit.
That is, sales may generate accounts receivables in the short run but no immediate cash to meet maturing
obligations. Similarly, a high growth in sales with low profits can also create a cash crunch, especially if
assets have simultaneously grown to generate the high sales growth. For instance, the sales in a given
year might have doubled from $100,000 to $200,000, but if net profits are low (say 5% of sales, that is,
$200,000 x 0.05 = $10,000), and if assets have grown from $50,000 to $75,000 during the same year, then
the net profits of $10,000 are inadequate to finance the additional assets of $25,000 unless one borrows
the required amount ($15,000) from banks, suppliers or stockholders. In general, profits alone are
inadequate to finance significant growth, and in which case, a comprehensive financing plan or
forecasting must be developed. A cash budget is an important component of a comprehensive financing
plan.

A cash budget is a series of monthly or quarterly budgets that indicate cash receipts, cash payments,
and the borrowing requirements for meeting capital expenditures. It is normally constructed from the pro
forma income statement and other supportive schedules.

11
 Cash outflows and inflows are not perfectly synchronized or certain, and some level of cash holdings
is necessary to serve as a buffer. Figure 4.1 sketches various cash inflow and cash outflow items to
create short-term net cash flows. If the firm maintains too small a cash balance, it may run out of cash for
necessary transactions, and then, the firm must sell marketable securities or borrow, and both transactions
involve trading costs.

Notice that XYZs cash balance remained constant at $175,000 during 2002 and 2003 (see Table 4.5),
even though cash flow from operations (that is, net income plus depreciation, the two major items that
finally affect cash) was (259,000 + 105,000) = $364,000 (see Table 4.6 under the year 2003). Its cash
remained the same simply because the sources of cash were equal to the uses of cash for the year 2003 as
is demonstrated in Table 4.7. For instance, XYZ derived a major source of cash from net profits
($259,000) and depreciation ($105,000) for 2003, totaling to $364,000.

Another source of cash was increase in accounts payable by $87,500 this is same as increased
borrowing from suppliers. The notes payable increased by $350,000 from 2002 to 2003 this represents
increase in borrowing from the banks. Small amounts of cash were sourced, $8,750 in each case, from
wages (i.e., withholding wages or benefits from the employees) and taxes payable (in effect, this is
borrowing from the IRS). Thus, total sources of cash inflows for 2003 amounted to $819,000.

This increase in cash was spent on machinery and plant ($245,000), on dividends ($31,500), on
prepayments and deferred charges ($35,000), on additional inventory of $345,000, in additional accounts
receivable of $140,000 (this is equivalent to lending customers or granting credit), in purchasing $17,500
worth of marketable securities, and prepaying rent of $5,000 totaling uses of cash (outflows) to
$819,000.

Hence, the sources of cash (inflows) were exactly used by uses of cash (outflows), with no net cash
increase from 2002 to 2003. This case illustrates the difference between a firms cash position on the
balance sheet and cash flows from operations. We will resume discussion on cash flows when we derive
cash flow statements of XYZ Inc.

Cash Flow Management

Cash flow management relates primarily to short-term financial decisions than to long-term ones, the
latter being capital budgeting, dividend policy or capital structure. Short-term finance is an analysis of
decisions that affect current assets and current liabilities, and their impact on the firm is normally felt
within the year. The term, net working capital (current assets current liabilities) is often associated with
short-term financial decision-making. Short-term finance involves cash inflows and cash outflows within
a year or less (e.g., ordering raw materials, paying in cash, goods are produced and sold, and sales-
revenues are received in cash within a year). That is, cash flows management relates to short-term
liquidity: an organizations ability to meet current payments as they become due. Long-term financing
relates to purchases, use, and revenue streams that roll over many years: e.g., a costly machinery or
technology license bought this year, paid in five annual equal installments, and used for production that
will increase cost savings over the next five years that, in turn, will more than cover the cost of the
machine or technology license. Long-term financing relates to long-term solvency that is, an
organizations ability to generate enough cash to repay long-term debts as they mature.

Cash flow management refers to valuable accounting information that includes product-cost data (i.e.,
how much labor, material and overhead are used in each product line and each product unit), break-even
data (on fixed and variable cost), and a variance analysis that looks for efficiencies and inefficiencies by

12
comparing actual costs against industry standards. Cash flow management also includes a cash budget:
this describes the expected inflows and outflows of cash that is used for wages, supplier outlays, and
receipts from customers, bond and interest payments, dividends and the like. Conversely, a recovering
company has to concentrate more intensely than ever on managing its cash flow and working capital.

Because in almost all turnarounds a cash crunch is well nigh inescapable, dealing with it becomes
very critical for the turnaround. Cash can come from only two sources:

Internal sources: (e.g., cash equivalents, accounts receivables, acceleration of receivables, turning
receivables into cash, forgiveness, conversion or extended terms for payables, inventory
management, converting inventory to cash, asset restructuring, selling fixed assets, divestitures,
and converting assets to leases).

External sources (e.g., banks, asset lenders, trust receipts, field warehousing, intermediate debt
financing, venture capital, public issues, mergers, sellouts, and using loss carry-forward).

For an effective business turnaround, each item of the internal and external sources must be managed
efficiently, effectively and quickly, and without much damage done to any stakeholders such as the
suppliers, banks, retailers, distributors, employees and the customers.

Cash Forecast: Running out of cash is not an abstraction. Any day checks could bounce, receivables
can become bad debts, and short-term payables may be due. Hence, daily cash projections, if possible,
are best. Weekly projections are the next best choice. Biweekly projections are an absolute requirement
(Whitney 1999: 36). Difficult as it may seem, the turnaround leaders would have to make their cash
projections, preferably short-term rollout cash forecast of at least 120 days, during the first week or ten
days of their term. Since a cash projection is a reflection of countless operating decisions, there could be
errors in ones projections, but some information is better than no information at all (Whitney 1999: 37).

The first element of a successful turnaround plan is accurate cash forecast based upon receipts and
disbursements. Good cash management works by actively managing and deciding about each of the line
items of your weekly, or even daily, receipts and disbursements. This will bring costs in line with
declining revenues. Most companies plan on a five-year forecast. However, if your long-range
projections indicate the company will run out of cash within nine months, change your planning horizon
to months, or even weeks or days if the crisis becomes near-fatal (Alix and Ramaekers 1995).

Cash flow is not depreciation added to the bottom line of an income statement. Nor is it looking at
the balance of cash in the bank and developing a picture of how much cash will be there next month based
on net income this month. Forecasting cash is an important ingredient of cash flow management.
Seventy percent of companies with revenues exceeding $50 million forecast cash. That percentage
declines as companies become smaller, to the point where only 25% of companies with revenues of $10
million or less forecast cash (Kort 1999).

An income statement is not a good barometer of a companys financial well-being, even though an
income statement budget for the next year may set goals for revenue and profitability by providing
benchmark for performance. Moreover, managers or accountants can manipulate the numbers on an
income statement to obtain figures that please banks and security analysts. In such cases, earnings report
the desires of management rather than the underlying financial performance of the company.

Income statements and budgets do not provide management with information on issues that affect
cash flows, such as the collection of receivables or the adequacy of cash flows to cover debt payments or
equipment purchases. These issues often translate into dramatic differences between profits and cash

13
flows. Managing a company by looking at past profitability (as judged from an income statement) is
reactive. Managers must be proactive if they want to look at what lies ahead. One critical item that can
help them in this regard is cash forecast. Figure 4.1 includes most of the major cash inflow and cash
outflow items where a good controller could do the cash forecast for each year.

Studies have shown that cash flows from operations are a better predictor of financial well-being than
income statements because it is much harder to manipulate cash flows. When comparing healthy
companies to those involved in a turnaround, financially sound companies tend to have the ratio of net
income (excluding depreciation) to cash flows from operations as 1/1 over a period of five years and
more. Companies in financial trouble have such ratios also well exceeding one over one owing to
fraudulent overstatement of income. For example, one company reported net income over a five-year
period of several million dollars. Yet, cash flow during that period was less than $9,000, and the resulting
ratio of net income (excluding depreciation)/cash flows from operations was 293 over a five-year period.
The company was in serious trouble. No one at the company, however, noticed this because they focused
attention on net income as an indicator of financial health.

Measures of Operating Cash Flows

In a business turnaround situation, most cash flow metrics are sensitive to what the lenders or
creditors, secured or unsecured, can claim from a companys net cash flows. Secured lenders claims on
cash flows precede those of federal taxes (Tax-Trust funds and payroll taxes), state taxes (income taxes
and UIA [Unemployed Insurance Agency] taxes) and equity investors. Thus, the critical question is what
the lenders are entitled from a companys net cash flow, and what the company can legitimately deduct
from its revenuers before paying its lenders.

Each operating cash flow formula must adjust for: a) depreciation tax shields, b) loan amortization tax
shields, c) interest expense tax shields, d) federal corporate tax rates, e) state corporate tax rates and f) net
operating losses (NOL) carry forward tax shields. Additionally, operating cash flows should reflect CFA
= Cash flow adjustments = Depreciation + Net cash + Proceeds from asset sales or divestitures Capital
replacement expenditures - Investment in growth capital expenditures for a given year. Exhibit 4.3 lists
some of the common Alternative Discounted Cash Flow Valuation Methods.

EBITDA (earnings before interest, taxes, depreciation and amortization) is one useful but crude
measure of pre-interest, pretax, pre-depreciation and pre-amortization cash flow. It is a crude measure of
cash flow because although it is calculated before two key non-cash expenses, depreciations and
amortization, it does not adjust for other non-cash items such as changes in working capital accounts.

EBITDA differs from the cash flow from operations found on the Statement of Cash Flows if you ignore
payment for taxes or interest. EBITDA also differs from free cash flow, as it does not recognize the cash
requirements for replacing capital assets.

EBITDA is different of operating cash flows since, for instance, uncollected receivables belong to
revenues and therefore to EBITDA but not to operating cash flows. Similarly, cash paid to purchase
inventory, which remains on hand if unused, would not reduce EBITDA but will reduce operating cash
flow.

EBITDA, however, is most useful when evaluating a companys true ability to earn profits, a factor that is
critical for acquirers in acquisition decisions. But, EBITDA is not an accurate measure of debt-service
capacity unless the creditors are actually willing to accept accounts receivable or inventory as payment of
interest and principal on a loan (Mulford and Comisky 2005: 12).

14
EBITDAR: A popular variation of EBITDA that is EBITDA measured before rent (lease) expense.

Exhibit 4.3: Comparison of Alternative Discounted Cash Flow Valuation Methods

Valuation Method Calculation of Cash Flows

Adjusted Present Value (R C D) x (1 T) + CFA + IxT + NxT

(APV) {EBIAT} {Interest tax shield} {NOL tax shield}

Capital Cash Flow

(CCF):
a) Net Income Version (R C - D I) x (1 T) + N x T + CFA + I
{Net income}

b) EBIT Version (R C D) - (R C D I N) x T + CFA

{EBIT} {Taxes payable}

c) EBITDA Version (R C) - (R C D I N) x T + CFA - D

{EBITDA} {Taxes payable}

Weighted Average Cost (R C D) x (1 T) + NxT + CFA

of Capital (WACC) {EBIAT} {NOL tax shield}

Where:
A = Amortization of long-term loans; C = Cost of goods sold (CGS) + Selling, general and administrative
(SGA) expenses; D = Depreciation; I = Interest expense on debt; N = Taxable income shielded by net
operating loss (NOL) carry-forwards; R = Revenues, and T = Marginal corporate tax rate.
CFA = Cash flow adjustments = Depreciation + Net cash + Proceeds from asset sales or divestitures Capital
replacement expenditures - Investment in growth capital expenditures.

Deterioration of Receivables and Acceleration of Payables

Two of the most troublesome problems in the crisis stage of a turnaround are deterioration of
receivables and acceleration of payables. Slowing of collections can come about because of slowing
sales, billing errors, extended credit granted in desperation, sloppy collection procedures, and some
customers, recognizing that the company is desperate, may not pay or just deliberately delay payments.
Acceleration of payables will occur because vendors recognize the companys plight and may refuse to
ship other than on cash on delivery (COD) terms, unless the account is paid current. Often, in troubled
companies there could be inadequate purchase controls (e.g., the purchase order system could have been
circumvented), in which case there could be grossly understated payables, creating those unpleasant
surprises of receiving unexpected invoices for unauthorized expenditures.

Current computer software can empower the turnaround managers to run infinite variations of cash
projections as well as balance sheets and operating statements. By manipulating relevant variables,
turnaround managers can quickly assess what would happen if collections are slowed or if payables are
accelerated, or if both events occur simultaneously. The turnaround managers can alter the variables by
any increment that deem useful to them in order to derive a wider picture of cash projections under wider

15
range of situations and assumptions. For an illustration, see how Arthur Andersen & Company does cash
flow projections using Lotus 123 software (Whitney 1999: 38-49).

Two cardinal assumptions or rules in the early turnaround stages of projecting receivables or payables
are (Whitney 1999: 37):

1. The company cash flow situation is worse than it seems.

2. The cash flow situation will deteriorate.

From hindsight, these are realistic assumptions even though pessimistic. They help you face up the
bad news even though they may not reduce the shock of deteriorating receivables and accelerating
payables.

Cash Flow Time Line

Short-term finance is concerned with the firms short-run operating activities. For a typical
manufacturing firm, such as XYZ Inc., the short-term activities consist of a sequence of events and
decisions such as those outlined in Table 4.8. Current liabilities are short-term obligations that the
company must meet with cash within a year or within the operating cycle, whichever is shorter.

The operating cycle is the time period from the arrival of stock of raw materials until the receipt of
cash that accrues from the product (converted from the raw materials) when sold. That is, it begins when
an order (for raw materials or finished goods) is received (in the inventory) and ends when cash is
collected from the sale of the goods produced or inventory. The length of the operating cycle is equal to
the sum of the lengths of the inventory and accounts receivable periods. The inventory period is the
length of the time required to order, produce and sell a product. The accounts receivable period is the
length of the time required to collect cash receipts.

The cash cycle or cash flow cycle begins when cash is paid for the raw materials and ends when cash
is collected from receivables that is, it is the time between cash disbursement and cash collection, from
accounts payables to accounts receivables. A cash flow cycle is the pattern in which cash moves in and
out of the firm. The primary consideration in managing the cash flow cycle is to ensure that inflows and
outflows of cash are properly synchronized for transaction purposes. Technically, however, the cash
cycle is operating cycle minus the accounts payable period. The accounts payable period is the length of
the time the firm is able to negotiate to delay payment on the purchase of various resources such as raw
materials and wages.

The cash flow time line consists of an operating cycle and a cash cycle. The activities listed in Table
4.8 create patterns of cash inflows and cash outflows that are both unsynchronized and uncertain. In
preparing efficient cash forecast, each item listed in Figure 4.1 must be estimated by using corresponding
questions listed in Table 4.8. The need for short-term financial decision-making is a function of the gap
between the cash inflows and cash outflows that is, the length of the operating cycle and the accounts
payable period. The wider or longer the gap, the more complicated the production process, the longer the
production cycle, the longer the marketing cycle, and longer and heavier the financial decisions during the
operating cycle. The gap is managed by borrowing or by holding a liquidity reserve. The gap can be
shortened by various strategies such as just-in-time inventory, reducing inventory, and reducing accounts
receivable and payable periods.

16
Tracking Your Cash Flow
Managers often fool themselves when it comes to cash-flow management and its importance (Kort
1999). Cash flow management implies that cash is king. However, many business executives or
entrepreneurs are unlikely to accept the fact that cash is king. Entrepreneurs, especially, are impatient
with the methodical task of tracking the dollars that come in and go out. If they can afford it, this job is
delegated to the financial controller or officer. When cash runs short (either because of fast growth or
slowing sales), most entrepreneurs become optimists and prefer to wait until next month or next quarter
when things will surely improve, rather than take immediate action to confront and correct a cash-flow
imbalance (Wexler 2002). This entrepreneurial delusion can tempt one to spend now and hold off paying
vendors, employees, and taxes. Often, entrepreneurs spend on new projects without waiting to make
money from the current business. They may not have a business plan that projects when the company
will break even that is, when it will be taking in as much cash as it is paying out. Before they realize,
the cash crisis has already set in.

All companies benefit by tracing and controlling their cash flows. Every investor would be wise to
check out a companys cash flow before investing. Every creditor, supplier, and even customers, would
benefit from checking the financial health of the company they are involved in from its statement of cash
flows.

When insolvent, the court is satisfied if your company is failing to pay your debts when due: this is
the cash-flow test. Alternatively, the court is satisfied if your liabilities (including contingent and
prospective ones) significantly exceed your assets: this is the balance sheet test. Interestingly, though,
not every company prepares a specific statement of its cash flows. Not all countries require such
statements (e.g., Austria, India), and the most countries that do, require cash flow statements under
different forms. Here we define, derive and analyze cash flow statements as per requirements in the
United States of America.

Businesses can run out of cash for several reasons (Blayney 2002: 30; Wexler 2002):

1. Lack of profit: the available cash has been drained away by losses.
2. Excess non-liquid assets: too much capital (cash) has been tied in fixed assets such as plant,
machinery, land, slow-moving stock, or in developing new products that did not roll out.
3. Too much growth: the business transactions are expanding faster that the cash resources needed to
fund them; that is, the company is overtrading or over-expanding.
4. Too many accumulating receivables.
5. Overspending to build market share at the expense of profit.
6. Your company is operating at less than break-even point, and for too long.

Under all these cases, the company can lose cash-flow control. The third reason seems to occur more
often in the case of turnarounds. For instance, a growth-oriented firm that has grown too fast may
continue to be quite profitable while at the same time get into a severe cash flow crisis (Slatter and Lovett
1999: 2). The first reason, however, is also very plausible. The profit picture of the typical turnaround
situation is several years of successively low profits culminating in a loss situation and a cash-flow crisis.

Most cash flow problems occur when big customers postpone payment or pay in notes payable or by
signing mortgages payable. Waiting for their payments may be nerve-wracking. Sometimes, payments
from big customers may come, if ever, just a few hours before the biweekly or monthly payroll causing
much anxiety, and that could seriously impair ones abilities to function and channel energies in much
needed areas of the business.

17
 Stay on top of your collections. High receivables and high inventory are trouble signs, even though
the balance sheet may call them assets. Cash is an asset. You can buy groceries with it. However, you
cannot buy groceries with your receivables and inventory. In fact, high receivables and inventories
should be called liabilities, especially when they grow. Accumulating inventory or receivables is the first
warning that the product or service is slipping while your income statement shows profits. Sales collected
in the only true cash flow (Sutton 2002: 216). Receivables should be viewed as nothing more than test
market expenses until they are paid. There is no sale assumed, no customer satisfaction believed, and no
commission paid until the money arrives (Sutton 2002: 215).

Your accountants may say that your business is profitable. However, their assessment is mostly
based on the profit-and-loss statement (which tracks non-cash items as well as dollars but not cash) or the
balance sheet (which is a snapshot of assets and liabilities at one particular point in time the end of the
fiscal year). Making profits does not necessarily imply that your company is successful unless you
generate cash or have access to cash when you need it. Irrespective of the health of the underlying
business, if the operating cash flow cannot finance the debt and equity obligations, the company will
remain fatally damaged. In such circumstances, the only solution is a financial restructuring. The
objective of any financial restructuring is a) to restore the business to solvency on both cash-flow and
balance sheet bases, b) to align the capital structure with the level of projected operating cash flow, and c)
to ensure that sufficient financing in the form of existing cash and new money is available to finance the
implementation of a turnaround plan (Slatter and Lovett 1999:90).

Cash flows are different from profits, yet both are required for long-term success of an enterprise.
Eroding profits may take a long time to cause a problem for a company, but a sudden decrease in cash
flow will cause immediate discomfort (Caplan 2003: 28). On the other hand, sufficient cash flow could
mask potentially serious organizational distress. For example, restaurants and retail shops may have a
steady flow of cash collected from daily customers and may be able to pay the most pressing bills keeping
creditors at bay. However, if at the same time the owners were to draw large sums of money, say for
expansionary purposes, then a large accumulating debt could throttle their business.

Measures of Cash Flow Management

In accounting practice, the inventory period, the accounts receivable (A/R) period, and the accounts
payable (A/P) period are measured by days in inventory, days in receivables, and days in payables,
respectively.

Cash as Generated by Inventory Management

From the balance sheet and consolidated income statement in Tables 4.5 and 4.6 of XYZ Inc., a
diversified manufacturing company, we may derive the following:

Average inventory during 2002-2003 = (1,045,00 + 700,000)/2 = $872,500 (1).

Inventory turnover ratio = (cost of goods sold)/(average inventory) = 2,000,000/872,500 = 2.29 (2).
The inventory cycle occurs 2.29 times a year or the days in inventory is 365/2.29 = 159.39 days (3).

Cash as Generated by Accounts Receivable Management

Assuming XYZ Inc. makes no cash sales but only credit sales we may calculate the following ratios:

Average accounts receivable = (700,000 + 560,000)/2 = $530,000 (4).

Average receivables turnover = (Net credit sales)/ (Average accounts receivable)
= 4,025,000/530,000 = 7.594 (5).

18
 That is, the average A/R cycle occurs 7.594 times a year or the days in receivables is
= 365/7.594 = 48.06 (6).

Cash as Generated by Accounts Payable Management

Average accounts payable = (350,000 + 262,500)/2 = $306,250 (7).

Average payables turnover = (Cost of goods sold)/ (Average accounts payable)
= 2,000,000/306,250 = 6.531 (8).

That is, the average A/P cycle occurs 6.531 times a year or the days in payables is
= 365/6.531 = 55.89 days (9).

Thus, the operating cycle = days in inventory + days in receivables, which from
equations (3) and (6), = 159.39 + 48.06 = 207.45 days (10).

The cash cycle = operating cycle days in payables, which from equations (9) and (10)
= 207.45 55.89 = 151.56 days (11).

Defining Cash in Terms of other Elements of the Balance Sheet

The balance sheet equation is:

Net working capital + fixed assets = Long-term debt + stockholders equity (12).
Now, Net working capital = Cash + (Currents assets other than cash current liabilities) (13).

Rearranging (13) and substituting net working capital from (12), we have:

Cash = net working capital (current assets other than cash - current liabilities)
= long-term debt + equity fixed assets (current assets other than cash - current liabilities)
= long-term debt + equity fixed assets net working capital (excluding cash) (14).

cash = long-term debt + equity fixed assets net working capital (excluding cash) (15).

That is, a change () in cash is a function of change in the long-term debt of the firm, change in the
equity, change in fixed assets, and change in the non-cash part of the working capital.

Equations (14) and (15) imply that some of the corporate policies for increasing cash in the firm are:

1. Increase long-term debts (such as bonds).

2. Increase stockholders equity (common and preferred stock).
3. Decrease investment in fixed assets (like land, building, machinery and office equipment).
4. Decrease net working capital excluding cash (which means increase accounts payable, notes
payable, accrued expenses payable and taxes payable and decrease accounts receivable,
inventories, marketable securities and prepaid rent).

Each of these four major policies and the implied fifteen sub-policies (within brackets) can certainly help
cash flow management in turnaround situations. Much would depend, however, upon the nature, size,
industry, country, competition, and legal implications of your company and its offerings. For instance,
what should be the optimal size of your firms investments in current assets such as cash, marketable
securities, accounts receivable and inventories? The solution would be a function of the level of your
firms total operating revenues. A flexible short-term financial policy would maintain a high ratio of
current assets to sales, whereas a restrictive short-term policy would do the opposite: maintain a low ratio

19
of current assets to sales. Similarly, how should your firm finance its current assets? The answer is a
function of your firms ratio of short-term debt to long-term debt. Here again, a flexible short-term
financial policy would advocate less short-term debt and more long-term debt. A restrictive policy,
however, would dictate otherwise.

Short-Term Financial Policies as a Function of

Carrying Costs and Shortage Costs
Any short-term financial policy has at least two sets of costs:

Carrying costs: these are costs that rise with the level of investment in current assets. For
instance, a flexible short-term financial policy would keep large balances of cash and marketable
securities, would maintain large inventories, and grant liberal credit terms that result in high
accounts receivable. All these policies imply high carrying costs, especially opportunity costs of
money and costs of maintaining the assets economic value.

Shortage costs: these are costs that fall with increasing investments in current assets. For
instance, holding high cash balances will enable you to pay all short-term debts and liabilities
without borrowing or selling marketable securities. Also, future cash flows are highest with a
flexible financial policy: sales are stimulated by easy credit terms; you never run short of
products and you can deliver quickly when you maintain a high finished goods inventory; and
some firms could even charge higher prices for easy credit terms and quick delivery.

The opposite, however, would happen, that is, shortage costs would rise, if you decreased investments
in current assets such as in maintaining low inventories of a) unfinished goods (trading and order costs
would be high in this case) and b) finished goods (costs of lost sales, lost customer goodwill, disruption of
production and shelving schedules would be high in this case). Table 4.9 summarizes this argument.

Hence, in general, if carrying costs are low and shortage costs are high, the optimal policy will be a
flexible one that carries high level of current assets. If carrying costs are high and shortage costs are low,
then a restrictive policy of maintaining low level of current assets may be optimal.

Cash Flow Statements

Given the primary importance of cash, cash flows, and cash flow management to any business, the
statement of cash flows has become one of the central financial statements. It provides a thorough
explanation of the changes that occurred in the firms cash balances during the entire accounting period.
The statement of cash flows enables both investors and managers to keep their fingers on the pulse of any
companys lifeblood: cash. Companies that lose too much cash become critically ill or bankrupt.
Bankruptcy is loosely used to refer to companies that are unable to meet their financial obligations.

In the United States, prior to 1971, companies were required to prepare only the balance sheet and
income statement. That year, a statement showing the changes in financial position between balance
sheets was added. However, financial problems, mainly inflation in the 1970s and 1980s, caused many
economists and accountants to call for a greater emphasis on cash management. In response, in 1987, the
Financial Accounting Standards Board (FASB) required the preparation and presentation of the statement
of cash flows in its present form.

While the balance sheet shows the financial status of a company at a single point in time, the
statement of cash flows and income statements show the performance of a company over a period of time.

20
Both explain why the balance sheet items have changed. The statement of cash flows explains where
cash came from during a period and where it went.

The statement of cash flows reports all the cash activities (both receipts and payments) of a company
during a given period. It also explains the causes for the change in cash by providing information about
operating, financing, and investing activities.

Operating activities are generally activities or transactions that involve producing and selling goods
and services, and they affect the income statement (e.g., sales are linked to collections from
customers, and wage expenses are related to cash payments to employees).

Investing activities reflect increases and decreases in long-term assets. They involve the purchase and
sales of long-term assets such as land, building, computers, software, equipment, and investments in
other companies. Loans to others, and collection of loans from others, are investing activities.

Financing activities involve obtaining resources as a borrower or issuer of securities and repaying
creditors and owners. These activities include issuing stock, borrowing money, buying and selling
treasury stock, and paying dividends to stockholders.

Note, however, that financing and investing activities are really opposite sides of the same coin. For
instance, when stock is issued for cash to an investor, the issuer treats it as a financing activity while the
investor treats it as an investing activity. Financing cash flows relate to long-term liabilities and owners
equity. Table 4.10 lists operating, investing and financing activities, their nature as inflows or outflows,
and their impact on cash. The relationship of these activities to cash is fairly straightforward and obvious.

What is not always obvious is the classification of some activities as operating, investing or financing.
For instance, interest payments and dividend payments are both outflows whose impact on cash is
negative, and both seem to be disbursements related to financing activities. After much debate, however,
the FASB decided to classify interest payments as cash flows associated with operations and dividends
payments as financing cash flows.

Table 4.10 reflects this decision. This classification maintains the long-standing distinction that
dividend transactions with the owners cannot be treated as expenses, while interest payments to creditors
are expenses incurred for operations (Horngren, Sundem, and Elliott 2002: 411).

According to FASB, the purpose of cash flow statements is (Harrison and Horngren 2004: 546-7):

1. It shows the relationship of net income to changes in cash balances. For instance, cash balances can
decline despite positive net income, and vice versa. Usually cash and net income move together.
High levels of income tend to lead to increases in cash, and vice versa. A companys cash flow,
however, can suffer even when net income is high.
2. The cash flow statement reports cash flows as an aid to predict future cash flows, to evaluate the way
the management generates and uses cash, and to determine a companys ability to pay interest and
dividends and to pay debts when they are due. Past cash receipts and payments are good predictors
of future cash flows.
3. It identifies changes in the mix of productive assets.
4. It can evaluate management decisions. The statement of cash flows reports cash flows from
operating activities, investing activities and financing activities. This gives investors and creditors
cash flow information for evaluating management decisions.
5. Determine the companys ability to pay dividends to stockholders and interest and principal to
creditors.
6. The statement of cash flows can help investors and creditors predict whether the business can make
these payments.

21
Formulating Cash Flow Statements
Following the listing of activities in Table 4.10, we next track and compute cash flows from the
operating, investing, and the financing activities of a firm. Computing cash flows from investing and
financing activities is fairly straightforward and easy, whereas computing cash flows from operating
activities is somewhat complicated. We first undertake computing cash flows from operating activities.

Computing Cash Flows from Operating Activities

The operating section of the statement of cash flows reports the cash effects of operating activities.
Operating activities create revenues, expenses, gains, and losses. They are the most important of the three
categories (operating, investment and financing activities) because they are at the heart of every
organization. They affect net income on the income statement, a product of accrual-basis accounting.
Operating activities also affect current assets and current liabilities on the balance sheet. For instance, a
sale on account increases sales revenue on the income statement and accounts receivable (current asset)
on the balance sheet.

Two approaches are used in computing cash flows from operating activities (or operations): direct
method and indirect method. In the direct method, we report all cash receipts and cash payments from
operating activities; that is, cash flows are computed as collections less operating disbursements. In the
indirect method, which reconciles from net income to net cash, we adjust the accrual net income to
reflect only cash receipts and cash outlays.

Under the direct method, we identify the cash part of each item in the income statement. Because
depreciation does not use cash, it is not part of the calculation. We use equation (15) to compute the
change in cash under each operating activity.

cash = long-term debt + equity fixed assets net working capital (excluding cash) (15).

That is, any change in cash in the left-hand side (LHS) of (15) must be accompanied by a change in
one or more items of the right-hand side (RHS) of equation (15) to keep the equation in balance. The
LHS of equation (15) tells us what happened to cash; the RHS of (15) tells why it happened. The
statement of cash flows focuses on the changes in the non-cash accounts in the RHS of (15) as a way of
explaining how and why the level of cash went up or down during a given period.

We can further simplify equation (15) as follows:

cash = long-term debt + Stockholders equity fixed assets

- (current assets excluding cash current liabilities)
= (long term debt + current liabilities) + Stockholders equity
- (fixed assets + current assets excluding cash) (16).
= (Liabilities) + (Stockholders equity) (non cash assets)
= L + SE NCA . (17).

We will use equation (16) to compute cash flows from all operating activities. To illustrate
computing cash flows, consider the balance sheet (Table 4.5) and income statement (Table 4.6) of XYZ
Manufacturing Corporation. As of June 30, 2003, the following operating activities can be derived from
Tables 4.5 and 4.6 (all figures are in $millions) and these are listed in Table 4.11. Those that impact cash
will be marked by an asterisk (*). Some entries in Table 4.11 need explanation.

22
Collection of accounts receivable from customers: (figures in $000s)

Sales on credit: 4,025.00

Accounts receivable at the beginning of fiscal year 2003: 560.00
Potential collection: 4,585.00
Less: ending accounts receivable 700.00
Cash collection from customers during 2003: * 3,885.00

Alternately:

Sales 4,025.00
Less: Increase in accounts receivable: 140.00
Cash collection from customers: 3,885.00

Purchase of inventory on account and Payment to suppliers: (figures in $000s)

Ending of inventory: 1,045.00

Plus cost of goods sold: 2,000.00
Inventory to account for: 3,045.00
Less: beginning inventory 700.00
Purchase of inventory: 2,345.00
Less: Beginning trade accounts payable: 262.50
Total amount to be paid: 2,607.50
Less: Ending trade accounts payable: 350.00
Amounts paid to suppliers for inventories in cash:* 2,257.50

The same amount paid for inventories during 2003 can be computed as follows:

Cost of good d sold: 2,000.00

Increase (decrease) in inventory: 345.00
Decrease (increase) in trade accounts payable: (87.50)
Payments to suppliers:* 2,257.50

Payment of Wages to employees: (figures in $000s)

Beginning wages and salaries 78.75

Wages 800.00
Total wages to be paid: 878.75
Ending wages and salaries payable: 87.50
Cash payments to employees:* 791.25

Alternately:

Wages 800.00
Less: Increase in wages payable: : 8.75
Cash payments to employees: 791.25

Payment of taxes: (figures in $000s)

Beginning income taxes payable: 78.75

Provision for income tax 213.50
Total income tax to be paid: 292.25

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 Less: Ending income taxes payable: 87.50
Cash payments to taxes:* 204.75

Alternately:

Taxes 213.50
Less: Increase in taxes payable: 8.75
Cash payments to employees:* 204.75

Payment of Interest: (figures in $000s)

Beginning interest payable: 10.00

Interest on bonds and other liabilities 105.00
Total interest to be paid: 115.00
Ending interest payable: 10.00
Cash payments to interest:* 105.00

Alternately:

Interest on bonds and other liabilities 105.00

Less: Increase in interest payable: 0.00
Cash payments to interest:* 105.00

The other elements in Table 4.11 such as rent paid ($50,000), miscellaneous expenses ($20,000),
prepaid rent ($5,000), selling and administrative expenses ($490,000), and dividends and interest ($
17,500) that are included under operating activities are straightforward since there are no beginning and
ending entries for these cash flow items. Depreciation is entered, but there are no cash flows associated
with it. Depreciation is an allocation of historical cost to expense and does not entail a current cash
outflow. Net cash provided by all operating activities is - $21,000.

Computing Cash Flows from Investing Activities

The second major section of the statement of cash flows is from investing activities such as the sale of
plant, property, equipment, and other long-term assets. Long-lived assets are investments. Thus, we need
to report four cash flow items under investing activities: a) acquisition of fixed assets, b) disposal of fixed
assets, c) prepayment and deferred charges, and d) change in intangibles. For XYZ, however, items (b)
and (d) are zero. Items (a) and (c) are computed as follows:

Payment of machinery and plant as fixed assets: (figures in $000s)

Beginning machinery and plant: 280.00

Ending machinery and plant: 525.00
Cash payments to machinery and plant:* 245.00

Prepayment and deferred charges: (figures in $000s)

Beginning prepayment and deferred charges 105.00

Ending prepayment and deferred charges 140.00
Cash payments to prepayment and deferred charges 35.00

Thus, the net cash provided by investing activities is (-245 + - 35 =) - $280.00 (In thousands).

24
Computing Cash Flows from Financing Activities

The third major section of the statement of cash flows is from financing activities. These flows
describe the source of capital such as stocks, bonds, and notes payable that were used for financing the
purchase of fixed assets under investing activities. For XYZ Inc., there was no fresh issuance of stock
during the fiscal year 2003, nor was there the incurrence of long-term debt, but $31,500 was paid out in
dividends. Net cash flows from notes payable and marketable securities are computed as follows:

Increase in notes payable: (figures in $000s)

Beginning notes payable: 165.50

Ending notes payable: 515.00
Cash inflows from increase in notes payable 350.00

Increase in marketable securities: (figures in $000s)

Beginning marketable securities 157.50

Ending marketable securities 175.00
Cash payments to net marketable securities 17.50

Thus, net cash provided by financing activities was (-31.50 + 350 17.50 =) $301.00 (in thousands)

In conclusion, net cash flows from all activities: -$21,000 from operating activities, -$280,000 from
investing activities and +$301,000 from financing activities. The net cash is (-21,000 280,000 +
301,000 =) 0.00 dollars. This figure of net cash of 0.00 dollars matches that of Table 4.3. During the
fiscal year 2003, total cash outflows were (-4510 + -175 =) -$4,685 millions and total cash inflows were
(+437.50 + 4247.50 =) +$4,685 millions, resulting in zero net cash balance.

Measuring Cash Flows Using the Indirect Method

Table 4.12 is a statement of cash flows using the indirect method referred to earlier. The indirect
method is convenient and reconciles net income to the net cash provided by operating activities. It also
shows the link between the income statement and the statement of cash flows (if provided). In the
indirect method, the statement of cash flows begins with net income. Then, additions or subtractions are
made for changes in related asset or liability accounts. Thus, Table 4.11 computes cash flows starting
from net income, while Table 4.12 computes cash flows from all the operations during the fiscal year
2003, starting from sales revenues.

The main difference is that Table 4.11 is a statement of the sources of cash versus uses of cash and
combines all operating, investing and financing activities together. If we separate the figures by
operating, investing and financing activities these numbers are identical to those of Table 4.11 as is
evidenced in Table 4.12. Note that depreciation (even though not a cash flow item) is added back to net
income just because it was deducted in the computation of net income in the Income Statement (see Table
4.6). Its addition now cancels its deduction in calculating net income.

Interpreting Linked Performance in Cash Flows

While all the three sets of activities, namely, operating, investing, and financing operations, are
important for a business, the nature of their net cash flows (positive versus negative) have different

25
implications for the health of the firm in a given industry. With positive or negative net cash flow states
(+ or -) under each of the 3 sets of activities, there are eight (23) combinations that we could explore.
Table 4.13 captures some of the business growth and health implications under each of the eight cases.

In general, investors (e.g., shareholders, venture capitalists, investor institutions) prefer firms that are
growing as represented by the negative net cash flow in investing activities (cases 3, 4, 7 and 8), but
which can still qualify for long term debt and attract shareholder capital by issuance of new stock, and
pay out less dividends for higher retained earnings, thus maintaining positive net cash flows from
financial activities (cases 3 and 7). Between cases 3 and 7, investors prefer case 3 as one that is
continuously generating positive net cash flows from its operating activities. Typical current case 3
companies in the United States are homebuilder companies (e.g., Fanny May, Lennar, D. R. Horton,
Centex, Plute Homes), and computers and software IT companies (e.g., Dell, Microsoft, IBM, Hewlett-
Packard) that are high growth industries, high growth in profits and represent relatively young industries.
Case 7 companies are young, high-risk, speculative, and those struggling hard to generate positive net
cash flows from their operations while investing heavily in new technologies and acquisitions, and
attracting heavy investor capital. Most dot.com companies that survived the year 2000 crash belong to
this group, such as eBay, Amazon.com, Google.com and Yahoo!

The next best scenario is case 1 with positive net cash flows in operating, investing and financial
activities. These are old, steadily growing, and high long-term profit companies in the United States, such
as petroleum refining companies (e.g., Exxon Mobil, Chevrontexaco, Conocophilips) and pharmaceutical
companies (e.g., Johnson & Johnson, Pfizer, Merck, Bristol-Myers Squibb). Case 4 companies (+ - -)
rank next in performance and for reasons suggested in Table 4.13.

Case 5 companies are interesting. They represent the old but still high-risk industries with uncertain
profitability, but are still promising, and hence, generate negative net cash flows from operating activities
but positive net cash flows from investing and financing activities. Currently, hospitals, hotels, casinos,
commercial banks and airlines belong to this category.

Cases 2 is a relative opposite of case 5: represents old industries with steady but low profit
operations, positive cash flows from selling old fixed assets such as land, building and equipment, but are
failing to attract venture or shareholder capital. Typical U. S. industries struggling in this category are
chemicals, steel, railroad, tobacco, shipping, forest and paper products and energy companies.

Cases 6 and 8 are distressed companies that need turnaround management. Here, the problem may
not be linked with the industry (young or old, dynamic or static) or with the companys growth stage in
the cycle (young, mature or old). There is a management problem of apathy or inefficiency, or downright
fraud and deception.

Cash Basis versus Accrual Accounting

Venture capitalists, investors and lenders use accounting data to evaluate companies. Venture
capitalists look for good value-creating innovations that can be brought to large target markets. Investors
typically look for corporations whose stock price will increase and which pay high dividends. Lenders
(especially, banks) want to lend to borrowers who will repay their loans on time. Accounting provides a
framework for organizing the necessary financial information. The accounting framework can be on
accrual basis or cash basis.

In accrual accounting, an accountant recognizes the impact of a business transaction as it occurs (e.g.,
a sale is made, an expense is incurred) and records the transaction even if it receives or pays no cash. The
Generally accepted accounting practices (GAAP) require that businesses use accrual accounting. In cash-

26
basis accounting, revenues are recognized as cash is received and expenses as cash are paid. That is, the
accountant records a transaction only when it receives or pays cash. Actual cash receipts are treated as
revenues and actual cash payments are reckoned as expenses. Accrual accounting, on the other hand,
records all types of cash-transactions, including all types of receivables (e.g., actual and future collections
from customers, cash from interest earned, borrowing money, issuing stock), and all types of payables
(e.g., paid, accrued or deferred salaries, rents, taxes and other expenses, paying off loans).

Accrual accounting also records all types of non-cash-transactions, such as inventory purchase on
account, sales on account, accrual of expenses incurred but not yet paid, depreciation expense, and usage
of prepaid rent, lease, insurance, and supplies. All transactions are recorded when they are completed and
either revenues are earned or liabilities or payments are incurred, even though either may not have
resulted in actual cash receipts or disbursements. The amount recorded is the cash value of the
transaction (e.g., sales as revenue or purchase as expense). Accrual accounting, thus, completes the
process leading up to the financial statements.

Accrual accounting, however, poses ethical problems that cash-based accounting can avoid. For
instance, if in August 15, 2006 your turnaround advertising company, ABC, received a prepaid amount of
$3 million from your client PQR for advertising services for the next three months starting from August
31, 2006. Suppose your fiscal year ends September 30, 2006, how should you report this transaction in
your financial statements? It should be:

Financial Statements ABC Company: September 30 2005 September 30 2006:

Income statement (September 30, 2006):
Advertising service revenue earned (from PQR for September 2006) $1 million

Balance Sheet statement (September 30, 2006):

Liabilities: (unearned advertising service revenue for October/November 2006) $2 million

Statement of cash flows (September 30, 2006):

Cash receipts (August 15, 2006) $3 million

Now, if a) you want to look good on net income for the fiscal year 2006 (and are expecting a
promotion based on net income), you may be tempted to report all $3 million as earned revenue for fiscal
year ending September 30, 2006. Alternatively, if b) you are expecting a lean year and want to look good
for the next fiscal year, you could report the entire transaction as accruing for the next fiscal year. The
unethical action would be to pre-pone $2 million advertising unearned revenues of fiscal year 2007 to
2006 in the first instance (case a), or to postpone $1 million earned earnings of fiscal year 2006 into 2007
in the second context (case b). Worse, if knowing ABC is in trouble, PQR voids the contract and
demands back $2 million of prepaid expenses, then you are already $2 million short when starting to
turnaround ABC. Under cash-basis accounting, ABC would record the full amount $ 3million as earned
revenues in October 30, 2006 because the prepaid amount will become fully earned revenues by that day.
However, the cash basis accounting is unacceptable for GAAP because it distorts reported figures for
assets, expenses, and the net income.

Another ethical challenge in accrual accounting can arise if you choose to overlook an expense at the
end of the period. If by the end of September 2006, you found the year has been really bad, you could be
tempted to manufacture net income by postponing some expenses (e.g., you owed $ 2 million in interest
expense to your bank by October 30, 2006) to fiscal year 2007 (under case a) or vice versa, under case b).
This easy manipulation process can explain most of the accounting irregularities listed in Appendix 2.1.

An Effective System of Internal Controls

27
 Whatever the accounting system used, any organization needs an effective system of internal controls
for cash flow management. In general, an objective system of internal controls would have the following
characteristics (Harrison and Horngren 2004: 181-185):

a) Competent, reliable and ethical personnel: Train, retain and develop your employees by
supervising them, rotating their jobs, paying good salaries, and holding them responsible for all
their operations.
b) Assignment of responsibilities: Each employee should be assigned specific duties and
responsibilities and should report to either the treasurer or the controller. The treasurer usually
manages cash, while the controller is in charge of accounting. The two departments should be
kept separate. For instance, the controller may be responsible for approving invoices (bills) for
payment, while the treasurer may actually sign the checks. This avoids anyone signing checks for
oneself. Working under the controller, one accountant is responsible for property taxes and
another, for income taxes.
c) Proper Authorization: An organization generally has rules that outline approved procedures. Any
deviations from standard policy require proper authorization from the right person.
d) Supervision of employees: Even the most trusted employees could be opportunistic and be tempted
to steal or defraud the company if they are not properly supervised. All employees, no matter
what their position, including the CFO and the CEO, need supervision. Hence, the prospect of
making the CEO also the Chairman of the board of directors violates this rule.
e) Separation of duties: Separation of duties limits fraudulent practices. For instance, accounting
should be completely separated from a companys operating departments (e.g., manufacturing,
sales). Accountants should not be allowed to handle cash, and cashiers should not have access to
accounting records. If the same employee has both accounting and cash-handling duties, that
person can steal cash and conceal the theft by making a bogus entry on the books. While the
company treasurer handles cash, the company controller should handle accounts. Similarly,
computer programmers should not operate a companys computers, as they can program a
computer to write checks to themselves.
f) Internal and external audits: Typically, an auditing firm examines the companys financial
statements, accounting systems, and internal controls. Auditors must be independent of the
operations they are auditing. Auditors can be internal or external. Internal auditors audit
throughout the year checking various segments of the organization to ensure that employees
follow company policies. External auditors are periodically hired from outside; they audit the
entity as a whole and are concerned mainly with the financial statements.
g) Electronic and computer controls: Currently, there are several electronic devices to safeguard a
companys assets, especially cash and checks. Electronic sensors attached to merchandise can
reduce theft by 50 percent. Computer software can control accounting systems, check-writing
systems, payroll systems, purchasing systems, retailing check out systems, and the like.

Toward Understanding Business Risk

Any business entails risk. Even every specific business activity implies risk. Growth in production,
number of brands, number of retail outlets, sales revenues, customer loyalty, market share and profits
seldom come from risk-free or risk-eliminating strategies. Some risk is inevitable.

In general, economic risk comes under four types (Arnold 2007: 511-514): business risk, insurable
risk, currency risk, and interest rate risk.

Business Risk: This is the every day risk of operating a business in a competitive environment. It is the
variability of the firms operating income (i.e., income before interest and taxes) brought about by
internal factors (e.g., cost overruns, evolving production technologies, poor product quality, wage
inflation, labor boycotts) and external factors (e.g., industry stagnation, recession, unemployment,
reduced consumer buying power, changing customer lifestyles, government regulation, competitive

28
 advantage, new competitive entrants, and globalization). Consequences of both factors could imply a
decline in sales revenues and/or market share and, therefore, in profits. Similarly, costs may also rise
owing to wage inflation, inflated wage benefits, strong labor unions, overstocked inventories,
increasing receivables, accumulating payables, bad debts, theft, merchant or consumer fraud, tight
commodity markets, government imposed quotas, tariffs and custom protocols, credit squeeze, rising
interest rates, EPA regulation, or political turmoil. Some of these risks are inevitable and
unmanageable, while some can be reduced by insurance, hedging, derivatives, flexible designing,
reengineering, futures trading, trading carbon emissions allowances, securitization, vertical or
horizontal integration, divestitures, mergers and acquisitions, or seeking chapter 7 or 11 bankruptcy
protection. In general, business risk is determined by general business and economic conditions and
is not related to the firms capital or financial structure. On the contrary, financial risk is the
additional variability in revenues and returns that arises from the firms financial structure.

Insurable risk: Most business operations involve risk such as risk to employee life, risk to
productivity, risk of defective products, risks of cost overruns, risk of market uncertainty, risk of
consumer rejection, or risk of government over-regulation. Corporate executives can sell or transfer
many such business risks (specifically, factory fires, worker accidents, machinery damage, ecological
degradation, and hurricane damage) to insurance companies through the payment of insurance
premiums. Insurance companies (e.g., Prudential, MetLife, AIG, and Hartford) handle risk better
than commercial banks or ordinary commercial firms. That is, they: a) can better estimate, through
long experience, the probabilities of occurrences of bad events and, accordingly, price risk premiums,
b) know methods of reducing risk better and can pass on their knowledge to commercial clients to
obtain lower premiums, and c) can pool risk or diversify risk better (e.g., AIG sold over 250 different
insurance products such as fire, marine, defense, workplace, health, home, collision, accident, car,
and mortgage insurance packages), and hence, can lower their premiums to be competitive.
Insurance premium prices will also reflect two additional phenomena called adverse selection and
moral hazard (see below).

Currency Risk: If the company is multinational in its supplier and customer base, then payments will
have to be made or received in currencies of the transaction-originating country or converted to any
hard (G Seven or G Eight) currencies. The currency risk would then reflect currency appreciation or
depreciation via a hard currency, the commission for each transaction, and other charges.
Currency risk can be reduced by hedging currency fluctuations. For instance, if you are buying
hundred million Yen worth of steel from Japan three months from now, then you could agree (hedge)
the price of Japanese steel either at todays prices or at forward prices of steel three months from
now.

Interest Rate Risk: Volatile interest rates are difficult to predict with accuracy. If your debt is large
with a floating interest rate, then rising interest rates will harm you. Alternately, if your debt is large
and with a fixed interest rate, then declining interest rates will make you pay higher debt costs than
necessary. Commercial banks and insurance agencies provide various financial instruments that can
help you to cap the interest rates.

Economic or market risk is always with us, mostly in the form of credit or liquidity crisis. Recent
financial disasters include:

The U. S. Savings & Loan crisis (1986-1995);

Black Monday in 1987
The Russian debt default and the related dive of Long-Term Capital Management in 1998;
The Japanese banking crisis (1990-1999);
The Asian financial crisis (1998-1999);
The dot.com bust of 2000, and
The Enron-led merchant power collapse of 2001
The financial market crisis of September-October 2008

29
 As the recent economy began to stall, the underlying problem of consumer and corporate
indebtedness in the USA totaled about 380% of GDP, nearly two and a half times the level at the
beginning of the Great Depression. In 2007, major financial institutions have written off nearly $400
billion in losses, and central banks around the world have initiated emergency measures to restore
liquidity. In the latter half of 2008 alone, around 18 major banks of USA lost over a trillion dollars in
capitalization (see Table 2.1 under Wicked Problems).

A good business strategy seeks to trade-off the costs of absorbing inevitable risks versus enjoying the
benefits of such risks. There are several reasons why firms sacrifice potential profits in order to spread or
sell risk (Arnold 2007: 510).

a) It helps financial planning: Predicting and controlling risks of fluctuating material costs, interest
rates, and currency exchange rates can enable you to predict and manage your cash flows within
certain boundaries, and, accordingly, help you to plan and invest with confidence.

b) It reduces the fear of financial distress: Buying proper insurance can shield your firm from
potential and unforeseeable damages (e.g., from earthquakes, hurricanes, damage from toxic
products such as asbestos, coal and carbon emissions, and supertankers from ocean oil spillage),
relieve you and shareholders from undue stress, and your banks will be empowered to extend you
credit.

Business Risk and Value Line

Businesses and markets are fraught with risks along the backward, middle and forward value line.

Backward Value Line: misdirected market scanning, untargeted product research, under-budgeted
R&D; hence, risk of poorly identified market niches, bad business ideas, wrong business concepts,
flawed product prototypes, defective product designs, overpriced raw materials, defective production
processes, risks of labor apathy and malaise, low product quality, and cost overruns;

Middle Value Line: poor product bundling, unattractive product packaging, confusing product
labeling, flawed product costing, overstock product inventory, ineffective product logistics and
delivery;

Forward Value Line: unimaginative product pricing, unattractive product-price bundling, lackluster
product advertising, ineffective product rebates, too easy product credit, risky product financing,
poor promotions, unsatisfactory products and services, un-honored product warranties and
guarantees, and risks of market rejection.

Coupled with almost all value line risks are the general risks of inflation, wage inflation, stagflation,
unemployment and reduced consumer-buying power, risk of currency fluctuations, risks of volatile
interest rates and mortgage rates, risk of business loan rejection, risks of junk bond ratings, risks of
shareholder unrest, and the like. Hence, strategic decision-making has to with what risks a business
should undertake, and what risks it should carefully avoid, and under what intended and unintended
consequences the executives must foresee.

In general, business risk (i.e., project risk, new product risk) is associated with three types of error:

a) Type I Error: also called alpha error. This error arises when a business executive, in an effort to
eliminate or minimize risk, rejects something (e.g., an idea, a business concept or model, an
innovation, technology, or market opportunity) as false when it is true, as non-existent when it really
exists, as wrong when it is right. This is the error of ignored evidence. It spells the cost of a lost

30
 technology, product or service or market opportunity. Type I error is producer risk. Many
companies, for instance, cancel promising projects and products too early for lack of adequate data,
that is, for lack of evidence that it could succeed. Such alpha errors result from a failure to conduct
the right experiments to reveal a projects or products potential, often because of organizational or
personal biases against the project or because of shortage of resources. For examples, the biggest
pharmaceutical blockbuster, Prozac, narrowly escaped cancellation due to Type I error; Xerox
abandoned projects that went on to drive the success of Documentum and 3Com.

b) Type II Error: also called beta error. This error arises when a business executive, in an effort to
manage risk, accepts something (e.g., an idea, a business concept or model, an innovation, technology,
or market opportunity) as true when it is false, as existent when it really does not exist, or as right
when it is wrong. This is the error of selective evidence. The effect of this is a bad product, a defective
technology, a flawed business model, and eventually, this error impacts the consumers and the
markets. Hence, Type II error spells consumer risk. In this case, managers ignore evidence
challenging their assumption that a project or product will succeed. There are many reasons for
Type II error: power of product champions to stir collective faith in a projects promise; a dogmatic,
success-seeking mentality; the human tendency to seek only evidence that supports our beliefs and
assumptions (Isabelle 2003). Despite multiple red flags, new product managers rush products to
markets, only to fall dramatically after their launch. Thus, ignored evidence abounds in industries
ranging from chemicals and pharmaceuticals to building materials to entertainment products, where
new products of questionable viability are propelled to the market (e.g., RCAs videodisk; Fords
Edsel and Pinto; GMs EV1).

c) Type III Error, also called gamma error. Tukey (1975) described this error as solving the wrong
problem, that is, the error of wrong problem formulation, hence, deriving a wrong solution. While
a problem well formulated is half solved, a problem badly formulated generates either new problems
or wrong solutions. This error happens when you reject a real problem, or a right problem
formulation and accept a wrong formulation of either the problem or its resolution. Hence, Type III
error is a combination of both Type I and Type II errors. Such errors are disastrous and spell both
producer and consumer risk. This error represents a willingness to kill a product early and a
willingness to persist until its potential is realized. Some people become so afraid of failing that they
are unable to do a critical experiment. Some people, on the other hand, are so enamored of success
that they ignore evidence of critical experiments to the contrary. Pharmaceutical and entertainment
companies are famous for products rushed to the market; governments, universities, churches, and
in general highly bureaucratic organizations, are known for delayed projects and products.

Reducing Type I and Type II Errors

You could increase your chances of success in new product development by dividing the NPD
process in early and later stages. In the former, your goal is to eliminate quickly poor candidates and
absorb risk; in the latter, your goal is to increase the probability of national launch and market success.
This segmented approach is a good bet for your company if (Bonabeau, Bodick and Armstrong 2008):

If 60% to 80% of new product candidates would be eliminated at the early stages of NPD;
If 70% to 90% of the rest would go on to successful market launches and market success;
If per project costs are less (say one-fifth to one-fiftieth) at early stages of NPD.

This segmented approach to NPD is particularly suitable to drug development in the pharmaceutical
industry because it reduces risk in an environment where project costs and failure rates are very extremely
high. In fact, any company that needs to absorb a lot of risk in early-stage development (e.g., in the
chemical, biotechnology, medical devices, high technology, and semiconductor industries) should use this
segmented approach. This approach makes less sense for products that imply low development costs, low
failure rates, and for products that are well served by current engineering or rapid prototyping approaches
that promote fast scale-up at relatively low risk (Bonabeau, Bodick and Armstrong 2008: 98).

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 Bonabeau, Bodick and Armstrong (2008: 98-102).characterize the early and late stage NPD process
as follows:

Organizational: Early stages of NPD Later Stages of NPD

Goal Seek project/product truth Seek brand market success

Establish new project/products promise
or lack of it
Typically, the cost of early stage
Strength development are low; hence, conduct
many and short experiments
Reduce risk and uncertainty
Reduce Type I or alpha error
Maintain loyalty to the experiment and
scientific rigor to experimentation
Focus on scientific method
Operate with low fixed costs, low capital
requirement
Work in small experiment-based teams
Emphasize product testing
Approach Eliminate useless candidates
Do not ignore evidence of low promise or
high product risk;
Expose the truth about risky prospects
quickly and cost effectively
Willingness to kill a useless product early
Decrease the probability of launch
Repeated and frequent experimental tests
of product feasibility, viability, safety,
toxicity, side-effects, legality, patent
infringement and ecology
Take a product to the market
Typically, the cost of late stage
development are high; hence, conduct
few but sure product campaigns and
launches
Maximize value and profitability
Reduce Type II or beta error
Maintain loyalty to the project or
product
Focus on commercialization
Operate with high fixed costs, high
capital requirement
Work in large product-based teams
Emphasize brand refining
Promote promising candidates
Emphasize selective evidence of promise
and success
Exploit the truth for maximizing
likelihood of product launch
Willingness to persist until the products
potential is realized
Increase the probability of launch
Sustained clinical tests of product
strengths, uniqueness, differentiation,
customization, potency and economy in
use

Financial Innovations as Risk Management

Many important financial innovations in risk management have originated in the banking and
securities industries. This is because financial institutions are basically risk intermediation or risk
securitization businesses. Risk management became the core competence of such institutions. The more
sophisticated the financial institutions were, the better they could describe, price, and manage risk.
Moreover, these institutions are rich in financial data, and hence, a natural locus for quantifying risk using
sophisticated statistical methods. Moreover, their investors and shareholders kept exerting increasing
pressure on these financial institutions to improve risk management. Thus, for all the above reasons,
financial innovations have taken place primarily in risk management of securities, bond options, and
derivatives.

For the first 70 years of the 20th century, corporate risk management was largely about buying
insurance. Bank regulators lacked tools for measuring risk in the funds lending and depositing system,
and hence, constructive intervention was difficult. Moreover, banks themselves could not control the
interest-rate risk in their loan portfolios nor quantify or manage credit risk partly because, few

32
alternatives to insurance were available. Innovation in risk management was further slowed down by the
then prevalent indifference theory advocated by Franco Modigliani and Merton Miller that argued that a
companys value was (in most cases) not affected by its capital structure. That is, in a perfect market
(e.g., no taxes, no bankruptcy costs, no asymmetric information), the value of a company is independent
of its capital structure (e.g., debt-equity leverage, hedging). Obviously, this theory originally proposed in
1958, did not hold too long in the real world of taxes, bankruptcy costs, and asymmetric market
information. There was a need for efficient capital structure and risk-mitigation through hedging.

Hence, in the 1960s, William Sharpe and his associates introduced the Capital Asset Pricing Model
(CAPM). The authors argued that the markets compensate investors for accepting systematic or market
risk but do not discount for idiosyncratic risk, which is specific to an individual asset and can be
eliminated through diversification. That is, the authors argued that investors should manage risk
primarily through portfolio diversification and hedging.

All this changed in 1973, by the landmark Options-Pricing Model introduced by Fischer Black and
Myron Scholes, and expanded later by Robert C. Merton. They argued that the volatility of a security is a
key factor in options pricing. Hence, their new model enabled more effective pricing and mitigation of
risk. The model calculates the value of an option to buy a security as long as the user could supply five
pieces of data: a) the risk-free rate of return (mostly defined as the return on a three-month U. S. Treasury
bill); b) the price at which the security would be purchased (usually given); c) the current price at which
the security was traded (this could be observed in the market); d) the remaining time during which the
option could be exercised (given), and e) the volatility of the security (which could be estimated from
historical data). The equations in the model assume that the underlying security price volatility mimics a
Brownian motion (random way in which air molecules move in space).

The Black-Scholes model addresses a core idea called optimality that is embedded in all financial
instruments, capital structures, and business portfolios these are options that can expire, can be
exercised, or sold. Most options are obvious and bounded (e.g., an option to buy General Electric stock at
a given price for a given period). Other options are more subtle. The Black-Scholes Model assumes that
the holders of equity in a company with debt in its capital structure have an option to buy back the firm
from the debt holders at a strike price equal to the debt of the company. Some options depend upon the
companys real operations; e.g., the option to cancel or defer a project or venture. The theory of real
options places a real value on managerial flexibility something overlooked in straightforward NPV
calculations that assume an all or nothing attitude toward projects.

Several concurrent innovations enabled the spread and popularity of the Black-Scholes model.
Around 1973, Texas Instruments marketed an early version of financial calculators with the possibility of
computing Black-Scholes values. Options traders accepted the TI calculator readily, and this also fueled
the growth in derivative markets and the broad development of standard pricing models.

Other innovations quickly followed:

In 1975, the first personal computers were launched.

In 1979, Dan Bricklin and Bob Frankson released VisiCalc, the first spreadsheet designed to work on
a PC, giving managers a simple tool to work on simulations of what-if financial market scenarios.
In the 1980s, Sun Microsystems, Digital Equipment and the Bloomberg Terminal developed
ingenious work machines called workstations that revolutionized price calculations in derivatives and
fixed-income markets respectively.
In the 1990s, other firms (e.g., Crystal Ball) developed software that allowed traders to run Monte
Carlo simulations within a few minutes on laptops, rather than overnight on mainframe computers.

33
 In the late 1990s and 2000s, financial markets got so sophisticated that they developed synthetic
CDOs derivatives of derivatives of derivatives. This was the fastest growing sector of the multi-
trillion dollar market for collateralized debt obligations (CDOs) until credit crunch began in late
2007.

Thanks to these easy financial computing innovations, by the beginning of the 1990s, investors could
buy contracts that covered a wide variety of risks using derivatives of various kinds options, futures,
and swaps, in all combinations. Derivative markets began with currencies, equities, and interest rates, and
quickly expanded to include commodities like energy and metals.

In a second wave of innovation, financial instruments emerged that allowed the hedging or transfer of
credit risk at that time a major remaining category of financial risk and a subject of concern among bank
regulators. By the end of 1990s, derivative markets were exploding; the notional value of the securities
involved rose from $72 trillion in 1998 to $370 trillion in 2006, and $600 trillion by the end of 2007
(Buehler, Andrew and Hulme 2008: 94-98).

Strategic Management of Financial Risk

The Black-Scholes (1973) Model of optionality relates to securities. However, optionality goes well
beyond securities and financial services. It implies that a companys equity is a basket option in which
its various risks are pooled. Each shareholder is exposed to a tiny fraction of the risk to which the
company is subject. Thus, a simple but useful way of thinking about the companys balance sheet is to
see its equity as a cushion against the risk of performing badly. The risk that its market value will go
down is borne by the shareholders. No such cushion is offered by debt, as the accrued interest must be
paid regardless how the company performs. The optimal debt level of a firm is determined by a
companys key market, financial, and operating risks; it is directly affected by actions that mitigate those
risks. CFOs, therefore, can add value by separately and more cheaply hedging those risks ordinarily
managed by equity cushion. If risks can be priced and traded, it makes better sense for companies to sell
off those risks where they have no comparative advantage. Modern financial tools enable companies to
free up that capital and get it working to create value. Smart financial engineering can free-up equity
capital for strategic (value-adding) investments, allowing a firm to finance more value-adding growth for
the same amount of equity (Merton 2005).

A good strategy plans an optimal mix of debt and equity, short-term borrowing and long-term
borrowing, fixed rate financing versus variable rate financing, high debt/equity (leverage) ratio versus low
leverage ratio, borrowing in home currency versus borrowing in foreign currencies, and matching
financing with types of assets by maturity (matching principle) or otherwise. A good financial strategist
should consider number of factors such as the following:

Maturity Structure: Have you debt mature in different periods than within a year, and within a
quarter in that year. The sudden cash outflow retiring several maturing debt loans (e.g., short-term
loans, commercial paper, medium term loans, bonds, and other long-term loans), within one quarter,
for instance, can force you to violate loan covenants and lead to insolvency. Hence, chart your loans
by year of maturity (x-axis) and dollar size (y-axis), and study the pattern of your amortization.

Transaction Costs: While long-term debts involve fewer transactions, several short-term debts, even
though cheap, may involve high transactions costs (e.g., paper work, commissions, opening costs,
closing costs).

Flexibility: Short-term debt, however, is more flexible than long-term debt. If your business is
seasonal, then you may prefer short term loans when you need cash, than go for long term loans that
may result in idle surplus cash (cum accumulating interest) you may not need.

34
 Uncertainty of securing loans: On the other hand, when you have long-term projects that involve
long-term fixed and current assets, then you may prefer long-term borrowing for the project period
than opt short-term loans that may not always to renewed given your mid-project performance
conditions. Negotiating new loans or issuing new bonds at the end of each year can be very costly,
especially if interest rates are volatile, your creditworthiness is fluctuating, and if your banks credit
policies keep on changing in response to financial market turmoil.

The term structure of interest rates: Interest rates term structure relates to the schedule of interest
rates you must pay depending upon the maturity (say, one, two, five or ten years) of your loans.
Chart number of years to maturity of your loans on the x-axis and corresponding interest rates on
the y-axis, and study the yield-curve. For instance, your short-term interest rates may be lower
than long-term interest rates. Often, attractive short-term rates may make you go for short-term
loans. However, what if market conditions change (e.g., credit squeeze, high growth boom) and
interest rates rise? Also, if all the borrowing are floating rate then the firm is vulnerable to rising
interest rates, which often happen during recessions, and when sales revenue decline, thus increasing
vulnerability of a cash crisis.

Keeping all these factors in mind, Table 4.14 charts different financial risk-reducing borrowing
strategies. For instance, you can manage the risk of variable interest rates by balancing your long-term
versus short-term borrowing. Three points you need to consider here:

Cost of borrowing (e.g., interest rates, transaction costs);

The risk of borrowing (e.g., changing interest rates, risk of future loan refusals), and
Type of assets you want to finance by borrowing (e.g., fixed assets such as buildings and machinery,
permanent current assets such as cars, rentals, leases, utilities), or fluctuating current assets such as
seasonal inventory, payroll, taxes, or entertainment).

Some firms follow the matching principle in which the maturity structure of the finance matches
the maturity structure of the project or asset (see Table 4.14).

Financial Gearing

Other things being equal, financing a business through borrowing is cheaper than using equity. This
is because lenders require a lower rate of return than ordinary shareholders do. Moreover, finance
providers of debt financial securities face lower risk, as they have a higher priority claim on the assets of
the firm than shareholders in case of liquidation. Further, if the business is profitable, then debt interest
can be offset against pre-tax profits, thus reducing corporate profits tax bill. Thirdly, issuing and
transaction costs associated with raising and servicing debt are generally lower than for managing equity.
For these and other reasons, firms tend to finance company operations through more debt than equity a
phenomenon called financial gearing. Financial gearing concerns the proportion of debt in the capital
structure. The terms gearing or leverage are interchangeable; the term gearing is common in Europe,
while leverage is common in the USA. Various types of gearing are known:

Capital gearing: the extent or proportion of a firms total capital is in the form of long-term debt this is
debt/equity ratio. This ratio indicates the firms ability to sell assets to repay long-term debt. A value of
0.33 implies that net assets are three times to offset long-term debt. This ratio is unreliable, if the market
value of the assets is different (owing to depreciation, appreciation, obsolescence) to the book value of the
assets. This ratio ranges from zero to infinity, thus making inter-firm comparisons meaningless. Hence, a
bounded capital-gearing ratio is (long-term debt/[long-term debt + equity]). This ratio can also include
short-term (e.g., term loans, overdraft), and medium term (e.g., commercial paper) borrowings. In which
case the capital-gearing ratio is (all borrowings/[all borrowings + shareholders equity]). An even better

35
capital-gearing ratio is [Long-term Debt/ Total market capitalization]. This ratio indicates the ability of
the firm to sell stock to offset the threat of debt. All the capital gearing measures rely on the appropriate
valuation of net assets either in the balance sheet or through due diligence. Obviously, net-asset
evaluation is very challenging, as it is based on the evaluation of each of your assets (e.g., machinery,
building, raw materials) and liabilities (e.g. short- and long-term debts, payables, bad debts, bad credit,
write-downs). Some service agencies (e.g., advertising, consulting) may not have much assets. In which
case capital gearing may not be a useful indicator for raising debt. With the dramatic shift from
manufacturing to services, capital gearing based on asset valuation from balance sheets is becoming
increasingly irrelevant.

Operating gearing: the extent or proportion of a firms total costs is financed by debt. You can gear
various types of production costs such as pay roll, employee benefits, cost of raw materials, product
design costs, warehousing costs, transportation costs, inventory costs, supply chain management costs,
factory fire insurance, factory accident insurance, packaging and labeling costs, advertising and
promotion costs, and the like. You can underwrite some of these costs by buying appropriate insurance
policies. Of course, the more you break these costs and finance or insure them separately, the higher are
transaction and insurance costs.

Income gearing: the extent or proportion of a firms total pre-interest profits is interest charges. Instead
of focusing as net assets, income gearing focuses on the sources of income such as brands, brand equity,
media creations, patents, intellectual property, human resources skills, and other intangibles, most of
which do not feature on the companys balance sheets. The value of great companies like Microsoft,
Disney, Marks & Spencer, and great advertising agencies is not based on their assets but on their
intellectual pool of skills and software, media creations and brands.

Under such circumstances, balance-sheet gearing is no longer useful. One income gearing measure is
Interest Cover = Profits before interest and taxes/interest charges. Interest cover measures the proportion
of profits paid out in interest. The lower the interest cover ratio the greater the chance of interest payment
default and liquidation. Higher interest cover ratios, on the other hand, indicate how easy it is for
companies to service their debts.

A companys market capitalization (i.e., the total value at market prices of the outstanding shares of a
company) reflects its intangible assets. Market capitalization overcomes the inadequacies if balance sheet
measures of equity. Hence, another useful income-gearing ratio is to divide a companys debt by its
market capitalization. A higher ratio indicates that shareholders returns are more leveraged, and hence
risky. A lower ratio signifies excellent performance by the company.

However, excessive gearing could lead to financial distress, especially if net cash flows are negative, then
the company may find difficult to pay its bankers, bondholders and other creditors when such bills are
due. That is, at low gearing levels the risk of financial distress is low, but the cost of capital (via equity)
may be high. The opposite is true at high gearing levels, as long as the returns on equity are constant or
do not rise with much with gearing.

A simple illustration: Company XYZ is planning to start a subsidiary business with four different
gearing levels or capital structures for raising $20 million in capital:

a) All equity 10 million shares at IPO of $2.00.

b) $5 million in debt (at 7% interest) and $15 million in equity.
c) $10 million in debt (at 7% interest) and $10 million in equity.
d) $15 million in debt (at 7% interest) and $5 million in equity.

36
Obviously, gearing level increases from (a) to (d). We also assume that interest rates are independent of
the debt-size, which may not be always realistic. Such sophistication, however, can be easily built into
Table 4.15. In selecting a capital structure, the directors of Company XYZ project three scenarios as
follows:

Moderate business success: Income before interest and taxes of $1.5 million with 25% probability.
Good business success: Income before interest and taxes of $3.0 million with 50% probability.
Great business success: Income before interest and taxes of $6.0 million with 25% probability.

Shareholder returns under each scenario and capital structure are presented in Table 4.15. Table 4.15
assumes that interest on debt is tax deductible at 50%. As is clear from this table, given the projected
business success estimates:

The shareholder returns at any level of projected business success are higher than the cost of capital
rent (i.e., interest rate of 7%). That is, it pays to leverage debt.

The effect of gearing gets progressively better from capital structure (a) to (d), at all success levels
and at the (probability weighted) expected level of project success. That is, shareholder returns keep
increasing as gearing increases.

Increased gearing results in increased shareholder returns at all levels, modest, good and great, and
weighted (expected) average. Hence, other things being equal, increased gearing reduces business
and financial risk, and therefore, insurable risk.

Technically, one could even consider a 100% gearing capital structure as long as borrowing is available at
a given interest rate, and in this case, there are no shareholders shares, and the owner of the business
makes quasi-infinite profits.

Table 4.15 implies that firms with low business risk can take on relatively high levels of financial risk or
gearing without reducing shareholder returns. Note, however, that while interest payments are tax
deductible, dividends are not. Managers will generally increase the gearing level only if they are
confident about the future. Upward changes in financial gearing can become a positive signal of
managerial optimism to prospective shareholders, and hence, may lead to a rise in share price (Ross
1977).

On the other hand, had we projected a fourth and pessimistic poor scenario of $0.75 million EBIT with
probability of, say 0.15, attached to it, then Table 4.15 would look quite different, and indefinite gearing
would not be feasible for both the owner and the banker.

Table 4.16 presents various financial gearing ratios for different industries.

What is a Business Model?

From an academic point of view, a business plan or model is a roadmap, a statement of strategy, an
operational model, a business forecast or some other conceptual label. From an entrepreneurs viewpoint,
a business plan is a selling document, a sales pitch you give to prospective venture capitalists and banks.
A business plan does not sell a product or a service or a work environment, it sells an entire innovation
project, the entire business venture or your new company. If you are really excited about and believe in
your project or your new company, it should reflect in the business plan. Excitement, however, is not
based on puffery or exaggeration. It is based on supporting evidence in the form of solid research and
experience. The innovation, new product or service idea that you sell or form a company about should

37
be real, credible, convincing, promising, attractive, demonstrable, and worth investing to your
stakeholders. Hence, have a clear purpose, content, audience and expected outcome for your business
plan. These will generate a sense of commitment, focus and realism to your document.

According o Johnson, Christensen and Kagermann (2008), a business model consists of four
interlocking elements that, taken together, create and deliver value: a) Customer value proposition, b)
Profit formula, c) Key resources, and d) Key processes. These four elements form the building blocks of
any business. The first two elements define value for the customer and the company, and the last two
describe how the company will deliver that value to the customers and the company, respectively. Profit
formula is not the same as the business model; the former is just a piece of the latter. Start by setting the
price required to deliver the CVP and then determine backwards what should be the variable and fixed
costs should be and he gross margins. In other words, do not start with a cost-driven price (e.g., cost-plus,
mark-up) but a price-driven cost. Thus, you avoid the third deadly sin of executives, according to Peter
Drucker (1996).

Customer Value Proposition (CVP): A successful company is one that has found a way to create and
deliver value to customers. The most important attribute of a CVP is its precision how perfectly it
identifies the customer need or nails he customer job to be done. Value relates to helping customers
to get an important job done. Job relates to a fundamental problem to which the customer needs an
effective solution, and better than existing solutions. The more important the job is, the higher is
customer expectation, the lower is customer satisfaction with existing solutions, and hence, the higher
is CVP. Design and deliver your product/service to do that important job. CVP is the most
important part of the business model.

In precisely defining customer need or job or CVP, one may consider four constraints that shape and
cause needs: insufficient buying power, access, skills and time. For instance, software maker, Intuit,
devised QuickBooks to fulfill the needs of small business owners to avid running out of cash.
QickBooks greatly simplified existing accounting packages that needed sharper skills. Similarly,
MinuteClinic, the drug-store based healthcare provider, that made nurse practitioners available
without appointments, broke the time barrier that kept people from visiting doctors offices with
minor health issues.

Profit Formula: this is a blueprint how the company creates value for itself while providing value to
the customer. The profit formula has several sub-components:

1. Revenue model: basically, price that the market bears multiplied by the volume you want to
offer at that price.
2. Cost Structure: relates to direct or variable costs, fixed or indirect costs, and the economies of
scale. The key resources primarily determine the cost structure.
3. Margin Model: Given the expected volume and cost structure, what is the contribution
margin that the company needs from each transaction?
4. Resource Velocity: how fast do we need to turnover inventory, fixed costs and utilize other
key resources to support our expected volume, cost structure, and profits?

Key Resources: these are assets such as key skills, brand equity, technology, new products, new
equipment, channels and brand names required to create and deliver value to the target customers
and the company. Having articulated the value proposition for the customer and the business,
companies must next consider the key resources and processes needed to deliver that value. Key
resources are those that create competitive differentiation.

Key Processes: Successful companies have operational and managerial processes that deliver value
(e.g., training and retraining employees, strategic planning, sales planning, budgeting, forecasting,
market scanning, organizational routines, performance metrics, company mores and codes of
conduct, inventory management skills, new product development skills, production skills, packaging

38
 and product bundling skills, promotional skills, and channels) that enable them to deliver value to
the customer and the company.

This four-component business model is simple. Its power lies in the complex interdependencies of its
parts. Major changes to any of these four elements affect the others and the whole. Successful businesses
weave a more or less stable system in which these elements bond to one another in consistent and
complementary ways. Often, it is not the individual key resources and processes that make the difference
but their relationship to one another. Companies need almost always to integrate their key resources and
processes in a unique way to get a job done perfectly for a set of customers. This integration ensures
differentiation and sustainable competitive advantage. For instance, National Jewish Health in Denver
organizes itself around a unique CVP pulmonary disorder cure. Narrowing its focus has allowed NJH
to develop key resources and processes to deliver a unique CVP very effectively and profitably. Similarly,
the Tata Nano fulfills a specific job for scooter/motorcycle families a cheap, safe and all-weather family
transport. The young group of engineers that designed Nano dramatically minimized the number of parts
in the vehicle, resulting in significant cost savings (Johnson, Christensen and Kagermann 2008: 53-55).

When do we need a New Business Model?

You do not need a new business model if you can fulfill CVP and value to your company with your
existing model. Otherwise, invent a new business model when the opportunity is large enough to justify
the effort of changing a business model. Pursuing a new business model that is not new to the company
or the market or game-changing to the industry is a waste of time and money. Creating a new business
model for a new business does not mean that the current one is threatened or should be changed. A new
model often reinforces and complements the core business. For instance, when there are significant
changes to the four components of a business model, then we need to innovate or reinvent the business
model. A new business model may be more efficient if you are dealing with an entire new CVP, a new
business process, a new key resource, or just to disrupt your competitors. Johnson, Christensen and
Kagermann (2008: 57-59) observe five strategic circumstances that often mandate a new business model:

1. The opportunity to reach larger markets: Some customers have no access to existing products or
services as they cannot afford them. Under such circumstances, we need business models that can
democratize such products or services in emerging markets so that larger masses can benefit from
them (e.g., the case of Ford Model T in 1907, Tata Model Nano in 2008).

2. The opportunity to capitalize on a brand new technology: One can wrap a new business model around
it (e.g., Apples iPod and iTunes around MP3 technology of file sharing); this opportunity can also
extent to leveraging a tested technology by bringing it to a whole new market (e.g. commercializing
the Internet in 1993; using military technology to commercial use as GMs use of GPS, or Hummer
I, II and III).

3. The opportunity to bring a job-to-be-done focus when one does not exist: For instance, when FedEx
entered the package delivery market, it did not compete with USPS or UPS through lower prices or
better marketing, but focused on an entirely unmet market need of receiving packages faster, more
reliably and predictably than did USPS, UPS or any other competitor. FedEx had a considerable
competitive advantage in doing just this job; it took years for USPS and UPS to catch with FedEx.

4. The need to fend-off low-end disrupters: For instance, if the Nano is successful it will disrupt the
regular automakers; the mini steel mills disrupted the big integrated steel companies; Cemex the
mini cement-concrete manufacturer rocked the big suppliers.

5. The need to respond to a shifting basis of competition: an acceptable solution in a market will change
over time, inviting core market segments to commoditize the solution. The need for tissue transplant,

39
 organ transplant and surrogate motherhood is getting to be highly commoditized. Home Depot
commoditized hitherto complex home improvement products.

Successful new businesses typically revise their business models four times or so, on the road to
profitability. While a well-considered business-model-innovation process can often shorten this cycle,
successful incumbents must accept and tolerate initial failure and proceed to correct the process learning
from ones mistakes. Companies have to focus on both learning and executing. A profitable business is
the best early indication of a viable business model. Truly transformative successful businesses are never
exclusively about the discovery and commercialization of new technology; their success comes from
enveloping the new technology in an appropriate and powerful business model

Concluding Remarks
Any business plan must take into account uncertainty and the volatility of the markets in which the
corporation is engaging. Successful executives that cut their teeth in stable and predictable industries or
in developed countries often stumble when entering more volatile markets of the developing world. They
mistakenly believe they can foresee and control the deep future and draft a long-term strategy that will
ensure them sustainable competitive advantage. However, visibility in volatile markets is sharply limited
owing to many uncontrollable and unknown variables in play. Many variables are individually uncertain,
and they interact with one another to create unexpected outcomes. Managers in turbulent markets cannot
control the timing either of the rare golden opportunity or the equally rare sudden death-threat. These
events are clear in retrospect, but impossible to predict. Knowing what to do during periods of relative
calm can spell the difference between industry leadership and extinction (Sull 2005:121-123).

Business model innovations have reshaped entire industries and redistributed billions of dollars of
value. Wal-Mart and Target entered the discount retailing market with pioneering business models
against the founder and first mover K-Mart, but now account for nearly 75% of the U. S. retailing sector.
Similarly, some 11 low-cost U. S. airlines that sprung during the last quarter of a century now control
55% of the air dollar traffic and have made their into Fortune 500 during the last ten years they had
great business model innovations.

Established companies do not succeed with radically new product offerings unless they understand
exactly how the opportunity relates to their current business model and proceed accordingly (Johnson,
Christensen and Kagermann 2008: 53). A business model should start by a strong customer value
proposition. Then constrict a profit formula that can deliver value to your company. Then decide upon
key resources and processes that you will need to deliver the value to the customer and the company.
Many companies start with a product and a business model and then go in search of a market. Real
success comes from figuring how to satisfy a real customer need or a job that the customer wants done.
The product and the business model should be dovetailed to the customer need. It is not possible to
invent or reinvent a business model without first identifying a clear customer value proposition.

When Ratan Tata of the Tata Group saw thousands of scooters and motor cycles in heavy Mumbai
traffic carrying literally the whole family with them, he saw a need for a safer, all-weather alternative for
scooter and motorcycle families. Typical cars cost at least five tines the value of scooters or motorcycle.
These families could not afford that. Hence, the Tata Group devised a small car safe and cheap enough to
carry them safely, and the $2,500 Nano car was born. That was a car the customer could afford it was
less than half the price of the cheapest car then available, but about 25%-50% more than that of an
ordinary scooter or motorcycle. The Tata Group had to change the cost structure radically in order to
make Nano profitable. It required both a significant drop in gross margins and a radical reduction in many
elements of the cost structure. The company knew it could still make money if it could increase sales

40
volume dramatically. A team of young engineers developed new processes outsourcing 85% of the car
components, using 60% fewer vendors, and eventually employing a network of assemblies to build to
order. The rest is history.

In 2003, Apple introduced the iPod followed by the iTunes, revolutionizing portable entertainment,
creating a new market, and transforming the company. By 2006, the iPod/iTunes bundle became a $10
billion product, accounting for almost 50% of Apples revenue. Apples market capitalization
skyrocketed from around $1 billion in early 2003 to over $150 billion by late 2007 (an annual compound
growth rate of nearly 250%). Apple, however, was not the first to bring digital music players to the
market. Diamond Multimedia introduced the Rio in 1998, and Best Data launched the Cabo 64 in 2000;
both were good and stylish products of portable entertainment. While the latter two failed, Apple
succeeded. The reason: Apple had a brilliant business model that backed its products. Apples true
innovation was to make downloading digital music easy and convenient. To do that, Apple built a
groundbreaking business model that combined hardware, software, and service. This approach worked
like Gillettes famous blades-and-razor model in reverse: Apple essentially gave away the blades (low
margin iTunes music) to lock in purchase of the razor (the high margin iPod). The business (product
bundling) model defined value in a new way and provided game-changing convenience to the consumer.
Every successful company operates according to an effective business model. By systematically
identifying all of its constituent parts, executives can understand how the model fulfills a potential
customer value proposition in a profitable way using certain key resources and key processes (Johnson,
Christensen and Kagermann 2008: 51-54).

References
Arnold, Glen (2007), The Handbook of Corporate Finance: A Business Companion to Financial Markets, Decisions
and Techniques, Financial Times: Prentice Hall.

Bonabeau, Eric, Neil Bodick and Robert W. Armstrong (2008), A More Rational Approach to New Product
Development, Harvard Business Review, (March), 96-102.

Buehler, Kevin, Andrew Freeman and Ron Hulme (2008a), The New Arsenal of Risk Management, Harvard
Business Review, (September), 93-100.

Buehler, Kevin, Andrew Freeman and Ron Hulme (2008b), Owning the Right Risks, Harvard Business Review,
(September), 102-110.

Bygrave, William D. (Ed) (1997), The Portable MBA in Entrepreneurship, 2nd edition, John Wiley & Sons.

Gumpert. David E. (1997), Creating a Successful Business Plan, in The Portable MBA in Entrepreneurship,
Bygrave, William D. (ed), 2nd edition, John Wiley & Sons.

Johnson, Mark W., Clayton M. Christensen, and Henning Kagermann (2008), Reinventing your Business Model,
Harvard Business Review, (December), 50-59.

Megginson, William L., Mary Jane Byrd, Charles R. Scott and Leon C. Megginson (1994), Small Business
Management: An Entrepreneurs Guide to Success, Burr Ridge, IL: Irwin.

Merton, Robert (2005), You have more Capital than you Think, Harvard Business Review, (November), 84-94.

Royer, Isabelle (2003), Why Bad Projects are so Hard to Kill, Harvard Business Review, (February), xx-xx.

41
 Figure 4.1: Net Short-Term Cash Flows in a Given Period:
Sources versus Uses.

Net Income for the year: Increase in Fixed Assets:

Cash or credit from sales Land & Building

Net Increase in Increase in Fixed Assets:

Depreciation Plant and Machinery

Increase in accounts Increase in Fixed Assets:

payable: credit from Office Equipment and
suppliers Stationery

Increase in notes Increase in prepayments

payable: credit from Net Short- and deferred charges
banks Term Cash
Flows
Increase in interest Increase in Intangibles:
payable: credit from Skills, Goodwill and
suppliers and banks Reputation

Increase in accrued Increase in other assets:

wages: Dividend Payments
Credit from employees

Increase in taxes Increase in Inventory:

payables: Credit to Suppliers
Credit from IRS

Increase in Accts
Increase selling of fixed Receivables: Credit to
assets: Customers
Cash via asset reduction
Increase in Marketable
Securities: Credit to
Stockholders Equity: Governments
Cash from shareholders
Increase in Prepaid
Rent

42
 Table 4.1: Contents of an Effective Business Plan
Business Factors Dimensions Company Timeframe for Barriers to goals
Objectives achieving and how they can
objectives be overcome?
The Proposed Its nature: what is it? How does it work?
Product Its domain: attributes, features, benefits
Its industry: nature, scope, newness
Satisfaction of need, want or desire
Its expected target The target market: local, national, global
market Its current market: size, buying power
Augmented market: growth rate
Any new market? New use? New options?
The strengths and Stagnant industry? Trends, cycles
weaknesses of the Vibrant industry? competition
industry Future growth? Local, national, global
Converging industry? Digitizable?
Expanding industry?
Production Quality materials and costs?
methods and Quality parts and costs?
facilities Quality components and costs?
Quality design and costs?
Quality engineering and costs?
Quality packaging and costs?
Quality bundling and costs?
Scaling and scope economies?
Required labor skills
Financing aspects Estimated total costs
Range of total costs
Cost contingencies
Potential investors? How to raise funds?
Innovation intermediaries?
Bank loans?
Marketing policies Product bundling, branding
and strategies Price bundling, price signals
Pricing, costing, mark-ups
Premium pricing
Penetration pricing
Competitive pricing
Discount pricing
Promoting; free sample use/test
Advertising
Distribution Warehousing and inventory mgmt
Transportation logistics
Shipping and tracking
Distribution channels and retailing outlets
Slotting allowances
Shelving & POP display
Profitability Sales revenue in one, two or three years?
Cost of good sold in one to three years?
Gross margins in the first 3 years?
Marketing and selling expenses
Contribution margin
Administrative overhead
Net contribution margins
Retained earnings
ROQ, ROS, ROM, ROI, ROE, ROA,
EBIT, EBITD, EBITDA, EBITDAR
Free cash flow analysis
Net present value of earnings

43
Table 4.2: A Sample of Projected Income (Profit & Loss) Statements 2007-2010
(Fiscal year ending: March 31)

Items Sub-items 2007-2008* 2008-2009* 2009-2010*

Sales Sales revenues
Cost of good sold
Gross profit

Controllable Salaries
or variable Wages
expenses Payroll taxes
Office furniture
Office supplies
Telephone
Utilities
Shipping and handling
Postage
Newspapers
Trade magazines
Legal and accounting
Advertising
PR
Miscellaneous
Total variables expenses
Fixed Cars
expenses Trucks
Insurance
Total fixed expenses
Profitability EBIT
Rent and lease
Tax and license
Interest on debt
Amortization
Depreciation
EBITD
EBITDA
EBITDAR+
* Projected profit and loss statements can be done by each month, each quarter, or each year.
+ Earnings before interest, taxes, depreciation, amortization and rents.

44
 Table 4.3: A Sample of Cash Flow Projections 2007-2010
(Fiscal year ending: April 01, 2008 March 31, 2009)
(ALL figures in US Dollars)

Items Start- 04/08 05/08 06/08 07/08 08/08 09/08 10/08 11/08 12/08 01/09 02/09 03/09
up
Beginning cash:
Cash 1,825 2,891
Cash equivalents 25,000 25,000
Total Cash 26,825 27,891
Receipts:
Cash sales 10,000 12,000
Loans 50,000
Other cash 20,000
Total Receipts 70,000 10,000 12,000
Variable Expenses:
Salaries 3,000 3,000
Wages 2,000 2,500
Payroll taxes 600 660
Material purchases 20,000 1,000 1,200
Office furniture 2,500
Office supplies 1,000
Telephone 1,000
Utilities 500 100 100
Shipping & handling 100 120
Postage 100 200 100
Newspapers 125 50 50
Trade magazines 200
Legal & Accounting 750 250 250 250 250 250 250 250 250 250 250 250 250
Advertising 500 500 500 500 500
PR 500 500 500 500 500
Miscellaneous 500 100 150

Total VE 27,675 7,400 7,980

Fixed Expenses:
Insurance 200 200 200 200 200 200 200 200 200 200 200 200
Cars lease 500 500 500 500 500 500 500 500 500 500 500 500 500
Trucks lease 500 500 500 500 500 500 500 500 500 500 500 500 500
Rent and lease 2,000 2000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000
Tax and license 500
Interest on debt 334 334 334 334 334 334 334 334 334 334 334 334
Amortization

Total FE 3,500 3,534 3,534 3,534 3,534 3,534 3,534 3,534 3,534 3,534 3,534 3,534 3,534
Capital
Expenditures:
Computers 5,000
IT Infrastructure 5,000
Technologies 2,000
Licenses

Total CE: 12,000

Total Expenditures 43,175 10,934

Ending Cash 26,825 27,891

45
 Table 4.4: Our Pro-forma Balance Sheet
(Year ending March 31, 2009)

Item Sub-item March 31, 2009 March 31, 2010 March 31, 2011
Current
Assets Cash 5,500 6,600 8,085
Marketable securities (at cost) 25,000 30,000 36,750
Accounts receivable 30,000 36,000 44,100
Inventories 21,000 25,200 30,870
Prepaid rent 2,000 2,400 3,000
Prepaid lease 0 2,400 3,000

Total Current Assets 83,500 102,600 125,805

Fixed Assets
Land
Building
Machinery and plant 3,500 4,200 5,145
Office Equipment & Supplies 4,500 5,400 6,615
Less: Accumulated depreciation 10,000 12,000 14,700

Net Fixed Assets 18,000 21,600 26,460

Prepayment & deferred charges
Intangible
Total Assets 101,500 124,200 152,265

Current
Accounts payable 12,500 15,000 18,375
Liabilities Notes payable (current portion) 2,500 3,000 3,675
Accrued interest payable 1,000 1,200 1,470
Accrued wages payable
Accrued income taxes payable
2,500 3,000 3,675
Other expenses payable 2.500 3,000 3,675

Total Current Liabilities 21,000 25,200 30,870

Long-term
Long term loans 50,000 40,000 30,000
Liabilities Deferred taxes 1,000 2,500 2,000
Total Liabilities 72,000 67,700 62,870
Stockholders
Common Stock (e.g., $5 a share, 20,000 40,000 50,000
Equity: Authorized 10,000 shares)
Capital surplus
Accumulated retained earnings
9,500 16,500 24,395
Dividends 15,000
Total Shareholders Equity 29,500 56,500 89,395
Total Liabilities & Shareholders Equity 101,500 124,200 152,265

46
 Table 4.5: XYZ Manufacturing Corporation
Balance Sheet: June 30 2002 June 30 2003
(All figures in $s)

Balance Sheet Items June 30, June 30, Change

2003 2002 from 2002
Assets
Current Assets:
Cash 175,000 175,000 0%
Marketable Securities (at cost) 175,000 157,500 11.11%
Accounts receivable less allowance for bad debts 700,000 560,000 25.00%
Inventories 1,045,000 700,000 49.29%
Prepaid rent 5,000 --- ---

Total Current Assets 2,100,000 1,592,500 31.86%

Fixed Assets:
Land 157,500 157,500 0.00%
Building 1,400,000 1,400,000 0.00%
Machinery and Plant 525,000 280,000 87.5%
Office equipment and supplies 17,500 17,500 0.00%
Less: Accumulated depreciation 700,000 595,000 17.64%
Net fixed assets 1,400,000 1,260,000 11.11%
Prepayment and deferred charges 140,000 105,000 33.33%
Intangibles 35,000 35,000 0.00%
Total Assets 3,675,000 2,992,500 22.81%

Liabilities
Current Liabilities:
Accounts payable 350,000 262,500 33.33%
Notes payable (current portion) 515,000 165,000 212.12%
Accrued interest payable 10,000 10,000 0.00%
Accrued wages and other expenses payable 87,500 78,750 11.46%
Accrued income taxes payable 87,500 78,750 11.46%
Total Current Liabilities 1,050,000 595,000 76.47%
Long term liabilities:
First mortgage bonds (5.5% interest, due 2020) 1,050,000 1,050,000 0.00%
Deferred taxes 210,000 210,000 0.00%
Total Liabilities 2,310,000 1,855,000 24.53%
Stockholders Equity:
Common stock, $5 par value each; authorized, issued,
and outstanding 300,000 shares 525,000 525,000 0.00%
Capital surplus 175,000 175,000 0.00%
Accumulated retained earnings 665,000 437,500 52.00%
Total shareholders equity 1,365,000 1,137,500 20.00%
Total Liabilities and stockholders equity 3,675,000 2,992,500 22.81%

47
 Table 4.6: XYZ Manufacturing Corporation
Consolidated Income Statement: June 30 2002 June 30 2003
(All figures in $s)

Income Statement Items June 30, June 30, Change

2003 2002 from 2002

Net sales 4,025,000 3,745,000 7.48%

Cost of goods sold 2,000,000 1,909,400 4.74%
Gross profit (or gross margin) 2,025,000 1,835,600 10.32%
Gross profit as percentage of sales 51.31% 49.01% 2.30%

Operating expenses:
Wages 800,000 700,000 14.29%
Rent 50,000 50,000 0.00%
Miscellaneous 20,000 30,000 -33.33%
Depreciation 105,000 96,250 9.09%

Total operating expenses 975,000 876,250 11.27%

Operating income (or operating profit) 1,050,000 959,350 9.45%
Operating profit as a percentage of sales 26.09% 25.62% 0.47%

Selling and administrative expenses 490,000 463,750 5.66%

Operating Profit (EBIT) 560,000 495,600 12.99%

Operating Profit as percentage of sales 13.91% 13.23% 0.68%

Other Income:
Dividends and interest 17,500 17,500 0.00%

Total Incomes from Operations 577,500 513,100 12.55%

Less: Interests on bonds and other liabilities 105,000 52,500 100.00%

Income before taxes 472,500 460,600 2.58%

Provisions for income tax 213,500 210,000 0.76%

Net Profit after interest and taxes (NPAIT) 259,000 250,600 3.35%
NPAIT as percentage of sales 6.45% 6.69% -0.24%

Dividends paid out 31,500 46,200 -31.82%

Dividends as percentage of sales 0.78% 1.23% -0.45%
Retained earnings 227,500 204,400 11.30%
Retained earnings as percentage of sales 5.65% 5.46% 0.19%

48
 Table 4.7: XYZ Manufacturing Corporation
Sources and Uses of Cash during 2003

Major Cash Flow Major Cash Flow Items Cash Flow

Categories in 000$s
Sources of Cash

Cash Flow from Net Income during 2003 259.00

Operations Increase in depreciation over 2002 105.00

Total Cash Flow from Operations 364.00

Decrease in net working Increase in accounts payable over 2002 87.50

capital Increase in notes payable over 2002 350.00
Increase in interest payable over 2002 0.00
Increase in accrued wages & other expenses payable over 8.75
2002
Increase in taxes payable over 2002 8.75

Total Sources of Cash 819.00

During 2003
Uses of Cash
Increase in fixed assets Investments in land over 2002 0.00
Investments in building over 2002 0.00
Investments in machinery and plant over 2002 245.00
Investments in office equipment and supplies over 2002 0.00

Total increase in fixed assets over 2002 245.00

Increase in other assets Increase in prepayments and deferred charges over 2002 35.00
Increase in intangibles over 2002 0.00
Dividends paid in 2003 31.50

Increase in net working Increase in inventory over 2002 345.00

capital Increase in accounts receivable over 2002 140.00
Increase in marketable securities over 2002 17.50
Increase in prepaid rent over 2002 5.00
Total Uses of cash 819.00
During 2003

Change in cash balance Total sources of cash minus total uses of cash 0.00
During 2003

49
 Table 4.8: Cash Flow Time Line and the Cash and Operating Cycles

Operating Cash Events Decisions

Cycle Cycle
Buying raw From whom to buy?
materials How much inventory to order?
Just-in-time inventory?
When to order?
At what price?
With what trade terms?
Paying for the Purchase against cash?
raw materials Purchase on credit?
Purchase on debit?
bought Part payment?
Prepayment?
Borrow money for payment?
Draw down cash balance to pay?
Manufacturing Which specific product to produce?
the product Which specific brand to produce?
With what process technology?
With what production technology?
With which core competences?
Which employee skills to tap?
How much to produce?
How to size the product?
How to brand or label the product?
When to produce?
How to manage the inventory?
Selling the How do distribute the product?
product How to pre-announce the new product?
How to promote the product?
How to advertise the product?
How to price the product?
What price discounts?
What rebates?
What financing arrangements?
What guarantees and warranties?
Retailing the Selling exclusively through retailers?
product In which retail outlet types?
Upscale? Middle-scale? Discount stores?
Urban versus rural stores?
In big versus medium versus small cities or towns?
Pay slotting allowances (i.e., buy selling space in the store)?
Sell products on consignment (i.e., collect cash after sale)?
Sell on credit to the retailers?
Provide selling incentives to retailers?
Collecting cash How to collect cash?
from retailers When to invoice?
Request payment within how many days from invoice?
or customers Request prepayment in full or in part?
Request full payment on receiving the product?
Request full payment within 30 days of invoicing?

50
 Table 4.9: Short-term Financial Policies as a Function of
Carrying Costs and Shortage Costs
Carrying Costs: Shortage Costs:
a) Opportunity costs: for a) Trading or order costs: costs of placing frequent orders
alternative use of money (brokerage costs) and production set-up costs when
invested in current assets such maintaining low inventories.
as high levels of cash, b) Costs related to safety reserves: costs of lost sales, lost
accounts receivable and customer goodwill when running short of product
marketable securities. inventories, and disruption of production schedules.
b) Costs of maintaining assets
economic value: e.g., High Low
warehousing, inventory
management and sunk capital
costs in high inventories.

TC is high TC is medium
Policy: Policy:
Monitored policy: maintain Restrictive policy;
medium levels of ICA maintain low levels of ICA
High
Results: Results:
Medium growth opportunities Low growth opportunities
Medium risk investments Low risk investments
Medium returns Low returns

TC is medium TC is low:
An ideal economy!
Policy: Policy:
Flexible policy; maintain high Liberal policy; maintain
Low levels of ICA. high levels of ICA but
watch profit margins

Results: Results:
High growth opportunities High growth opportunities
High-risk investments High-risk investments
High returns High returns

TC = Total costs (carrying costs + shortage costs) of holding current assets.

ICA = Investments in current assets such as cash, marketable securities, accounts receivable, and inventories.

51
 Table 4.10: Analysis of Effects of Various Activities on Cash
(See Horngren, Sundem and Elliott 2002: 411)

Type of Activities Direction Change

Activities of cash in cash
flow
Operating Sales of goods and services for cash Inflows Positive
Activities Sales of goods and services on credit Inflows None
Receive dividends, rent or interest Inflows Positive
Collection of accounts receivable Inflows Positive
Recognize cost of goods sold Inflows None
Purchase inventory for cash Outflows Negative
Purchase inventory on credit Outflows None
Purchase machinery for cash Outflows Negative
Purchase machinery for credit Outflows None
Pay trade accounts payable Outflows Negative
Accrue operating expenses Outflows None
Pay operating expenses Outflows Negative
Accrue taxes Outflows None
Pay taxes Outflows Negative
Accrue interest Outflows None
Pay interest on long term debt Outflows Negative
Prepay expenses for cash Outflows Negative
Write off prepaid expenses Outflows None
Charge depreciation or amortization ? None
This years tax liability is increased Outflows Negative

Investing Purchase fixed assets for cash Outflows Negative

Activities Purchase fixed assets by issuing long-term debt Outflows None
Purchase fixed assets by issuing short-term debt Outflows None
Sell fixed assets for cash Inflows Positive
Sell fixed assets for credit Inflows None
Purchase marketable securities from retained earnings Outflows Negative
Purchase securities that are cash equivalents Outflows Positive
Purchase securities that are not cash equivalents Outflows Negative
Sell securities that are not cash equivalents Inflows Positive
Make a loan Outflows Negative

Financing Increase long-term debt Inflows Positive

Activities Increase short-term debt Inflows Positive
Reduce long term debt Outflows Negative
Reduce short-term debt Outflows Negative
Sell common or preferred stock Inflows Positive
Repurchase and retire common or preferred stock Outflows Negative
Purchase treasury stock (marketable securities) Outflows Negative
Pay dividends Outflows Negative
Convert debt to common stock Inflows None
Reclassify long-term debt to short-term debt Outflows None
Allowance for bad debt is decreased ? None

52
 Table 4.11: Computing Cash Flows from the Balance Sheet and Income Statement
of XYZ Manufacturing Inc.: Direct Method
(All figures in $000)

Activities Change in Liabilities Change in Assets

in in + in + in - in - in
Cash = Current Long- Stock- Noncash Fixed
Liabilities term holders Current Assets
Debt Equity Assets
Operating Activities

1. Sales on credit + 4,025.00 -4,025.00

2.* Collection of AR +3,885.00 + 4,025.00 -140.00
3. Recognition of CGS - 2,000.00 - (- 2,000.00)
4. Inventory purchases on account +2,345.00 - (+2,345.00)
5.* Payments to suppliers - 2,257.50 -2,257.50
6. Wages and salaries expense + 800.00 - 800.00
7.* Payment to Employees - 791.25 - 800.00 + 8.75
8.* Amount of taxes paid - 204.75 -213.50 + 8.75
9.* Rent paid - 50.00 - 50.00
10.* Miscellaneous expenses - 20.00 - 20.00
11.* Prepaid rent - 5.00 - 5.00
12* Selling and Administrative - 490.00 - 490.00
Expenses paid
13. Expenses not requiring cash: - 105.00 - (- 105.00)
depreciation
14.* Other income: Dividends from + 17.50 + 17.50
companys investments and
interest from companys loans
15.* Interests on bonds and other - 105.00 - 105.00
liabilities paid
Net cash provided by operating - 21.00
activities
Investing Activities

16.* Acquisition of fixed assets - 245.00 - (+ 245.00)

17.* Disposal of fixed assets 0.00 0.00
18.* Prepayment and deferred - 35.00 - 35.00
charges
19.* Change in intangibles 0.00 0.00

Net cash provided by investing - 280.00

activities
Financing Activities

20.* Issuing long term-debt 0.00 0.00

21.* Issuing common stock 0.00 0.00
22.* Dividends paid - 31.50 - 31.50
23.* Increase in notes payable + 350.00 + 350.00
24.* Increase in marketable securities - 17.50 - 17.50
Net cash provided by financing +301.00
activities

Net changes in cash 00.00 + 437.50 0.00 + 4,247.50 - 4,510.00 - 175.00

53
Table 4.12: Cash Flow Statement of XYZ Manufacturing Corporation:
Indirect Method

Activities Cash flows from Sub- Amount in $s

activities

Operational Activities: Net Income 259,000

Positive cash flows Depreciation 105,000
Net increase in accounts payable 87,500
Net increase in wages payable 8,750
Net increase in taxes payable 8,750

Total positive operational cash flows + 469,000

Operational Activities: Net increase in accounts receivable 140,000
Negative cash flows Net increase in inventory 345,000
Net increase in prepaid rent 5,000

Total negative operational cash flows - 490,000

Net operational cash flows - 21,000

Investing Activities: No activities
Positive cash flows
Investing Activities: Net increase in machinery and plant 245,000
Negative cash flows Net increase in prepayment and deferred 35,000
charges
Total negative investing cash flows - 280,000

Net Investing cash flows - 280,000

Financing Activities: Net increase in notes payable 350,000
Positive cash flows
Financing Activities: Net increase in dividends paid 31,500
Negative cash flows Net increase in marketable securities 17,500
Total negative financing cash flows - 49,000

Net Financing cash flows + 301,000

Total Activities Net Cash - 21,000 - 280,000 + 301,000 = 00.00

Flows

54
 Table 4.13: Linking and Interpreting the Three Elements of Cash Flow

Case Cash Flows from: Interpretation

Operating Investing Financing
Activities Activities Activities
(OA) (IA) (FA)
1 + + + Companies in old and viable industries with still good profitable opportunities
generate positive cash flows from their operations (hence + OA cash flows), but
continuously dispose old fixed assets or sell securities that are not cash
equivalents (hence, + IA cash flows), but can still attract much cash from
investors in terms of stock, bonds, and long-term debts (hence, + FA cash flows).
(E.g., All U. S. auto companies like the Big Three)

2 + + - Companies in old and phasing out industries with little profitable opportunities
generate positive cash flows from their operations (hence + OA cash flows) while
selling fixed assets and securities that are not cash equivalents (hence, + IA cash
flows) and reducing long term debt, retiring common and preferred stock or pay
heavy dividends with no retained earnings (hence, - FA cash flows). (E.g., most
steel and railroad companies in the U. S.)

3 + - + Companies in young and dynamic industries with good profitable opportunities

generate positive cash flows from their operations (hence, + OA cash flows), but
continuously invest much cash or debt on new fixed assets (hence, - IA cash
flows) and attract much cash from investors in terms of stock, bonds, and long-
term debts (hence, + FA cash flows). (E.g., Wal-Mart, Dell, Microsoft, IBM, and
homebuilder companies)

4 + - - Companies that are growing more slowly with some good profitable
opportunities, generate enough cash from their operations (hence + OA cash
flows) to invest in new fixed assets while maintaining old ones (hence, - IA cash
flows), but keep on reducing long term debt, repurchase or retire common or
preferred stock and purchase marketable securities for cash equivalents (hence,
-FA cash flows). (E.g., most fast food competing companies in the US:
McDonalds, Domino Pizza, Taco Bell).

5 - + + Companies in old and speculative or high-risk industries with uncertain

profitable opportunities, currently generate no profits from their operations
(hence - OA cash flows), but, regularly raise cash by selling older assets (hence, +
IA cash flows), and still qualify for long-term debt and equity (hence, + FA cash
flows). (E.g., hospitals, hotels, casinos, and resort companies)

6 - + - A shrinking firm with decreasing sales (hence, - OA cash flows) and realizing
cash from the sale or retirement of assets (hence, + IA cash flows), but not doing
well in operations and in attracting new capital (hence, - FA cash flows). (E.g.,
any firm that is either failing or insolvent).

7 - - + Companies that are young and in new industries may be currently unprofitable
in their operations (hence, - OA cash flows), but continuously invest much cash
on new fixed assets and acquisitions (hence, - IA cash flows), but are able to
attract good venture capital from high-risk investors (hence, + FA cash flows).
(E.g., several new dot.com companies that survived the 2000 crash).

8 - - - Companies in trouble: no positive cash flows or profits from operations (hence, -

OA cash flows), but trying to bail out by venturing into new acquisitions, joint
ventures or fixed assets (hence, - IA cash flows) and failing to attract new
investors while paying off old debts (hence, - FA cash flows). (E.g., Enron,
Kmart, Tyco, World.Com)

55
 Table 4.14: Financing Policy given Maturity Structure of the Assets

Financing Maturity Structure of the Assets Market

Policy Conditions
Fluctuating Long-Term Long-term
Current Current Fixed Assets
Assets Assets
Conservative Long-term Long-term Long-term When interest rates
financing via financing via financing via are expected to rise
debt and equity debt and equity debt and equity

Moderate Short-term Long-term Long-term When interest rates

borrowing financing via financing via are fluctuating and
(The expected to rise or
debt and equity debt and equity
Matching fall
Principle)
Aggressive Short-term Short-term Long-term When interest rates
borrowing borrowing financing via are fluctuating and
expected to fall
debt and equity
Ultra- Short-term Short-term Short-term When interest rates
borrowing borrowing borrowing are fluctuating and
Aggressive expected to fall,
costs of
transactions are
low, and risk of
borrowing is low.

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 Table 4.15: The Effect of Gearing

Gearing Performance Projected Business Success Probability

Level Measure Modest Good Great weighted
(p = 0.25) (p = 0.50) (p = 0.25) Average
success
Earnings before $1.5 million $3.0 million $6.0 million $3.375 million
interest and taxes
Interest on debt at 0.0 0.0 0.0 0.0
7%
Tax write-off on 0.0 0.0 0.0 0.0
(a): All interest at 50%
equity Earnings available $1.5 million $3.0 million $6.0 million $3.375 million
for shareholders
capital Returns on $1.5M/$20M = $3.0M/$20M $6.0M/$20M $3.375M/$20M
structure Company XYZ 7.5% = 15.0% = 30.0% =16.875%
shares

Interest on debt at $0.35M $0.35M $0.35M $0.35M

7%
Tax write-off on $0.175M $0.175M $0.175M $0.175M
(b): 25% interest at 50%
Earnings available $1.325M $2.825 M $5.825M $3.200M
gearing for shareholders
capital Returns on $1.325M/$15M $2.825/$15 = $5.825/$15M $3.200/$15M =
structure Company XYZ = 8.833% 18.833% = 38.833% 21.333%
shares

Interest on debt at $0.70M $0.70M $0.70M $0.70M

7%
Tax write-off on $0.350 $0.350 $0.350 $0.350M
(c): 50% interest at 50%
Earnings available $1.15M $2.65M $5.65M $3.025M
gearing for shareholders
capital Returns on $1.15M/$10M = $2.65M/$10M $5.65M/$10M $3.025M/$10M
structure Company XYZ 11.50% = 26.50% = 56.50% =30.25%
shares

Interest on debt at $1.05M $1.05M $1.05M $1.05M

7%
Tax write-off on $0.525 $0.525 $0.525 $0.525M
(d): 75% interest at 50%
Earnings available $0.975M $2.475M $5.475M $2.850M
gearing for shareholders
capital Returns on $0.975/$5M = $2.475M/$5M $5.475M/$5M $2.850M/$5M
structure Company XYZ 19.50% = 49.50% = 109.50% =57.00%
shares

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 Table 4.16: Financial Leverage Ratios of Contrasting Industries in June 2002
[Source: Derived from Smart, Megginson and Gitman 2007: 456)

Company Industry Debt/ Debt/Total Long-term Long-term Market

Total Assets Debt/Total Debt/Total to
Assets (Market Capital @ Capital Book
(Book Value)# (Book (Market Value) Ratio*
Value) Value)
Microsoft Computer software 0.0 0.0 0.0 0.0 5.54
Cisco Systems Computer systems 0.0 0.0 0.0 0.0 3.94
Intel Semiconductors 0.03 0.01 0.03 0.01 4.03
Dell Computer hardware 0.04 0.01 0.10 0.01 14.87
Exxon Mobil Integrated 0.07 0.04 0.09 0.03 3.72
petroleum
Johnson & Pharmaceuticals 0.08 0.02 0.08 0.01 7.32
Johnson
AOL Time Entertainment/medi 0.11 0.29 0.13 0.29 0.74
Warner a
Coco Cola Consumer products 0.12 0.04 0.10 0.02 12.85

Delta Airlines Airline 0.36 0.77 0.69 0.75 0.82

Verizon Common Telecommunications 0.36 0.36 0.58 0.26 3.63
BellSouth Telecommunications 0.39 0.23 0.45 0.17 3.18
General Electric Conglomerate 0.40 0.44 0.59 0.17 5.38
Georgia Pacific Forest products 0.49 0.69 0.68 0.55 1.19
GMC Auto manufacturing 0.51 0.84 0.89 0.83 4.12
Caterpillar Construction 0.53 0.50 0.67 0.35 2.52
equipment
Ford Auto manufacturing 0.60 0.84 0.96 0.84 4.24

# Total liabilities (book value) divided by the market value of equity plus the book value of debt.
@ Long term debt (book value) divided by the sum of the market value of equity and the book value of long-term debt.
* Per share price of company common stock divided by the per share book value of shareholders common equity.

58
 Appendix 4.1: On Mortgage Payments

Problem: As an entrepreneur, you need to buy your factory cum office space. You have cited a good place
available for $120,000. The following terms apply: upfront cash down $20,000. Annual mortgage
rate is 12 percent, or a monthly rate of one percent. If you wish amortize the remaining capital
debt of $100,000 in equal monthly installments of X dollars for the next ten years, then a) what is X,
b) what are your total cash disbursements, and c) what is your total capital rent?

Assume: 1) the first X is paid a month after the initial cash down payment of $20,000, and 2) the mortgage
annual rate of 12 percent is fixed for the next ten years.

Procedure: The first X paid a month after the cash down has the following effect on the remaining capital
debt P = $100,000.

Let r be the monthly interest rate.

Then, after the first payment of X, your total debt is P(1 + r) X (1).

After the second payment of X, your remaining total debt is:

= [P(1+r) X] X + [P(1+r) X]r

= [P(1+r) X] (1+r) X

= P(1+r)2 - X(1+r) X
[Augmented debt] minus [first payment + accrued interest] minus [second payment] (2).

After the third payment of X, your remaining total debt is:

= P(1+r)3 - X(1+r)2 - X(1+r) X (3).

[Augmented debt] minus [first payment minus [second payment minus [third payment]
+ accrued interest] + accrued interest]

After your n payments, equation (3) generalizes, and your total remaining debt is:
n-1
= P(1+r)n - X (1+ r)i (4).
i=0

That is, when all n (= 120)payments are made,

n-1
P(1+r)n = X (1+ r)i (5)
i=0
n-1
Or, X = P(1+r)n / (1+ r)i (6)
i=0

= P(1+r)n / [(1+r)n 1]/r (7)

= rP(1+r)n / [(1+r)n 1], which, given that P = 100,000, r = 0.01 and n = 120,
= 3300.3869/2.3003869 = $1434.7095.

Hence, your total payment is $20,000 + 120 (1434.7095) = $192,165.14, or $72,165.14 in total capital rent.
That is, the net present value (NPV) of $172,164.14 must be $100,000.

NPV(nX) = X/(1+r) + X/(1+r)2 + X/(1+r)3 + + X/(1+r)n (8).

= X [ 1 1/(1+r)n]/r] (9)
= $1434.7095 (69.70522) = $100,000.

59
In equation (6), to prove that the denominator of the RHS is [(1+r) n 1]/r.

Let

K = (1+r)0 + (1+r)1 + (1+r)2 + + (1+r)n-1 (10),

= 1+ (1+r) + (1+r)2 + + (1+r)n-1 (11).

Then

K(1+r) = (1+r)1 + (1+r)2 + (1+r)3+ + (1+r)n (12).

Subtracting (11) from (12) yields

K(1+r) K = rK = [(1+r)n 1] (13).

Hence,

K = [(1+r)n 1]/r QED.

To prove that RHS of equation (8) = RHS of equation (9) = X [1 1/(1+r)n]/r.

Let

S = 1/(1+r) + 1/(1+r)2 + 1/(1+r)3 + + 1/(1+r)n (14).

Then

S(1+r) = 1 + 1/(1+r) + 1/(1+r)2 + 1/(1+r)3 + + 1/(1+r)n-1 (15).

Subtracting (14) from (15) yields

S(1+r) S = 1 - 1/(1+r)n (16).

S + rS S = rS = [1 - 1/(1+r)n] (17).

S = [1 - 1/(1+r)n]/r QED.

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