MBA ASAP Corporate Finance Fundamentals for Career Success

I have added a bunch of quizzes to test your comprehension after video lectures. Here is why:

Practice with struggle > practice without struggle.

An example is a study of two groups of students. Group A studied a paper for 4 days. Group B studied it for 1 day and was tested on it for 3 days.

At the final test, Group B scored 50% more than Group A.

Why?

With every test, group B struggled. And that targeted struggle made them acquire more knowledge in the same amount of time.

This is about self-motivation and the measure of self-motivation in a person is the best predictor of upward mobility. Congratulations you have it.

Let me know what you think of the quizzes and this approach.

Cognitively the act of taking a quiz, calling up knowledge from memory, makes that memory stronger and easier to access. So students who are frequently quizzed retain more knowledge of the subject they are studying.

Here are some of the benefits of using quizzes in online courses:

· Retrieval practice occurring during quizzes can greatly enhance retention of the retrieved information. An even higher level of retention than from restudying or rereading the course material.

· Quizzes permit students to discover gaps in their knowledge and focus study efforts on difficult material.

· An indirect effect of quizzes was found that if quizzed frequently, students tended to study more and with more regularity.

· Quizzing has been found to enable better metacognitive monitoring for both students and teachers because it provides feedback as to how well learning is progressing. Quizzes can be a beneficial self-learning check for students.

· Every time a student calls up knowledge from memory like when taking a quiz, that memory solidifies becoming more stable and more accessible.

Quizzes help us identify we know and what we don't know.

Repeated testing with quizzes and exams improves the cognitive process that can amplify long-term memory retention and retrieval. It doesn't just measure knowledge, but challenges it. If you test yourself more regularly, you are going to learn in greater detail than before.

Practice with struggle > practice without struggle.

As we start, I want to give you an outline of the course and my thinking behind how I organized the material. I focus heavily on the fundamentals of finance at the beginning. 

To be successful, identifying what to learn matters most. When it comes to building a skill, which corporate finance is, the fundamentals are what we need to focus on. Everything takes off from there.

I take your time and attention very seriously. As your instructor, I am trying to balance going over the fundamentals, like financial statements, from several angles to ensure the concepts sink in and become obvious to you, and boring you by being too repetitive.

We all learn differently. Some of us come to this course with prior knowledge, and some have never encountered these concepts. My goal is for everyone to master these concepts. If the first part of the course dealing with financial statements seems too slow and repetitive, feel free to move on and get to the new topics. For the rest of us, take the time to watch the videos until each topic is mastered and makes sense. The fundamentals are what everything else is built on.

Elon Musk, the Tesla and SpaceX boss, shares a nugget of pure learning gold:

"One bit of advice: it is important to view knowledge as sort of a semantic tree -- make sure you understand the fundamental principles, i.e., the trunk and big branches before you get into the leaves/details, or there is nothing for them to hang on to."

Welcome to this course on Corporate Finance!  The video lectures are the main part of the course and the book supports the lectures.  Download the book provided here and give it a quick peruse.  You can follow along in the book with each video segment and the two will reinforce each other and the concepts presented.

Some of the material may seem repetitive.  I repeat the fundamental concepts from several different angles so that they have a chance to sink in.  If you find any of the videos or material repetitive, consider it a good sign.  That means you understand that concept.  The course isn't too long so have patience with the process.  Once you are comfortable with these concepts like Ratio Analysis, Time Value of Money, Discounted Cash Flows, and Present Value, you will be unstoppable!

This course is part of the MBA ASAP series.  I hope you find it valuable, instructive, and enjoyable.  

If you have any questions or suggestions email me at jjcousins@gmail.com   

Follow me on twitter @jjcousins   

Sign up for my email list at MBA-ASAP.com  

Thanks!  

John  

Bookkeeping and Accounting produce Financial Statements, the cornerstone of Corporate Finance. Therefore, understanding how business transactions aggregate to make financial statements is critical to a foundational understanding of corporate finance. 

Setting Up the Books

When we talk of the "books," we refer to the group of all the accounts of the transactions of an enterprise. This list, or group, makes up the general ledger.

The general ledger collects all asset, liability, equity, revenue, and expense accounts. Transactions are grouped in some related way as accounts, and accounts are grouped and categorized into the General Ledger ("GL").

Transactions are usually related by vendor, customer or type of transaction. For example, your office rent payments would be grouped in an account called "Landlord," "Office Rent," or something similar. Your sales income might be grouped by customer or simply in a general "sales revenue" account; your electric bills and payments would be recorded in an account set up for the utility company.

This list of accounts and vendors is the basic organizing principle of your accounting system. When starting an accounting system for a company, you create a chart of accounts that classifies different groupings of business transactions.

The chart of accounts is a listing of all accounts used in an organization's general ledger. The chart of accounts is simply a laundry list of all the accounts.

Usually, when you begin working for an existing company, the chart of accounts already exists, and as new vendors occur, a new account is added.

The vendor list shows information about the people or companies from whom you buy goods and services, including banks and tax agencies.

The Accounting Cycle

The accounting cycle is a straightforward eight-step procedure for finishing a business' bookkeeping duties. It offers a precise roadmap for the documentation, evaluation, and final reporting of a company's financial operations.

The whole accounting cycle is employed throughout a single reporting period. As a result, maintaining organization throughout the process can be a crucial component that contributes to maintaining overall efficiency. Depending on the necessity for reporting, accounting cycle times will change. Most businesses aim to evaluate their performance monthly. However, some could concentrate more on results on a quarterly or annual basis.

In any case, most bookkeepers are aware of the business's daily financial situation. In general, timing each accounting cycle is essential since it establishes dates for opening and closing. A new cycle starts once an accounting cycle ends, continuing the eight-step accounting procedure.

Understanding the 8-Step Accounting Cycle

The eight-step accounting cycle begins with the individual recording of each business transaction and concludes with a thorough report of the business's actions for the specified cycle duration. In addition, many companies use accounting software to automate the accounting cycle. This automation allows accountants to program cycle dates and receive automated reports.

The eight-step accounting cycle often has to be modified in particular ways for each organization to conform to its own business model and accounting practices.

Double-entry accounting is necessary for businesses to construct the income statement, balance sheet, and cash flow statement.

The 8 Steps of the Accounting Cycle

The following are the eight steps of the accounting cycle:

Step 1: Identify Transactions

The accounting cycle's initial stage is to identify transactions. Business transactions will be numerous throughout the accounting cycle. Each one must be accurately recorded in the business's books.

Recordkeeping is critical for recording all transactions. For example, many companies will use point-of-sale technology linked to their books to record sales transactions. In addition, expenses come in wide varieties.

Step 2: Record Transactions in a Journal

The cycle's second phase is producing journal entries for each transaction. Once more, combining steps one and two with point-of-sale technology is possible, but businesses must also keep track of their costs.

Both must be recorded at the moment of the sale following accrual accounting, which involves matching revenues and costs.

Double-entry bookkeeping requires that two entries be recorded with each transaction to maintain a balance sheet, income statement, and cash flow statement.

Public corporations must prepare their financial accounts according to accrual accounting and generally accepted accounting standards (GAAP).

Each transaction in double-entry accounting has a debit and a credit equal to one another.

Step 3: Posting

A transaction should post to an account in the general ledger after it has been entered as a journal entry. All accounting actions are broken down by account in the general ledger.

This enables a bookkeeper to keep track of account-by-account financial conditions and statuses. For instance, the cash account, which shows how much cash is on hand, is one of the general ledger accounts most frequently referred to.

The ledger was previously considered the gold standard for documenting transactions, but because practically all accounting is now done electronically, the ledger is no longer a significant issue.

Step 4: Unadjusted Trial Balance

The fourth stage of the accounting cycle involves calculating a trial balance at the conclusion of the accounting period. The firm may learn the unadjusted amounts in each account from a trial balance. After testing and analysis in the fourth stage, the unadjusted trial balance is taken on to the fifth step.

Once the accounting period has concluded, and all transactions have been discovered, documented, and posted to the ledger, this is the initial activity that takes place (this is usually done electronically and automatically).

This step is taken to ensure that the overall credit amount and debit balance are identical. If those figures are off, this step can catch a lot of errors.

Step 5: Worksheet

The fifth phase in the cycle involves reviewing a worksheet and locating modifying entries. A worksheet is first made to ensure that debits and credits are equivalent. Again, there will need to be modifications made if there are inconsistencies.

When adopting accrual accounting, correcting entries may also be required to match income and expenses and discover mistakes.

Step 6: Adjusting Journal Entries

A bookkeeper makes corrections in the sixth phase. Adjustments are documented in journal entries.

Step 7: Financial Statements

The seventh phase is when the business prepares its financial statements after completing all adjustment entries. These statements typically consist of an income statement, balance sheet, and cash flow statement for businesses.

Step 8: Closing the Books

In the eighth phase, a business finally completes the accounting cycle by closing its books at the end of the day on the designated closure date. The concluding remarks offer a report for analyzing performance throughout the period.

After closure, a new reporting period is used to restart the accounting cycle. Closing is typically a great time to submit documentation, make plans for the upcoming reporting period, and go through a schedule of the forthcoming activities.

Debits and Credits

Debit and Credit are the two most basic accounting terms to become familiar with. This is because they represent the fundamental concept of bookkeeping. However, the practice of double-entry bookkeeping and the application of debits and credits to accounts is not intuitive and will take some time to get used to. With that in mind, let's discuss the concepts more.

In accounting, there are two sides to every transaction, and they are called debit and Credit. Each journal entry affects at least two accounts; it can affect a group of debits and a group of credits, but they must equal each other. This concept may take a while to get your head around and get used to. But you will. Think of a situation where you lend someone $10.

As Shakespeare said, there are two sides to this IOU-type transaction: the borrower and the lender. You record that you expect the money back (asset), and the other party records that they expect to pay it back (liability). All transactions are two-sided like this example: one account is enhanced, and one is depleted. Or think of a deli counter transaction: you get a sandwich, and the deli receives money. But each side records two entries. From the deli side, they get money, which increases their revenue, and they give up a sandwich, which depletes their inventory. From your side, you get a delicious sandwich, an asset (albeit temporary), and you give up money, which depletes your bank account. Each side records a double-entry transaction. Each side's transaction entry mirrors the other: what you gain, and they give up, and vice versa. Accounting is a zero-sum endeavor.

Debit and Credit can be tricky concepts to understand initially. Here is another attempt at a simple explanation. A Debit increases the enterprise's resources, and a Credit reduces the resources. So, with Asset accounts that are resources, a Debit will increase the account.

With a Liability account, which are obligations of the enterprise, a Debit will decrease that account; because the decrease of a liability, like a loan, means, in essence, increasing the company's resources. Think of this as if you pay off a credit card, you have increased your resources by no longer carrying that debt obligation (and at the same time, you save a ton of interest payments!)

Credits are the mirror image opposite. When you pay a bill, you credit cash (an asset account) because you have reduced your cash amount. If you take out a loan, you credit the loan account (a liability account) because you have increased an obligation of the company.

You may have to refer to this concept of debits and credits several times. Acknowledge that this concept may be challenging, and stay calm. It will become clear with use.

Welcome to the first section of this course: understanding financial statements. I promise that these video lessons and the supplemental materials will have life-changing consequences. You will have a better command of your world and deeper insights into its workings.

Financial statements are the end product of accounting. Accounting can seem tedious, but it is the basis of business and investing. Double-entry bookkeeping is 500 years old and is one of the most significant technological inventions ever. The economic development it unleashed fueled the renaissance, the enlightenment, and the modern era.

Johann Wolfgang von Goethe rapturously described accounting this way: “Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit.”

Understanding financial statements are the door to understanding accounting and business.

By the end of this short course, you will understand financial statements and open up a world of potential for your career and life.

You will probably look back over the following years and decades and see this as an inflection point in your destiny. 

Download the book here as a printable pdf or Kindle compatible file.

Let’s get started!

Understanding Financial Statements

Financial statements are essential tools that provide a clear picture of a business's or individual's financial activities. At their core, they serve as a report card detailing how money moves in and out.

Income Statement: Think of this like a monthly budget. It tracks money coming in (revenues) and money going out (expenses). The difference between the two gives the profit or loss. For individuals, it's akin to measuring salary against monthly expenses to determine savings.

Balance Sheet: This offers a snapshot of what a business owns and owes at a specific point in time. On one side, there are assets – everything the business owns that has value, like buildings, equipment, or even cash in hand. On the other side, there are liabilities (what the business owes to others) and equity (the owner's share). The fundamental rule is that assets will always equal the sum of liabilities and equity.

Cash Flow Statement: While the income statement might show a profit, it doesn't necessarily represent cash. This statement bridges the gap. It tracks actual cash moving in and out, divided into three categories: money from doing business (operations), money from buying or selling big items (investing), and money from loans or paying back loans (financing).

Business leaders, investors, and banks use these statements to understand a company's health. They help determine whether a business is growing, if it can pay its bills, and if it might be a good place to invest money. Public companies share these with the government for regulatory reasons, and private companies provide them to the government primarily for tax purposes.

Intro to Financial Statements

• What are financial statements?

• The 3 Financial Statements:

• Income Statement

• Balance Sheet

• Cash Flow

  
  

Understanding Financial Statements   

When you have completed this section of MBA ASAP, you will have a solid understanding of Financial Statements and you will be able to draw meaningful conclusions from their contents.  This knowledge can be highly impactful for the quality of your career, job prospects, and life.   

Financial Statements are the basic language of money and business. Everyone should have a basic understanding of Financial Statements: what they are and what information they provide.  It’s a competency that can open up opportunities and vistas that are closed off otherwise.        

Executives like the CEO, COO, and CFO routinely share and discuss financial data with marketing, operations, and other direct reports and personnel within an organization.  They also compile and share financial information with stakeholders outside the firm such as bankers, investors and the media.    

But how much do you really understand about finance and the numbers? A recent investigation into this question concluded even most managers and employees don’t understand enough to be useful. Check out the quiz in this section to see how you stack up.  I will offer the quiz again at the end of the course so you will be able to gauge how your level of financial competency has improved.    

Three Main Financial Statements   

There are three main financial statements and they are linked together to provide a picture of the financial position and health of an enterprise. They represent the end product of accounting, meaning they are the reports generated by accounting covering all of the transactions of a company.   

The three basic financial statements are the   

• Balance Sheet: which shows firm's assets, liabilities, and net worth on a stated date   

• Income Statement: also called profit & loss statement or simply the P&L: which shows how the net income of the firm is arrived at over a stated period, and    

• Cash Flow Statement: which shows the inflows and outflows of cash due to the firm's activities during a stated period.    

Knowing how to read and understand financial statements is a business skill you can’t ignore. It can help working your way up the corporate ladder by communicating with others in your company and understanding the big picture.  It is also a useful skill in order to understand where your efforts and work can make the most impact.    

When you are thinking about possibly changing jobs and working for a company you can check their financials and make sure they are a healthy organization.  If you are considering starting your own company you will need to have financials prepared by your accountant in order to talk to investors, bankers and vendors.    

If you want to invest wisely in the stock market, analyze the competition or benchmark your performance, you can look up the financials of any publicly traded company at the Securities and Exchange Commission website’s’ EDGAR filings and get an idea of how they are doing.  Check out any public company’s most recent 10K filing there.  A 10K is the Annual Report of the company and its most important business and financial disclosure document.          

Next we will go over each of the financial statements individually and how they are interrelated.  You will find lots more information in the books and other downloadable documents that accompany this course.

Here is a quiz to test your comprehension of the material in the last video Financial Statements Overview.  It's ten questions. If you get more than a couple wrong, I suggest going back and reviewing the video.

The Most Important Finance Job

The most important set of tasks that a CFO (Chief Financial Officer) has is the oversight, management, and preparation of financial statements.  Financial reporting with financial statements happens regularly, at least every quarter and once a year for audited financials.  Once you complete a set of financial statements, you are working on the preparation of the next set. 

Becoming intimately familiar with financial statements and how they are interconnected and flow is the critical skill set for corporate finance.   

Financial statements also underlay Discounted Cash Flow analysis, NPV, IRR, and all the valuation techniques of finance.  We will now spend some time thoroughly understanding financial statements.

In this video I discuss that Financial Statements are what accounting produces.  Double entry bookkeeping and accounting helped usher in the modern world. History of Accounting and Commerce

The Fundamental Importance of Understanding Financial Statements

Being able to read and understand financial statements is a fundamental skill to understanding how businesses function. Since financial statements are the end product of accounting, understanding them provides the context for understanding accounting. Mastering this skill will help you become a better manager.    

Being able to read financial statements will also help you make better investment decisions in the stock market because you will be able to get meaningful information out of an Annual Report or a 10K.    

If you are an entrepreneur planning a start up then understanding financial statements is critical for your credibility as you meet with angel investors, bankers, and VCs.    

Financial Statements   

Accounting information is prepared, organized, and conveyed in Financial Statements. Financial statements are reports in which accounting information is organized so users of financial information have a consistent, quick, and thorough means of reading and understanding what is going on in the business.     

There are two basic financial statements: the Balance Sheet and the Income Statement.     

Interested parties need to understand the financial and accounting activities of a business.  The Balance Sheet and Income Statement are a formal record of the financial activities of a business. They are presented in a structured manner and in a form that is consistent and easy to understand once you understand the format.   

Financial Statements provide a high level view of accounting and a summary of how a business is performing. They provide a quick picture that can be easily compared across businesses and industries. Understanding how to read and analyze a Balance Sheet and Income Statement is a great place to start understanding accounting and finance.     

Financial statements are the end product of bookkeeping.  Think of financial statements as the destination or goal of bookkeeping and accounting. When you know where you are going and who the audience is, it is easier to make good bookkeeping decisions.  When you understand the liquidity, solvency and capital structure of a company you can make good financing and investment decisions.    

Financial Statements contain information required to quickly analyze and assess the relative health of a business.  A basic understanding of financial statements also provides the high level perspective on the goals of the bookkeeping work and accounting entries.  The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed.  It’s all about the money. Financial statements let you follow the money.

Revenue = profit per unit sold X number of units sold

Pricing power. Charge more.

Silicon Valley legend Marc Andreessen was asked what he would put on a billboard. Marc said two words: "Raise Prices.

The number one thing – just the theme, and we see it everywhere – the number one theme that our companies have when they get really struggling is they are not charging enough for their product. It has become absolutely conventional wisdom in Silicon Valley that the way to succeed is to price your product as low as possible under the theory that if it's low-priced everybody can buy it and that's how you get the volume. And we just see over and over and over again people failing with that because they get in the problem we call too hungry to eat. They don't charge enough for their product to be able to afford the sales and marketing required to actually get anybody to buy it. And so, they can't afford to hire the sales rep to go sell the product. They can't afford to buy the TV commercial, whatever it is. They cannot afford to go acquire the customers."

The Income Statement

The basic structure and components of the Income Statement are reviewed in this section. The Income Statement is sometimes called the Profit and Loss Statement, or P&L for short.

The components of the Income Statement are:

• Revenue

• Expenses

• Net Income

• Profit

• Earnings

The Income Statement

The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed. It's all about the money. Financial statements follow the money.

The report that measures these daily operations of money in and money out over a period of time is the Income Statement.

Revenues minus Expenses equals Net Income.

The Income Statement can be summarized as Revenues less Expenses equals Net Income. Net Income simply means Income (Revenues) net (less) of Expenses. Net Income is also called Profit or Earnings.

The terms "profits," "earnings" and "net income" all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.

You understand the dynamics of this concept intuitively. We always strive to sell things for more than they cost us to make or buy. When you buy a house, you hope it will appreciate in value so you can sell it in the future for more than you paid.

It's also the rule for stocks: buy low, sell high.

The same logic applies to having a sustainable business model in the long run. You can't sell things for less than they cost to make and stay in business for long. So if you own and run a sandwich shop, you had better make sure that you are selling the sandwiches for more than they cost you to make.

Think of the Income Statement in relation to your monthly personal finances. You have your monthly revenues: in most cases the salary from your job. You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc. Our goal is to have our expenses be less than our income.

There is an old adage: "If you outflow is more than your income, your upkeep is your downfall."

Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn't spend more than we make. Instead, we strive to have some money left over at the end of the month that we can set aside and save. In business, what is set aside and saved is called Retained Earnings.

We may invest some of what we set aside with an eye toward future benefits. We may invest in stocks, bonds, mutual funds, or education to expand our future earnings and career prospects. This is the same type of money management discipline that is applied in business. It's just a matter of scale. In business, we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company's Income Statement, but the idea is the same.

This concept applies to all businesses. Revenues are usually from Sales of products or services. Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc. What is left over is the Net Income or Profit.

Again: Revenues – Expenses = Net Income.

Net Income is either saved to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.

The Income Statement is also known as the "profit and loss statement." Business people sometimes use the shorthand term "P&L," which stands for profit and loss statement. A manager is said to have "P&L responsibilities" if they run an autonomous division where they make marketing, sales, staffing, products, expenses, and strategy decisions.

P & L responsibility is one of the most critical responsibilities of any executive position. It involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.

Google the term "income statement," and you will see many examples of formats and presentations. Again, you will see there is variety depending on the industry and nature of the business, but they all follow these basic principles.

Remember: Income (revenue or sales) – Expenses = Net Income or profit

Here is a quiz to test your comprehension of the material in the last video The Income Statement: Revenue Overview. It's five questions. If you get more than a couple wrong, I suggest going back and review the video.  Let's get started!

This is a condensed version of the next lecture that hits the main points of the Income Statement without the examples and discussion of public company reporting.  Hearing the basics twice can help make it stick. If you feel relatively familiar with financial statements then you may want to skip this lecture.  Its only three minutes and I have found value in hearing the concepts presented over again. I want to make sure these concepts really sink in. 

The Income Statement

An income statement is one of the three financial statements used for reporting a company’s financial performance over a specific accounting period.

The other two financial statements are the Balance Sheet and the Cash Flow Statement. The income statement focuses on the revenue, expenses, gains, and losses reported by a company during a particular period. It is also known as the Profit and Loss (P&L) statement or the statement of revenue and expense. An Income Statement provides insights into a company’s operations, efficiency of management, underperforming sectors, and performance relative to industry peers.

Here is a bonus lecture on the Income Statement.  This is from a classroom lecture going over the Income Statement concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Income Statement ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

The Income Statement

The basic structure and components of the Income Statement are reviewed in this lecture.  The Income Statement is sometimes called the Profit and Loss Statement or P&L for short. 

The components of the Income Statement are:

• Revenue

• Expenses

• Net Income

• Profit

• Earnings

  
  

The Income Statement    

The daily operations of a business are measured in the money that comes in as revenues, the money that goes out as expenses, the money that is retained as profit, the money that is invested in operational assets, and the money that is owed.  It’s all about the money. Financial statements follow the money.    

The report that measures these daily operations, of money in and money out over a period of time, is the Income Statement.    

Revenues minus Expenses equals Net Income   

The Income Statement can be summarized as: Revenues less Expenses equals Net Income.  The term Net Income simply means Income (Revenues) net (less) of Expenses.  Net Income is also called Profit or Earnings.  The terms "profits," "earnings" and "net income" all mean the same thing and are used interchangeably. They are synonyms for the bottom line number on the Income Statement. Revenues are often called Sales and are represented on the top line.    

You understand the dynamics of this concept intuitively.  We always strive to sell things for more than they cost us to make or buy. When you buy a house you hope that it will appreciate in value so you can sell it in the future for more than you paid for it. It’s also the rule for stocks: buy low, sell high. In order to have a sustainable business model in the long run, the same logic applies.  You can’t sell things for less than they cost to make and stay in business for long. If you own run a sandwich shop you had better make sure that you are selling the sandwiches for more than they cost you to make.    

Think of the Income Statement in relation to your monthly personal finances.  You have your monthly revenues: in most cases the salary from your job.  You apply that monthly income to your monthly expenses: rent or mortgage, car loan, food, gas, utilities, clothes, phone, entertainment, etc.    Our goal is to have our expenses be less than our income.     

There is an old adage: “If you outflow is more than your income, your upkeep is your downfall.”   

Over time, and with experience, we become better managers of our personal finances and begin to realize that we shouldn’t spend more that we make.  We strive to have some money left over at the end of the month that we can set aside and save.  In business, what is set aside and saved is called Retained Earnings.      

Some of what we set aside we may invest with an eye toward future benefits.  We may invest in stocks and bonds or mutual funds, or we may invest in education to expand our future earning and career prospects.  This is the same type of money management discipline that is applied in business.  It’s just a matter of scale. In business we buy assets that help the enterprise expand or perform more efficiently. There are a few additional zeros after the numbers on a large company’s Income Statement but the idea is the same.    

This concept applies to all businesses.   Revenues are usually from Sales of products or services.  Expenses are what you spend to support those sales in terms of the operations: Salaries, raw materials, manufacturing processes and equipment, offices and factories, consultants, lawyers, advertising, shipping, utilities etc.   What is left over is the Net Income or Profit.   Again: Revenues – Expenses = Net Income.    

Net income is either saved in order to smooth out future operations and deal with unforeseen events (save for a rainy day); or invested in new facilities, equipment, and technology. Or part of the profits can be paid out to the company owners, called shareholders or stockholders, as a dividend.     

The Income Statement is also known as the "profit and loss statement". Business people sometimes use the shorthand term "P&L," which stands for profit and loss statement.  A manager is said to have “P&L responsibilities” if they run an autonomous division where they make the decisions about marketing, sales, staffing, products, expenses, and strategy. P & L responsibility is one of the most important responsibilities of any executive position and involves monitoring the net income after expenses for a department or entire organization, with direct influence on how company resources are allocated and responsibility for performance.     

Google the term “income statement” and you will see lots of examples of formats and presentations. You will see there is variety depending on the industry and nature of the business but they all follow these basic principles.    

Remember:  Income (revenue or sales) – Expenses = Net Income or profit   

The top line of the Income Statement: Revenue

This section goes over the economic concept of Supply and Demand and ties Supply and Demand to Revenue, which is the top line of the Income Statement. Revenue is Price times Quantity, and Price and Quantity are the axes of the Supply/Demand relationship graph.

Definition of Supply and Demand: the amount of goods and services available for people to buy compared to the amount of goods and services people want.

If less of a product than the public wants is produced, the law of Supply and Demand says that more can be charged for the product.

The four basic laws of Supply and Demand:

1) If the Supply increases and Demand stays the same, the price will go down.

2) If the Supply decreases and Demand stays the same, the price will go up.

3) If the Supply stays the same and Demand increases, the price will go up.

4) If the Supply stays the same and Demand decreases, the price will go down.

Basics of Microeconomics

Supply and Demand

Let’s break the concept of graphing Supply and demand down by thinking about any product you buy regularly and are familiar with. How about pizza?

Demand is a function of how many people or customers are interested in purchasing a particular product or service.

Many dimensions affect your decision to buy a pizza: quality, delivery, timeliness, taste, etc. But the one we will be concerned about (and plot on a graph) is probably dear to your heart (and purse): price.

Consider your purchasing decision: if a pizza costs $30, you probably will not buy too many of them. If it costs $1.50, you may eat nothing but pizza until you really fatigue from it.

Most everyone else thinks about the pizza purchase decision the same way. Therefore, the Demand graph is the sum of everybody’s decisions to purchase based on price.

We graph Supply and Demand on two axes: the horizontal axis is Quantity: which is how many pizzas get purchased in aggregate at each Price; Price is the vertical axis.

The Demand curve (even though it is usually represented as a line, we call it a curve) has a downward slope, which means that at high prices, less Quantity is sold, and at low prices, more is sold.

The Supply curve is the amount providers will make at a certain price. The curve is the sum of what happens to Quantity at all these different price points.

The way to think about Supply is: if pizzas are selling at $30 a piece, lots of folks will think about getting into the pizza business because they feel they can make lots of money; and if pizzas are selling at $1.50 many pizza makers will abandon the business because they are losing money.

So more Quantity is supplied to the market at higher prices and less at lower prices.

These two lines, Supply and Demand, make an X on the graph. Where they intersect is where the market balances and enough are sold at that price to satisfy both the Demand for pizza and the Supply of pizza. That is the market equilibrium and determines the Quantity and the price at which the market clears.

Elasticity of Demand

Elasticity of Demand measures the slope of the demand curve and helps locate the point where total Revenue is maximized. Total Revenue is price times quantity.

Revenue is calculated as Price times Quantity Sold. Prices are determined through Supply and Demand.

Price is determined by where the Demand for a good or service meets the Supply.

Revenue is the Price times the Quantity sold. Revenue is the top line of the Income Statement. So this section reviews the dynamics and components of how that Revenue number is derived.

This lecture analyzes the top line of the Income Statement: Revenue.  Revenue is calculated as Price X Quantity Sold.  I go into detail as to how prices are determined through supply and demand. 

This Lecture goes over the concept of Supply and Demand and ties it to price, sales and revenue. Price is determined by where the Demand for a good or service meets the Supply. Revenue is the Price times the Quantity sold. Revenue is the top line of the Income Statement. So this lecture reviews the dynamics and components of how that Revenue number is derived.

Expenses

Salaries are usually a company's most significant Expense.

Opex vs. Capex.

Opex is short for Operating Expense, and Capex is short for Capital Expense. For example, salaries are an operating expense, and automation or robotics is a capital expense that offsets salaries by reducing the number of employees necessary to run a business.

Capital expenses appear as an asset on the balance sheet and are depreciated in the Income Statement.

COGS cost of goods sold.

Cost of goods sold (COGS) is the direct cost of making a company's products. It is an important line on your income statement that can tell you a lot about your financial performance, efficiency, and profitability.

SG&A

SG&A is an initialism used in accounting to refer to Selling, General, and Administrative Expenses, which is a significant non-production cost presented in an income statement.

Fixed costs

A fixed cost is an expense that a firm incurs that remains the same regardless of how many goods and services are produced or sold. Fixed costs are frequently associated with ongoing expenditures like rent, interest payments, and insurance that are not directly tied to production.

Variable costs

A variable cost is an expense for the firm that varies according to how much is produced or sold. Depending on a company's production or sales volume, variable costs grow or fall. They climb as output rises and reduce as production declines.

A manufacturing company's raw material and packaging costs, credit card transaction fees, or shipping charges, which increase or decrease with sales, are examples of variable costs.

Fixed costs and variable costs can be compared and analyzed.

Break even with revenue.

When determining when you will break even financially, a break-even analysis compares the expenses of a new business, service, or product against the unit sale price. In other words, it indicates when you will have generated enough revenue to pay for all your expenses, both fixed and variable.

Non-cash expenses: AP, depreciation, and amortization

The second most significant Expense in business is usually Taxes.

Here is a quiz to test your comprehension of the material in the last video The Income Statement: Expenses. It's four questions. If you get more than a couple wrong, I suggest going back and review the video. Let's get started!

Net income. Profit. Earnings

Net income, Earnings, and Profits are synonyms.

In business, as in life, it’s not what you make (revenue). It’s how much you keep (profit). Two ways to achieve more net income: increase revenue or decrease expenses.

EBIT earnings before interest and taxes

EBITDA. Cash flow. Remove distortions of non-cash expenses.

These questions cover key aspects of the last video and test the your understanding Net Income and of terminology and financial ratios commonly used in business finance and investment analysis.

I use this video as a promo but it is an effective intro or refresher on The Balance Sheet.

Balance Sheet

Assets reflect a firm’s investment decisions and liabilities plus shareholder’s equity reflect a firm’s financing decisions.

Assets = Liabilities + Shareholder’s Equity

Or

Investing = Financing

In general, firms attempt to balance the term structure of their financing with the term structure of their investments.

When analyzing a balance sheet, one looks for a reasonable balance between the term structure of assets and the term structure of liabilities pls shareholder’s equity. The proportion of short versus long term financing should bear some relation to the proportion of current versus noncurrent assets.

Balance Sheet Basics

The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period.

Among other items of information, a balance sheet states

• What Assets does the entity own,

• How it paid for them,

• What it owes (its Liabilities), and

• What is the amount left after satisfying the liabilities (its Equity)

Balance sheet data is based on what is known as the

Accounting Equation: Assets = Liabilities + Owners' Equity.

Think of a Balance Sheet in terms related to everyday life. For example, homeownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership has the three components of Asset, Liability, and Equity.

The Asset is the value of the house. An appraisal determines this. An appraisal considers recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.

The Liability is the mortgage. This debt is how much you owe against the house.

Equity is the difference between the asset's value and the Liability amount. For example, if your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner's Equity.

If your mortgage balance is more than the value of the home, then you are considered "upside down" or "underwater." The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets, then the enterprise is insolvent and probably headed for bankruptcy.

A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity.

The Balance Sheet, along with the income and cash flow statements, comprises the financial statements, a set of documents indispensable for running a business.

What does the Balance Sheet balance?

The balance sheet is structured to show the amount and type of assets an enterprise owns and how those assets are funded. One side of the balance sheet shows what you have (assets), and the other side shows how you paid for it (Debt and Equity).

Assets can be purchased and paid for in two ways: with debt or with Equity (or a combination of the two). What a company owes, the obligations or loans, are called Liabilities; what a company owns is the Equity or Stock.

The Liabilities and Equity are equal to the Assets. Therefore, they are two sides of the same coin and must balance, hence the term Balance Sheet.

This balancing is a fundamental principle of Accounting called the Accounting Equation. Assets = Liabilities + Equity.

Balance Sheet Format

A Balance Sheet is typically organized in two columns, with the Assets on the left and the Liabilities and Equity on the right. It is divided into subcategories, with the most current types on top and the more long-term varieties towards the bottom.

Current Assets are ones like cash that can be used on short notice, and Long term Assets are things like factories that would take longer to convert to cash—current means short-term, stuff that needs to be addressed within one year. Long-term means stuff longer than the next year.

Bills that need to be paid within the month are considered Current Liabilities, and loans that are paid back over years are regarded as Long term Liabilities.

Equity is what the owners actually own. Equity is basically Assets less Liabilities and is shown as accounts below the Liabilities on the left-hand side. Equity is shown below the Liabilities because debt has senior claims on the assets.

In the event of liquidation like bankruptcy, the debt holders get paid from the sale of assets first, and then anything left over goes to the equity holders.

Here is an example Balance Sheet to get and idea of the format; notice that the Total Assets equals the Total Liabilities plus Equity.

These five questions test your understanding of the key concepts presented in the Balance Sheet video, particularly as they relate to the structure and significance of the balance sheet in both personal finance and broader corporate finance and economic contexts.

If you are unsure of any of the answers, go back and review the Balance Sheet videos.

Here is a bonus lecture on the Balance Sheet.  This is from a classroom lecture going over the Balance Sheet concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Balance Sheet ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

Balance Sheet Basics 

  The Balance Sheet is a condensed statement that shows the financial position of an entity on a specified date, usually the last day of an accounting period.         

Among other items of information, a balance sheet states

• What Assets the entity owns,    

• How it paid for them,   

• What it owes (its Liabilities), and    

• What is the amount left after satisfying the liabilities (its Equity)   

Balance sheet data is based on what is known as the 

Accounting Equation: Assets = Liabilities + Owners' Equity.   

Think of a Balance Sheet in terms related to everyday life.  Home ownership, when you have a mortgage, is represented as a Balance sheet. Your home ownership basically has the three components of Asset, Liability and Equity. The Asset is the value of the house. This is determined by an appraisal. An appraisal takes into account recent sales of homes in the area and compensates for differences like the number of bath or bedrooms, the size of the lot, etc.    

The Liability is the mortgage. This is how much you owe against the house. The Equity is the difference between the value of the Asset and the amount of the Liability. If your home is worth $200,000 and you have a remaining mortgage balance of $150,000, then you have $50,000 in Equity. We sometimes call this homeowner’s equity.    

If your mortgage balance is more than the value of the home, then you are considered “upside down” or “under water”. The same principle applies to a business: if the value of its Liabilities is more than the value of the Assets then the enterprise is insolvent and probably headed for bankruptcy.     

    A Balance Sheet is organized under subheadings such as current assets, fixed assets, current liabilities, Long-term Liabilities, and Equity With income statement and cash flow statement, it comprises the financial statements; a set of documents indispensable in running a business.     

What does the Balance Sheet balance?   

The balance sheet is structured to show the amount and type of assets an enterprise owns and how those assets are funded.  One side of the balance sheet shows what you have (assets) and the other side shows how you paid for it (debt and equity).    

Assets can be purchased and paid for in two ways: with debt or with equity (or a combination of the two).  What a company owes, the debts or loans, are called Liabilities; what a company owns is the Equity or Stock.    

The Liabilities and Equity are equal to the Assets.  They are two sides of the same coin and they must balance; hence the term Balance Sheet. This is a fundamental principal of Accounting called the Accounting Equation.  Assets = Liabilities + Equity.     

Balance Sheet Format   

A Balance Sheet is typically organized in two columns with the Assets on the left and the Liabilities and Equity on the right. It is divided into subcategories with the most current types on top and the more long-term varieties towards the bottom.     

Current Assets are ones like cash that can be used on short notice and Long term Assets are things like factories that would take longer to convert to cash.  Current means short term; stuff that needs to be addressed within one year. Long-term means stuff longer than the next year.    

Bills that need to be paid within the month are considered Current Liabilities and loans that are paid back over years are considered Long term Liabilities.    

Equity is what the owners actually own.  Equity is basically Assets less the Liabilities and is shown as accounts below the Liabilities on the left hand side.  Equity is shown below the Liabilities because debt has senior claims on the assets. In the event of liquidation like a bankruptcy, the debt holders get paid from the sale of assets first and then anything left over goes to the equity holders.    

Here is an example Balance Sheet to get and idea of the format; notice that the Total Assets equals the Total Liabilities plus Equity.

Here is another bonus lecture on the Balance Sheet.  This is from a classroom lecture going over the Balance Sheet concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. If you feel comfortable with the Balance Sheet ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

The Balance Sheet

Assets = Liabilities + Equity

What Is an Asset?

The fundamental bet of a new business is that a founder can use the capital from investors to purchase a variety of assets, uniquely combine those assets, and create more value than those assets could produce on their own.

Return on Invested Capital (ROIC) measures the success of this effort and strategy.

Let's say I wanted to raise money for a crypto company: I don't know how it will work, but considerations will involve stuff like ownership, community, and software. I first need to raise capital from investors. My investors hope I will use this capital to build the business, and I will use the money to buy assets of some sort.

If you asked a startup founder what excited them about their new venture, none would say "responsible stewardship of assets." It's all about building products! Building teams! Few people get into entrepreneurship to carefully manage spreadsheets.

However, understanding how to communicate in assets allows technology leaders to relate with their management team; it means founders no longer glaze over when their accountant speaks; it means understanding investors' incentives.

Knowing finance is power.

The most fundamental atomic unit of business is the asset. Understanding what an asset is, why it matters, and what excites investors is critical to career success. This is the way I wish I had been taught finance!

What is An Asset, and Why Do They Matter

Assets are a concept where the outline is clear, but the details are blurry. When you use the word "asset" at a meeting, everyone will vigorously nod their heads in accord while also conjuring up completely different definitions. A wise company builder can only realistically resolve this conundrum by comprehending what asset implies in relation to other factors.

On the outline level, an asset is any resource with an economic value. That's it! However, there is a big difference between your boss calling you an asset and your accounting team deciding what number to put next to "assets" on the balance sheet.

In a company, assets produce income. They are called income-producing assets. An asset can increase sales and revenue or help reduce costs. Both ways add to improving the bottom line (net income).

Let's take a step back and ask why we need to keep track of this stuff. First, the point of GAAP (generally accepted accounting practices) is to enforce a standard quantifiable version of a story that a business tells about itself. This standard is critical so that investors can look at the company's information and have reasonable trust that it corresponds to something specific in the real world.

So, if standard transparent information for owners (or potential owners) is generally the reason for accounting classifications, what is the need for an "asset" specifically? It's to give you some idea of the value of a company.

In business, assets break down into four broad categories. They are:

Current Assets

Current Assets are easy to liquidate; Cash and one step removed from cash assets. These are what a company uses when it needs Cash quickly. When things get tight, you want current assets readily available. Interestingly, there is no universal rule on what level of disclosure is required, so you'll often see different companies emphasize different things depending on their type of business.

The second thing an asset can be is:

Fixed Assets

Assets lasting longer than a year are called fixed assets. These are also called Tangible Assets. In corporate meetings, you will hear it called "PP&E": property, plants, and equipment. Financial judgments are made in calculating and depreciating the asset for an expense. Depending on which country a company is headquartered in and what accounting standard they adhere to, depreciation can occur over the "useful life" of the asset or on a more accelerated timeline.

Treating your assets and claiming depreciation expenses can result in huge swings in valuations.

Financial investments

Say you are a successful company like Apple. One of the best parts about being a great company is making lots of Cash. A company can, and probably should, return it to shareholders, but sometimes they choose to keep it. But when inflation strikes, you want only some of that sitting in a bank account. You want it out in the market, making a return or keeping up with inflation. Cash management is where you'll see some companies deploy their excess Cash in various ways.

Microstrategy put their excess Cash in Bitcoin. It worked incredibly well until it didn't. Tesla also took a position with its Cash in Bitcoin, but then Elon thought better of it and decided to sell that position and be safer. Most companies put their Cash in marketable securities. Marketable Securities is the Asset line on the Balance sheet just below Cash for most companies.

Intangible assets

The last type of thing an asset can be is intangible. Intangible assets are the best example to highlight the difference between accounting and finance. Finance is about long-term power: it deals with the strategic use and investment of capital. Accounting is tracking the day-to-day flows of value and is concerned with painting a hyper-accurate current picture of reality.

For intangible assets, there is often strong disagreement between the two functions. For example, when trying to value a brand or a patent, accountants have to use the principle of conservatism.

This point is significant because most technology companies' competitive advantages are intangible assets. Ask yourself this: what value would you ascribe to the network effects of LinkedIn? How valuable is the data housed therein? When Microsoft bought them for $26.2B in 2016, the company had a book value of assets worth roughly $7B. The $19.2B difference comprised future expectations of cash flows AND the other assets that hadn't been valued up to the point of acquisition.

The difference between finance and accounting is minute compared to the difference between executives and accounting. Perhaps the most crucial assets of all, a talented workforce and productive culture, aren't considered assets by accountants. They're an expense. There is a vast difference between how financial statements portray the world and reality.

How To Think About Technology Companies in the Pursuit of Assets

Many of the most successful companies have as few assets as possible. They can wring more economic value out of the minimal amount of assets. The more assets required to make your economic engine work, the more capital you must raise, and the lower the return on invested capital. Asset-light companies have a better return on assets.

There are notable exceptions, with some of the most highly valued companies today (Walmart and Tesla) taking an asset-heavy approach, but they are the exception. Vertical integration is a risky strategy. Hard tech, like building factories and producing complicated things like computer chips or batteries, can act as moats and barriers to entry—this approach limits threats of competition.

It's simple. The more a company can offload its unprofitable assets onto suppliers, the better return it can generate.

An investment round into a project is about purchasing returns-driving assets. Sometimes asset means the accountant definition, sometimes the CEO one. The game of finance is knowing when and how you should appeal to the right audience.

In this lecture I review the Balance Sheet and Income Statement and how they are connected and the flow of money through them.  This is a summary and preparation for discussing the Cash Flow Statement. 

In this lecture I talk about Accrual Accounting and the Matching Principle and why they are so important.  Then I discuss the impact of these concepts on the Balance Sheet and Income Statement.  Then I talk about Liquidity Ratios and the Current Ratio and the Quick Ratio. 

So this lecture starts to tie together Accounting, Financial Statements, Corporate Finance, and Financial Analysis.

Depreciation is the last concept I present in preparation of discussing the Cash Flow Statement.  Depreciation is an accrual concept that creates an asset on the Balance Sheet and a non-cash expense during the asset's useful life.  Depreciation then gets reconciled with cash in the Cash Flow Statement.  You are really starting to become a savvy business person!

Cash Flow

Suppliers who allow a firm to pay later for goods and services received now are in effect supplying the firm with cash.

Creditors who permit a firm to increase amounts owed are in effect providing cash.

These questions are designed to evaluate an understanding of the cash flow statement at a high level, as is expected for MBA students.  If you feel unsure about any of the questions, go back and review the  Cash Flow Statement lecture.

Here is a bonus lecture on the Cash Flow Statement.  This is from a classroom lecture going over the Cash Flow Statement concepts.  Sometimes hearing things a second or third time presented in a little different way can help make the concepts stick. The Cash Flow Statement can be a little tricky to understand at first so going over the material can be helpful. If you fell bored by this lecture then good! It means you understand the concepts.

If you feel comfortable with the Cash Flow Statement ideas, then by all means skip ahead.  One way to check if you really understand the concepts is to teach it to someone or rehearse teaching it to yourself. Give it a try and see where you might get stuck. Then focus on the parts that are still less than crystal clear.

Cash Flow is King

What is free cash flow yield, and why is it important?

In running a business, nothing beats real cash on hand.

In the investment world, cash flow, especially free cash flow, is essential to understand a company's stability and capital strength.

The Power of Free Cash Flow

Free cash flow is the money left after a company pays its expenses, taxes, interests, and capital expenditures. In addition, dividends, debt payments, stock buyback, and growth investments come from free cash flow.

When a company earns a positive free cash flow, it generates more cash than it needs to operate its business and can invest in growth.

Free cash flow (FCF) = Operating cash flow minus capital expenditure.

A company's cash flow statement is where operating cash flow and capital expenditure items are found.

Free cash flow is not net income because net income does not measure a company's actual cash position. For example, if a company increases revenue in the form of accounts receivable to be collected next year, the company has yet to receive the cash. So, an increase in accounts receivables will reduce cash flow even though the revenue is reported in the net income number.

Therefore, free cash flow (FCF) is better than net income for measuring a company's performance and how much cash is available to distribute to shareholders and invest for future growth.

Companies can manipulate their Net Income number but cannot mess around with free cash flow.

What is Free Cash Flow Yield?

Free Cash Flow Yield is calculated by comparing a company's free cash flow per share to its stock price per share.

Free cash flow yield (FCFY) = Free Cash Flow per Share/Price per Share

The higher the free cash flow yield, the more valuable the company is because of its stronger ability to pay off debt, distribute cash to shareholders, and invest for its benefit and growth.

Warren Buffett likes to look at cash flow rather than earnings multiples to determine whether an investment is a value.

"I wouldn't look for a single metric like relative P/Es to determine what — how — to invest money. You really want to look for things you understand, and where you think you can see out for a good many years, in a general way, as to the cash that can be generated from the business. And then, if you can buy it at a cheap enough price compared to that cash, it doesn't make any difference what the name attached to the cash is. "

Warren Buffett

What to Look For When Screening Investments

You have probably heard of "value" and "growth" stocks and wondered how to tell them apart and the benefits of one versus the other. Unfortunately, the two terms are arbitrary to a degree.

We want a screening tool that is less vague and subjective and more quantitative and objective.

Rather than looking for a value or growth stock, a better way to screen investments is to look at the free cash flow yield to understand the company's business strength compared to its market value.

In a risk-off environment, investors care for quality and cash flow.

A persistent negative free cash flow may signify a company is becoming illiquid and cannot sustain its operations.

A negative free cash flow yield is not always bad. For example, if the company is investing for the future and is expecting a higher investment return than the cash paid, like in a high-growth company, the temporary negative free cash flow yield needs to be investigated against the company's business needs and potential.

When measuring investment options, cash is King.

In this lecture I tie together the financial statement interconnection and flow and then review the Balance Sheet and Income Statement.

Based on the video  "8 Financial Statements Interconnection and Flow," here are 10 multiple choice questions designed at the level of an Ivy League MBA program

These questions aim to evaluate an individual's understanding of the interconnectedness and flow between the core financial statements, their purpose, and how they're used in corporate finance.

The Big Picture of Financial Statements

The three Financial Statements: Balance Sheet, Income Statement, and Cash Flow Statement, are interconnected, and the accounting numbers flow through them. They are the measure of a company's performance and health.

The basic interconnection starts with a Balance Sheet showing the financial position at the beginning of the period (usually a year); next, you have the Income Statement that shows the operations during the year, and then a balance Sheet at the end of the year.

The Cash Flow is necessary to reconcile the cash position starting from the Net Income number at the bottom of the Income Statement. The cash number calculated from the Cash Flow Statement is added to the cash reported on the beginning Balance Sheet. This number needs to match the actual money in the bank at the end of the period and is used as the Cash account balance at the top right (Asset column) of the end-of-year (EOY) Balance Sheet.

The Net Income number from the Income Statement is then added to the Retained Earnings number in the Equity section (lower left-hand side) of the end-of-year (EOY) Balance Sheet.

Changes in non-cash accounts like Accounts Receivable and Accounts Payable and Depreciation and Amortization will make up the difference between the Cash Flow number added on the right side of the Balance Sheet and the Net Income number added on the left-hand side.

When this is done correctly, all the numbers should reconcile. The Assets will equal the Liabilities and Equity (remember the Accounting Equation A = L + E) of the EOY Balance Sheet.

Financial Statement Interconnections and Flow

Think of it as a system of two Balance Sheets acting as bookends for the Income Statement. And the Cash Flow Statement is used to reconcile the Net Income (or Loss) at the bottom of the Income Statement with the amount of cash in the bank.

This process accounts for every penny that has come in, gone through, and gone out of a company during the period.

Understanding these three financial statements and how they knit together will allow you to assess any company's financial health, viability, and prospects and help you make rational, fact-based investment decisions. This is how Warren Buffett does it.

This section ties together the functionality of the financial statements. I hope this might be an "aha" moment for you. It was for me when I finally realized how this all fit and worked together. This understanding of financial statements is the basis of Financial Literacy and Capitalism. Understanding this big conceptual accounting picture will provide a context to keep you from getting lost in the details.

Now its time to test your new knowledge.

Here is a quiz to test your new knowledge of financial statements and how they interconnect and flow together. Download the spreadsheet and fill in the yellow squares numbered 1-22. The only number you need to know is at the top where it says that Accounts Receivable AR increased by $75.  This AR increase number is just a random change that I picked to illustrate that with just one given number, we can calculate all the other numbers with just addition and subtraction.

The following video will go over the quiz and the answers. Don't peak! : )

Download the attached PDF with the answers to the quiz and follow along with the spreadsheet lecture.

Here is another look and review of the Financial Statement Flow Quiz.  This one is from a classroom and the video isn't as clear as the one above, but hearing another take on the analysis will help the concepts sink in. You can Download the attached PDF with the answers to the quiz, if you haven't already, and follow along with the video lecture.

Intro to Financial Ratios and Analysis

• Financial performance metrics

Based on the above Intro to Financial Statement Analysis lecture video, here are five multiple choice questions to gauge your understanding and comprehension. Let's get started!

Two basic techniques are used in Corporate Finance.

One is the ratio analysis of financial statements, and the other is calculating the present value of future cash flows.

Bankers, investors, financiers, CFOs, and entrepreneurs use these tools and techniques to value assets and make decisions. 

This section will look at using financial ratios as a capital budgeting, analysis, and allocation tool. There are lots of different accounting ratios that get used inside a firm.   

By ratio analysis, I mean taking two numbers from financial statements and dividing one by the other. So we are taking two pieces of accounting data, putting one over the other, forming a ratio.

We are taking two pieces of data and creating a performance metric. Ratios are presented as a percentage or a number depending on whether the usual case is bigger or less than one. 

Ratios are a performance analysis tool. Ratios allow us to compare different companies or a company over time.

Ratios are great tools to make this comparison because they enable us to “normalize” the numbers. A ratio eliminates size differences and allows for pure comparison to compare apples to apples. 

Financial ratios are derived from accounting information and rely on understanding financial statements.

Financial Statement Analysis and Ratios

Accounting and Finance overlap in this area.  The launching place for Corporate Finance is the ability to read and understand Financial Statements. The analysis of financial statements and subsequent assumptions and projections based on that analysis is the next step.  Financial Statement Analysis is the process of analyzing a company's financial statements and comparing the analysis across companies and industries in order to make better operating and investing decisions. This analysis method involves specific techniques for evaluating and quantifying risk, performance, financial health, and the future prospects of an enterprise.  We can look at the performance of a particular company over time such as year to year results.  This is called Horizontal Analysis.  And we can look at various performance characteristics within a single time period. This is called Vertical Analysis.  We can create metrics across an industry segment as an average value to compare our company against.  This is called Benchmarking.  We can also aggregate up different industry groups and see how they perform relative to each other.  This type of analysis can be helpful in gauging where to allocate investment dollars in a portfolio.  It can also be used to see how a management team is performing relative to its competition.    

Here are five questions on the above video to gauge your understanding of the material.

In this lecture I show you a spreadsheet with Financial Statements and we calculate and discuss financial ratios.   Download the spreadsheet in order to get better insight into the calculations and how financial statements interconnect and flow.

Horizontal and Vertical Analysis

Horizontal analysis compares financial information over time, typically from past financial statements such as the income statement. When comparing this past information we look for variations of particular line items such as higher or lower earnings, sales revenues, or particular expenses. Horizontal analysis is used to look for trends that can be extrapolated in order to predict future performance.

Vertical analysis is a proportional analysis performed on financial statements. It is ratio analysis. Line items of interest on the financial statement are listed as a percentage of another line item. For example, on an income statement each line item will be listed as a percentage of Sales.  

Financial Ratios

Financial ratios are powerful tools used to assess company upside, downside, and risk. There are four main categories of ratios: liquidity ratios, profitability ratios, activity ratios and leverage ratios. These are typically analyzed over time and across competitors in an industry. Using ratios “normalizes” the numbers so you can compare companies in apples-to-apples terms.

Liquidity and Solvency

Solvency and liquidity are both refer to a company’s financial health and viability. Solvency refers to an enterprise's capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations. Liquidity is also a measure of how quickly assets can be sold to raise cash.

A solvent company is one that owns more than it owes. It has a positive net worth and is carrying a manageable debt load. A company with adequate liquidity may have enough cash available to pay its bills, but may still be heading for financial disaster down the road. In this case a company meets liquidity standards but is not solvent. Healthy companies are both solvent and possess adequate liquidity.

Liquidity ratios are used to determine whether a company has enough current asset capacity to pay its bills and meet its obligations in the foreseeable future (current liabilities).  Solvency ratios are a measure of how quickly a company can turn its assets into cash if it experiences financial difficulties or is threatened with bankruptcy. Both measure different aspects of if, and how long, a company can pay its bills and remain in business.

The current ratio and the quick ratio are two common liquidity ratios. The current ratio is current assets/current liabilities and measures how much liquidity (cash) is available to address current liabilities (bills and other obligations).  The quick ratio is (current assets – inventories) / current liabilities.  The quick ratio measures a company’s ability to meet its short-term obligations based on its most liquid assets, and therefore excludes inventories from its current assets. It is also known as the “acid-test ratio.”

The solvency ratio is used to examine the ability of a business to meet its long-term obligations. Lenders and bankers most commonly use the solvency ratio because they are most concerned about their ability to get paid back any money they lend. The ratio compares cash flows to liabilities. The solvency ratio calculation involves the following steps:

All non-cash expenses are added back to after-tax net income. This approximates the amount of cash flow generated by the business. You can find the numbers to add back in the Operations section of the Cash Flow Statement.

Add together all short-term and long-term obligations.  This is the Total Liabilities number on the Balance Sheet. Then divide the estimated cash flow figure by the liabilities total.

The formula for the ratio is:

(Net after-tax income + Non-cash expenses)/(Short-term liabilities + Long-term liabilities)

A higher percentage indicates an increased ability to support the liabilities of a business over the long-term. Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. 

Remember that estimations made over a long term are inherently inaccurate. There are many variables that can impact the ability to pay over the long term. Using any ratio to estimate solvency needs to be taken with a grain of salt.

From the above video on "Liquidity and Solvency Ratios," here are five multiple-choice questions. These questions and explanations are derived from the video lecture above, focusing on the key concepts and differentiations in the realm of liquidity and solvency ratios.

Return on Invested Capital  ROIC

Return on invested capital (ROIC) measures a firm's profit over the typical cost of the debt and equity capital it uses.

The value of other businesses can be determined using the return on invested capital as a benchmark.

The efficiency with which a company directs the funds under its control toward successful investments or projects is measured by its return on invested capital (ROIC). The ROIC ratio demonstrates how effectively a business generates returns from its capital (equity and debt). Investors determine the effectiveness of a company's use of invested capital by contrasting its return on invested capital with its weighted average cost of capital (WACC).

Calculate ROIC as EBIT/(debt + equity)

ROIC stands for Return on Invested Capital. ROA stands for Return on Assets. ROA tells us how efficiently a business uses its existing assets to generate profits. ROIC tells us how effective a business is in re-investing in itself.

Based on the general themes and concepts mentioned in the above video "Conclusion Ratio Analysis," here are five multiple choice questions. Several of the questions deal with concepts in the upcoming sections. Don't worry if you don't know the answers, just give your best educated guess. This process will help you recognize and remember the material you are going to encounter next. Let's go!

Audited Financial Statements are an integral part of financial reporting.

Accounting, finance and economics all deal with the way we view money. Accounting is about money going in versus money going out; finance is about how to divide the money you have; and economics asks the question: “what's the bigger picture when it comes to money?”.

Finance is empowering. It enables innovation. It empowers big risk takers and bold builders and makes the world better. Finance pulls the future forward.

Finance is a critical in-demand career skill. It starts with being able to read and understand financial statements.

Becoming familiar with financial statements and how they are interconnected and flow is a critical skill set for enhancing your career and understanding of business.

Financial statements also underlay Discounted Cash Flow analysis, NPV, IRR, and all the valuation techniques of finance. Therefore, we should spend some time thoroughly understanding financial statements.

Knowing how to read and understand financial statements is a business skill you can't ignore. Understanding finance fundamentals can help you work your way up the corporate ladder by communicating with others in your company and understanding the big picture. Knowing where your efforts and work can make the most impact is also a helpful skill that financial decision-making tools enable.

When you are thinking about possibly changing jobs and working for a company, you can check their financials and make sure they are a healthy organization. Likewise, if you consider starting your own company, you will need to have your accountant's financials prepared to talk to investors, bankers, and vendors.

If you want to invest wisely in the stock market, analyze the competition or benchmark your performance, you can look up the financials of any publicly traded company at the Securities and Exchange Commission website's EDGAR filings and get an idea of how they are doing. But, first, check out any public company's most recent 10K filing there. A 10K is the Annual Report of the company and its most important business and financial disclosure document.

There are two sets of data that we use in corporate finance: retrospective and prospective. Retrospective data is compiled in financial statements. These represent the historical performance of an enterprise and can be analyzed, compared, and extrapolated. Ratios are the tools of financial statement analysis and we just discussed them

Prospective data is compiled in financial projections. These represent management’s forecast of how the enterprise will perform in the future. These projections can be analyzed, risk adjusted, and a present value of those future cash flows can be calculated. We will now get into the forward-looking aspects of finance with the concept of the Time Value of Money (TVM).

Time is money, literally. If there is a prospect of receiving a certain sum, then the sooner you receive it, the more it is worth. Interest rates describe this relationship between present value and future value. This is the fundamental concept of finance. We will explore this relationship between present and future value from different angles and I will phrase it in different ways in order to let it sink in.

TVM represents the conceptual basis of finance. This is the underlying principle of how banks function, how stocks and bonds are priced, how assets and companies are valued, how projects are analyzed, and how you should think about the nature and function of money.

Lets look at the video lectures and explore this concept in more depth. 

Here are five multiple choice questions based on the above video lecture. 

Here are five multiple choice questions to test your comprehension of the concepts in the above lecture. 

History Lesson

The concept of the time value of money dates back to the 1500s. Martín de Azpilcueta of the School of Salamanca (December 13, 1491 – June 1, 1586), also known as Doctor Navarrus, was an important Basque theologian, and an early economist and the first person to develop monetarist theory. He invented the mathematical concept of the time value of money. It’s an idea that’s about 500 years old.

The core of corporate finance is calculating the present value of future cash flows.  This concept is based on the time value of money. A company is essentially an entity that generates cash flows each year into the future.  The trick is estimating those future cash flows and how much they might grow or shrink and what the risks are to realizing (i.e. receiving) them. 

It’s difficult to peer into the fog of the future. This is where you have to polish your crystal ball and do some deep analysis of the business, its markets and competitors. All this information is compiled in a spreadsheet of financial projections and the bottom line represents the future cash flows in each year. These are discounted back to the present value at a discount rate that takes into account what similar investments, which are just streams of expected cash flows, are priced at in the market and any and all risks specific to the particular enterprise or asset we are contemplating buying or selling.

This is the basic concept of Valuation. Valuation is an estimate of something’s worth.  Something’s worth can be set at auction where people bid and the highest bidder wins. But how do bidders know how much to bid and how much is too much? For income producing assets, like stocks, it’s the present value of the future cash flows.

Here are five multiple choice questions on the above lecture to test your understanding.  Quizzes help cement the concepts in your mind.

Financial Statements, Finance, and Decision Making

• Time value of money

• Discounting cash flows

To estimate the discount rate, CFOs and investors usually use the Weighted Average Cost of the Capital method. The weighted average cost of capital is the average cost of sourcing funds for all companies including both equity and debt. The WACC is calculated as follows:

WACC = (E/D+E) * Ce + (D/E+D) * Cd*(1-T)

Where:

E = Equity

D = Debt

Ce = Cost of Equity

Cd = Cost of Debt

T = Tax Rate

Based on the above video lecture "WACC: Weighted Average Cost of the Capital method" lecture, here are five multiple-choice questions, along with the correct answers and detailed explanations.

A Senseless Subsidy

Many nations and most Western economies sweeten the cost of borrowing.

As we see with the Weighted Average Cost of Capital WACC, debt interest is subsidized by being tax deductible: interest rate *(1-T).

THE prize for the title of world’s worst economic distortion is a crowded one. Fuel subsidies in the emerging world are one contender; the implicit government guarantee that props up big banks another. But it is a less noticed and more pervasive warping of the economic fabric that is the most damaging. Despite the fact that the world is mired in debt, governments make borrowing costs tax-deductible, cheapening debt and encouraging borrowers to pile on more.

Tax breaks for debt come in two principal forms. Interest payments on mortgages are tax-deductible for personal tax purposes in at least some way in America and over a dozen European countries, including Belgium, Italy, the Netherlands, Spain, Switzerland and most Nordic states. And across the world firms can deduct interest payments to debt-holders from their taxable earnings. In contrast the dividend payments and retained profits that flow to shareholders are taxed in most places.

The global convention that debt should enjoy tax perks emerged as much by accident as design. Britain made interest paid by firms tax-deductible in 1853. America allowed the partial deduction of interest for firms in 1894, a decision which was overturned as part of a Supreme Court ruling in 1895. A muddle of laws, judgments and a constitutional amendment partly restored the interest deduction in America from 1909 to 1916. One aim was to help the indebted railroad industry. The full deductibility of interest was eventually permitted in 1918 as part of a package to help companies struggling with the effects of the first world war. Mortgage-interest deduction was allowed in 1913, at a time when few Americans had mortgages. It was only after the second world war that this perk became associated with the political aim of boosting home-ownership to help support stable neighborhoods.

Today, tax breaks for debt are embedded in all economies and viewed as the natural order of things.

A big American firm typically pays an after-tax interest rate of 3% on debt, while the cost of equity (based on the annual return that shareholders expect) is 8% or more. About half of that gap is explained by tax breaks.

None of this is to deny the importance of debt. It serves many useful economic functions. It allows money to travel through time and across social divides. A firm that is short of cash but that has good prospects can raise funds and repay them tomorrow. A rich or frugal person with more money than they wish to spend can lend to those whose outlays exceed their income.

Bosses like debt because it allows them to raise funds while keeping full control of their firms, as long as they meet their payment schedule. Savers like to own bonds or make loans because those interest payments are usually a safe stream of income. If the borrower gets in trouble, creditors have first claim on their assets. Debt can take complex income streams and make them regular. Everything from Korean shipbuilders’ cash flows to the royalties from David Bowie’s song, “Space Oddity”, have been fashioned into bonds offering predictable payment schedules.

One person’s debt is another’s asset. Global debts should cancel out to zero. A thicker web of debt contracts is taken as a sign of economic sophistication, not impending insolvency. “Credit is the vital air of the system of modern commerce,” said Daniel Webster, an American senator, in 1834. “It has excited labor, stimulated manufactures, pushed commerce over every sea.” Emerging economies have long been told that “financial deepening” is essential to pay for the new roads and factories that they need.

Debt also hurts growth by creating fragility. Fixed payments mean that households and firms are more sensitive to downturns, cutting their spending deeper and faster in response, or going through disruptive defaults. The economy’s middle-men—banks—create a second layer of trouble since their solvency is especially sensitive to shocks. If banks have lots of short-term debt that needs to be rolled over, then they become vulnerable to runs.

The fragility of debt stands in contrast with another financial instrument—equity or shares. Unlike interest, the dividends paid to equity holders can be cut if things go wrong, without triggering a default. Equity does not expire, so does not need to be refinanced. The benefits of this flexibility were shown in the 2000-02 dotcom stockmarket crash. The losses then were $4 trillion, more than the $2 trillion global banks suffered in 2007-10. Yet there was no credit crunch. In a crisis, equity bends while debt breaks.

The closest there is to a rule governing the right level of debt is the theory of Modigliani and Miller. It says that the capital structure of a firm cannot alter its value (assuming a world without tax). Its operating profits and riskiness remain the same, no matter how its funding is sliced and diced into equity, debt or other instruments. The theory does not specify what the right level of debt or equity might be but it makes clear that firms should not regard one form of financing as better than the other.

Debt is the magic ingredient that makes modern finance possible. Risky cash flows can be packaged into apparently steady payments, making it easy to reassure—or deceive—customers. Arbitrage (exploiting differences in price between similar assets) is only profitable if magnified by leverage. By using layers of debt with different seniority, risk can be transformed in almost infinite ways.

Reforming the bias in the tax system is not the stuff of public campaigns. A vast web of contracts has been woven around a fiscal technicality, guarded by huge vested interests. America last seriously considered the idea in 1992, and beyond some tweaks to the tax code in Belgium, Britain, Italy and the Netherlands, there has been little sign of reform. But the moment for change may never be better. Interest rates are low, profits are high and house prices stable. As rates increase from rock-bottom levels, interest costs will rise, inflating the size of the distortion. The tax subsidy on the vast debts of rich countries will head back towards the levels seen just before the crisis in 2008. And the debt machine will kick into overdrive again.

Modigliani-Miller theorem

The mix of debt and equity on a firm’s balance sheet don’t affect the value of a company.

The Modigliani-Miller theorem states that a company's capital structure is not a factor in its value. Market value is determined by the present value of future earnings, the theorem states. The theorem has been highly influential since it was introduced in the 1950s.

The Modigliani-Miller theorem explains the relationship between a company's capital asset structure and dividend policy and its market value and cost of capital; the theorem demonstrates that how a manufacturing company funds its activities is less important than the profitability of those activities.

The expected return on equity of Firm A can be calculated based on the following formula:

RE Firm A = RE Firm B + D/E *(RE Firm B - RD).

Firm A is a levered firm and Firm B is an unlevered firm.

Companies have only three ways to raise money to finance their operations and fuel their growth and expansion. They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors.

The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value.

Merton Miller, one of the two originators of the theorem, explains the concept behind the theory with an analogy in his book, Financial Innovations and Market Volatility:

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk."

We estimate the cost of equity as 10.58% and the cost of debt as 5%. Looking at the company’s balance sheet, ABC has a market value of equity of $97.8 Billion and a Market Value of Debt of $52.6 Billion. ABC’s tax rate is 22%. Using the inputs, solve for the WACC of the firm.  After you finish, watch the next video to go over the answer.

The following method is used to estimate a firm's free cash flows:

FCF = EBIT * (1 - T) + Dep - CapEx +/- NWC

Where:

FCF = Free Cash Flow

EBIT = the Operating Profit (Earnings Before Interest and Taxes)

T = Tax Rate

Dep = Depreciation Expense

CapEx = Capital Expenditure

NWC = Change in the Net Working Capital

Free Cash Flow is Net Income with adjustments from the Operations and Investment sections of the Cash Flow Statement. These adjustments are made for non-cash expenses and revenues.

Net working capital (NWC), is the difference between a company's current assets—such as cash, accounts receivable/customers' unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts.

Understanding Free Cash Flow FCF

Introduction to Free Cash Flow

Free Cash Flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. It's a critical indicator of a company's financial health and ability to create additional shareholder value.

Definition and Importance of Free Cash Flow

FCF is the discretionary cash available for a company to deploy in various ways, such as paying dividends, reducing debt, or reinvesting in growth opportunities. It's an essential metric in discounted cash flow (DCF) valuations, providing a basis for estimating future cash flows and determining the present value of an income-producing asset.

Components of Free Cash Flow

1. Operating Cash Flow: The starting point for calculating FCF, representing the cash generated from regular business operations.

2. Capital Expenditures: Funds a company uses to acquire or upgrade physical assets like machinery or property.

3. Working Capital: Reflects the short-term liquidity position of a company, calculated as current assets minus current liabilities.

Calculating Free Cash Flow

The formula for FCF is:

FCF=EBIT×(1−Tax Rate)+Depreciation−Capital Expenditures±Changes in Working Capital

• EBIT (Earnings Before Interest and Taxes): A measure of a company's profitability.

• Depreciation: Added back to EBIT because it's a non-cash expense.

The Role of Depreciation in FCF

Depreciation spreads the cost of an asset over its useful life, impacting net income but not cash flow. Since FCF focuses on cash generation, depreciation expenses are added back to EBIT.

Working Capital in FCF Calculation

Working Capital changes reflect the cash tied up in day-to-day operations. It's crucial in understanding the cash flow dynamics of a company, especially for those with significant inventory or accounts receivable.

Interpretation and Application of Free Cash Flow

Understanding FCF allows management and investors to gauge a company's performance, efficiency, and potential for growth. It's particularly relevant for:

• Investment Decisions: Evaluating opportunities for expansion or acquisitions.

• Shareholder Value: Deciding on dividends or share buybacks.

• Debt Management: Assessing the company's ability to pay down debt.

Case Studies and Examples

Here are some scenarios illustrating how FCF analysis impacts corporate decision-making and valuation.

Incorporating case studies and examples can significantly enhance the understanding of Free Cash Flow (FCF) concepts. Below are two case studies that illustrate FCF's practical application and significance in corporate finance.

Case Study 1: Turnaround Strategy - Reviving a Struggling Retailer

Background: Consider a fictional retail company, "RetailMax," facing declining sales and increasing debt levels. RetailMax's management makes the decision to implement a turnaround strategy.

Analysis:

1. Assessing FCF: Initially, RetailMax's FCF is negative due to heavy capital expenditures and poor sales. This situation signals potential liquidity issues and an inability to sustain operations without external financing.

2. Strategic Changes: Management decides to close unprofitable stores, reduce inventory levels, and renegotiate supplier contracts. These actions are aimed at reducing capital expenditures and improving working capital.

3. Outcome: After a year, RetailMax's FCF turns positive, reflecting better operational efficiency. The company uses this cash to pay down debt, signaling improved financial health to investors.

Lessons Learned: This case study demonstrates how FCF can be a critical indicator of a company's health and the effectiveness of its turnaround strategies. Positive FCF post-restructuring reflects RetailMax's improved ability to generate cash internally.

Case Study 2: Tech Company's Expansion - Balancing Growth and Shareholder Value

Background: A fast-growing tech company, "InnovTech," is contemplating reinvesting its substantial FCF into new product development versus paying dividends to shareholders.

Analysis:

1. Evaluating FCF: InnovTech's substantial FCF results from strong sales and modest capital expenditures, reflecting its asset-light business model.

2. Decision Making: The management faces a choice: use the FCF for an aggressive expansion strategy, including R&D and potential acquisitions, or reward shareholders through dividends or share buybacks.

3. Outcome: InnovTech decides to allocate 60% of its FCF to growth initiatives and 40% to shareholder returns. This balanced approach facilitates sustained growth while maintaining shareholder loyalty.

Lessons Learned: This case highlights the strategic importance of FCF allocation in balancing growth with shareholder expectations. It also illustrates how FCF serves as a tool for assessing available options for using excess cash.

These case studies provide concrete examples of how FCF analysis is integral to strategic decision-making in different business scenarios. They offer practical insights into the application of FCF in corporate finance.

Conclusion

FCF is a versatile and vital metric in corporate finance, providing a clear picture of a company's financial strength and capacity for growth. Understanding its nuances is key for anyone involved in financial analysis or corporate decision-making.