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A Practical Overview of Finance for

New Management Consultants


By Victor Cheng

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Objective

Familiarity with Financial Concepts, Process, & People


(Enough to Avoid Embarrassing Yourself w/a Client)

(c) Victor Cheng, All Rights Reserved

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Themes for Today

Finance is a language

Financial Reports tell a Story...

Today’s Focus is on grasping the story (vs. teaching formulas)


Concepts are the same internationally, the terminology will vary

(c) Victor Cheng, All Rights Reserved

3
Agenda

Finance Concepts (Operational)


Independent Company
Division of Big Company
Financial Practices in Big Companies
Financial Processes
Organization Chart
Financial Concepts (Valuation)

(c) Victor Cheng, All Rights Reserved

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Finance Concepts (Operational)

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Financial Concepts: Independent Company

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3 Core Finance Concepts to Measure
“Financial Success”

Profit Cash Flow

Return on
Investment (ROI)

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A Business is Only Financially Successful When
All Three Measures are True

Profit Cash Flow

Return on
Investment (ROI)

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The 3 Key Financial Statements

Profit & Loss Statement

Cash Flow Statement

Balance Sheet

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A Business is Only Financially Successful When
All Three Measures are True

Profit Cash Flow

Return on
Investment (ROI)

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Profit Concepts

Business Economics

Profit = Revenue - Costs

Unit Economics

Price Per Unit - Cost Per Unit = Profit Per Unit

Two Key Measures - Gross Margin % & Overhead %

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A Business is Only Financially Successful When
All Three Measures are True

Profit Cash Flow

Return on
Investment (ROI)

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What is Cash Flow?

Cash Flow = Cash In - Cash Out

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Why Cash Flow is NOT the Same
as Sales - Costs

Profit captures when revenues and expenses are “accrued” (e.g.,


contract signed), but does NOT capture the timing of when cash is
actually COLLECTED or PAID

Profit does not capture cash from financing activities and pre/late
paid operating revenues & expenses

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Sources of Cash Flow
Net Income (Revenues - Costs)
Cash to/from Customers (Accounts Receivable)
Cash to/from Warehouse (Inventory)
Cash to/from Equipment (Plant, Property & Equipment)
Cash to/from Vendors (Accounts Payable)
Cash to/from Investments (Investments)
Cash to/from Lenders (Debt)
Cash to/from Owners (Equity Shareholders)

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Cash Flow Statement

Cash from Operations


Net Income
Adjustments to Net Income
Cash from Investments
Cash from Financing

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Common Causes of the Cash Flow
“Crisis”
Too Little Sales without a corresponding drop in costs
(Overhead eats up cash)
Too Much Sales (growing sales faster than cash flow isn’t sustainable)
Pre-buy inventory/materials for large customers
Pre-hire employees to handle new sales (but customers don’t pay
for 120 days)
Unfavorable Cash Timing of Clients vs. Vendors (A/R vs A/P Mix)
Too Much Debt

(c) Victor Cheng, All Rights Reserved

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A Business is Only Financially Successful When
All Three Measures are True

Profit Cash Flow

Return on
Investment (ROI)

(c) Victor Cheng, All Rights Reserved

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The Concept of ROI
(Return on Investment)

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Which Business is Better?
Business A Business B
$1 million in Profit $2 million in Profit

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Which Business is Better?
Business A Business B
$1 million in Profit $2 million in Profit

$1 million in Equipment $100 million in Equipment


100% Return on “Investment” per Year 2% Return on “Investment”

(c) Victor Cheng, All Rights Reserved

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Key Concepts

ROI = Comparing Profit to “Investment”

ROI = Comparing P&L to Balance Sheet

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A Balance Sheet Tracks a
Company’s “Investments”
Balance Sheet Formula

Assets - Liabilities = Equity


Assets = Liabilities + Equity
Liabilities = Assets - Equity

What You Possess - What You Owe = What You’re Worth

Your House - Your Home Loan = The “Net Worth” of Your Home

Company Assets - Company Debt = Company “Net Worth”

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Example Balance Sheet

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How ROI is Calculated
ROI = “Return” / “Investment”

“Return” is Often

Profit

EBITDA (Earnings Before Weird Accounting Stuff - Interest, Taxes, Depreciation, & Amortization)

“Investment” is Some Definition of “Capital” (e.g., Financial Assets)

Upfront Project Cost (e.g., cost of buying new machine or “capital” investment)

All Capital for Business (Debt from Lenders + “Equity” Money from Shareholders)

Equity (All Capital Excluding Debt)

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Common ROI Measures

ROA = Return on Assets = Profit / Assets

ROE = Return on Equity = Profit / Equity

ROIC = Return on Invested Capital = Profit / (Liabilities + Equity)

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The Balance Sheet Measures ROI

Key Formula that Defines Balance Sheet

Assets - Liabilities = Equity

Assets You Possess - Debt You Owe = Your Net Worth

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Financial Concepts: Division of Big Company

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The Problem of Finance in
Divisions of Big Companies

Balance Sheet is often at the Company-Wide Level (vs. Division Level)

Big Companies Have HQ + Divisions

Who pays for investor relations? Corporate auditor? or “headquarter”


costs? Human Resources? Corporate IT systems (e.g., email system)

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Common Problems with Finance in
Big Companies
Division Manager Controls Sales & Expenses for
Division... But Who Pays for Corporate-Wide Divisions manage operating cash flow, HQ decides
Expenses (e.g, email system, auditors, medical plan) on some investment & financing decisions

Profit Cash Flow

Return on
Investment (ROI) Corporate CFO decides on Debt & Equity Capital
Decisions for Company as a Whole

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The Role of Proxies & Estimations

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Profit & Loss Management in
Divisions of Big Companies

Allocated Overhead

Shared Services Expense

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“Cash Flow” Management in
Divisions of Big Companies
Instead of Full Cash Flow Management... Focus on Proxies:
Inventory vs. Sales (Sales / Inventory)
(What are your “Inventory Turns”?)
Accounts Receivable
Days Sales Outstanding (DSO) = (Receivables / Monthly Sales) * 30
Example: $1 sales/month, $1 receivables at any time = 30 Days
Sales Outstanding... (e.g., What are your DSO’s?)

(c) Victor Cheng, All Rights Reserved

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“Balance Sheet” Management in
Divisons of Big Companies
Capital Charge

Estimated Capital Used by Division * Interest Rate = Capital Charge

A way to move the role of the balance sheet onto the P&L

Interest Rate = Rate of Return Shareholders & Debt Holders Expect

Capital Investment “Hurdle” Rate


(Sometimes called IRR, Internal Rate of Return)

Minimum ROI % for New Capital Projects

(c) Victor Cheng, All Rights Reserved

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Finance Practices in Big Companies

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The Two Roles of Finance
Departments

Historical Finance (tax, compliance, management)

What happened?

Future Finance (decision support)

What will happen?

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Finance Department Roles

CFO or VP Finance

Controller

Director of Finance or Director of Finance, Planning & Analysis (FPA)

Treasury Operations (Only Corporate CFOs)

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Controller’s Organization
Controller

Accountants

Accounts Receivable

Accounts Payable

Collections

Contract Administrator

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Director of Finance Organization

Director of Finance / Director of FPA

Financial Analysts

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Financial Processes in Big
Companies
Finance
Annual Budgeting
Capital Investment Analysis
Sales & Expense Forecasting (Continually Updated)
Decision Support
Accounting
Budget vs. Variance Reporting
A/R, A/P
Monthly, Quarterly, Annual “Close” (Public Company Filings)

(c) Victor Cheng, All Rights Reserved

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Finance Concepts (Valuation)

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Financial Valuation Approaches

Market Method: Comparables

Asset Method: Value of Assets

Income Method: Discounted Cash Flow (DCF)

(c) Victor Cheng, All Rights Reserved

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Market (Comparables) Method

Concept:
The value of a company is based on what investors are willing to pay for
comparable companies

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Market Method - Examples

Residential Real Estate:


Price/Sq Ft
Public Companies:
Price/Earnings Ratio
Venture Capital-Backed Startup Companies
Price/Sales Ratio

(c) Victor Cheng, All Rights Reserved

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Asset Method

Concept:

The Value of a Company is the Sum of the Value of its Assets


(e.g., Case in the Bank, Buildings, Equipment, etc..)

Example: A Company with a Market Value of $100 Million that has $110
Million in Cash in the Bank (with no debt) is undervalued.

(c) Victor Cheng, All Rights Reserved

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Discounted Cash Flow Method

Concept:

Convert the future value of a business investment project into its


equivalent as a bank account investment, to compare which project is
more attractive.

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Discounted Cash Flow - Example
Project A: Build a New Factory

15% “rate of return”

Project B: Enter a New Geographical Market

22% “rate of return”

Project C: Put extra capital in the bank to earn interest

3% “rate of return”

(c) Victor Cheng, All Rights Reserved

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Discounted Cash Flow - Approach

Core Concepts (Simplified):

$100 in 10 years doesn’t have the same value as $100 today.

Add up all the future cash in/out flows of the project, adjust (or
discounted) for the “time value of money”

(c) Victor Cheng, All Rights Reserved

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Discounted Cash Flow - Terms
Net Present Value = NPV = Today’s Value of the Future Cash In/Out
Flows of Project Added Together
NPV = Yr 0 Cash Flow + Yr 1 “Discounted or Adj” Cash Flow + Yr 2 “Discount/Adj” Cash
Flow, etc...

Discount Rate: $100 next year is worth $90 today, $110 in 2 years is
worth $90 today (Discount rate = approx 10%)

Internal Rate of Return = IRR = “Rate of Return”

Technical Definition: IRR is the discount rate that causes the NPV to be $0

(c) Victor Cheng, All Rights Reserved

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How Discount Rates Are
Calculated
Capital Asset Pricing Model “CapM”

Interest Rate of “100% Safe Investment” x Stock Price Volatility


Ratio

WACC = Weighted Average Cost of Capital

Weighted Average of:


(Expected Return by Lenders + Expected Return by Owners)

(c) Victor Cheng, All Rights Reserved

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Closing

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Themes for Today

Finance is a language

Financial Reports tell a Story...

Today’s Focus is on grasping the story (vs. teaching formulas)


Concepts are the same internationally, the terminology will vary

(c) Victor Cheng, All Rights Reserved

52
Agenda

Finance Concepts (Operational)


Independent Company
Division of Big Company
Financial Practices in Big Companies
Financial Processes
Organization Chart
Financial Concepts (Valuation)

(c) Victor Cheng, All Rights Reserved

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