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TWO
CHAPTER
Understanding Financial
Statements
Dell Manages Profitability, Not Inventory
1
In 1994, Dell was
a struggling second-tier PC maker. Like other PC makers, Dell ordered
its components in advance and carried a large amount of component
inventory. If its forecasts were wrong, Dell had major write-downs.
Then Dell began to implement a new business model. Its operations
had always featured a build-to-order process with direct sales to cus-
tomers, but Dell took a series of ingenious steps to eliminate its inven-
tories.The results were spectacular.
Over a four-year period, Dell’s revenues grew from $2 billion to
$16 billion, a 50 % annual growth rate. Earnings per share increased by
62 % per year. Dell’s stock price increased by more than 17,000 % in a
little over eight years. In 1998, Dell’s return on invested capital was
217 %, and the company had $1.8 billion in cash. (The rapid growth
1983–
Michael Dell starts business of preformatting IBM PC HDs on
weekends
1985–
$6 million
sales, upgrading IBM compatibles for local businesses
1986–
$70 million
sales; focus on assembling own line of PCs
1990–
$500 million
sales with an extensive line of products
1996–
Dell goes online; $1 million per day in online sales;
$5.3B
in annual
sales
1997–
Dell online sales at $3 million per day; 50% growth rate for third
consecutive year,
$7.8B
in total annual sales.
2005–
$49.2B
in sales
1
Jonathan Byrnes, “Dell Manages Profitability, Not Inventory,” Harvard Business School, Working
Knowledge, June 2, 2003.
18
continued, and the company’s sales revenues finally reached $50 billion in
2005.)
Profitability management—coordinating a company’s day-to-day activities
through careful forethought and attentive oversight—was at the core of Dell’s
transformation in this critical period. Dell created a tightly aligned business
model that enabled it to dispense with the need for its component invento-
ries. Not only was capital not needed, but the change generated enormous
amounts of cash that Dell used to fuel its growth. How did Dell do it?
Account selection.
Dell purposely selected customers with relatively
predictable purchasing patterns and low service costs. The company devel-
oped a core competence in targeting customers and kept a massive data-
base for this purpose.
The remainder of Dell’s business involved individual consumers. To ob-
tain stable demand in this segment, Dell used higher-end products and
those with the latest technology to target second-time buyers who had
regular upgrade purchase patterns, required little technical support, and
paid by credit card.
Demand management.
Dell’s core philosophy of actively managing
demand in real time, or “selling what you have,” rather than making what
you want to sell, was a critical driver of Dell’s successful profitability man-
agement. Without this critical element, Dell’s business model simply would
not have been effective.
Product life-cycle management.
Because Dell’s customers were
largely high-end repeat buyers who rapidly adopted new technology, Dell’s
marketing could focus on managing product life-cycle transitions.
Supplier management.
Although Dell’s manufacturing system fea-
tured a combination of build-product-to-order and buy-component-to-plan
processes, the company worked closely with its suppliers to introduce more
flexibility into its system.
Forecasting.
Dell’s forecast accuracy was about 70 to 75 %, due to its
careful account selection. Demand management, in turn, closed the forecast
gap. When in doubt, Dell managers overforecast on high-end products be-
cause it was easier to sell up and high-end products had a longer shelf life.
19
20
CHAPTER 2 Understanding Financial Statements
Liquidity management.
Direct sales were explicitly targeted toward high-end cus-
tomers who paid with a credit card. These sales had a 4-day cash conversion cycle, while
Dell took 45 days to pay its vendors. This approach generated a huge amount of liquidity
that helped finance Dell’s rapid growth and limited its external financing needs. Dell’s
cash engine was a key underlying factor that enabled it to earn such extraordinarily high
returns.
If you want to explore investing in Dell stock, what information would you go by?
You would certainly prefer that Dell have a record of accomplishment of profitable oper-
ations, earning a profit (net income) year after year. The company would need a steady
stream of cash coming in and a manageable level of debt. How would you determine
whether the company met these criteria? Investors commonly use the financial statements
contained in the annual report as a starting point in forming expectations about future
levels of earnings and about the firm’s riskiness.
Before making any financial decision, it is good to understand an elementary as-
pect of your financial situation—one that you’ll also need for retirement planning, es-
tate planning, and, more generally, to get an answer to the question, “How am I
doing?” It is called your
net worth
. If you decided to invest $10,000 in Dell stocks,
how would that affect your net worth? You may need this information for your own
financial planning, but it is routinely required whenever you have to borrow a large
sum of money from a financial institution. For example, when you are buying a home,
you need to apply for a mortgage. Invariably, the bank will ask you to submit your
net-worth statement as a part of loan processing. Your net-worth statement is a snap-
shot of where you stand financially at a given point in time. The bank will determine
how creditworthy you are by examining your net worth. In a similar way, a corpora-
tion prepares the same kind of information for its financial planning or to report its
financial health to stockholders or investors. The reporting document is known as the
financial statements. We will first review the basics of figuring out the personal net
worth and then illustrate how any investment decision will affect this net-worth state-
ment. Understanding the relationship between net worth and investing decisions will
enhance one’s overall understanding of how a company manages its assets in business
operations.
Net worth
is
the amount
by which a
company’s
or
individual’s
assets exceed
the company’s
or individual’s
liabilities.
CHAPTER LEARNING OBJECTIVES
After completing this chapter, you should understand the following concepts:
The role of accounting in economic decisions.
Four types of financial statements prepared for investors and
regulators.
How to read the balance sheet statement.
How to use the income statement to manage a business.
The sources and uses of cash in business operation.
How to conduct the ratio analysis and what the numbers really mean.
Section 2.1 Accounting: The Basis of Decision Making
21
2.1
Accounting:The Basis of Decision Making
W
e need financial information when we are making business decisions.
Virtually all businesses and most individuals keep accounting records to
aid in making decisions. As illustrated in Figure 2.1, accounting is the
information system that measures business activities, processes the re-
sulting information into reports, and communicates the results to decision makers. For
this reason, we call accounting “the language of business.” The better you understand
this language, the better you can manage your financial well-being, and the better your
financial decisions will be.
Personal financial planning, education expenses, loans, car payments, income taxes,
and investments are all based on the information system we call accounting. The uses of
accounting information are many and varied:
•
Individual people
use accounting information in their day-to-day affairs to manage
bank accounts, to evaluate job prospects, to make investments, and to decide whether
to rent an apartment or buy a house.
•
Business managers
use accounting information to set goals for their organizations,
to evaluate progress toward those goals, and to take corrective actions if necessary.
Decisions based on accounting information may include which building or equip-
ment to purchase, how much merchandise to keep on hand as inventory, and how
much cash to borrow.
•
Investors and creditors
provide the money a business needs to begin operations.
To decide whether to help start a new venture, potential investors evaluate what
income they can expect on their investment. Such an evaluation involves analyzing
the financial statements of the business. Before making a loan, banks determine
the borrower’s ability to meet scheduled payments. This kind of evaluation includes
a projection of future operations and revenue, based on accounting information.
A
Post
audit
Company prepares reports
to show the results of
their operations
People make decisions
Business transactions occur
Figure 2.1
The accounting system, which illustrates the flow of information.
22
CHAPTER 2 Understanding Financial Statements
An essential product of an accounting information system is a series of financial
statements that allows people to make informed decisions. For personal use, the net-
worth statement is a snapshot of where you stand financially at a given point in time. You
do that by adding your assets—such as cash, investments, and pension plans—in one col-
umn and your liabilities—or debts—in the other. Then subtract your liabilities from your
assets to find your net worth. In other words, your net worth is what you would be left
with if you sold everything and paid off all you owe. For business use, financial state-
ments are the documents that report financial information about a business entity to deci-
sion makers. They tell us how a business is performing and where it stands financially. Our
purpose is not to present the bookkeeping aspects of accounting, but to acquaint you with
financial statements and to give you the basic information you need to make sound engi-
neering economic decisions through the remainder of the book.
2.2
Financial Status for Businesses
Just like figuring out your personal wealth, all businesses must prepare their financial sta-
tus. Of the various reports corporations issue to their stockholders, the annual report is by
far the most important, containing basic financial statements as well as management’s
opinion of the past year’s operations and the firm’s future prospects. What would managers
and investors want to know about a company at the end of the fiscal year? Following are
four basic questions that managers or investors are likely to ask:
• What is the company’s financial position at the end of the fiscal period?
•How well did the company operate during the fiscal period?
• On what did the company decide to use its profits?
•How much cash did the company generate and spend during the fiscal period?
As illustrated in Figure 2.2, the answer to each of these questions is provided by one of
the following financial statements: the balance sheet statement, the income statement, the
statement of retained earnings, and the cash flow statement. The fiscal year (or operating
Beginning of fiscal period (January 1, 2006)
How much profit did the
company make during the
fiscal period?
Income Statement
What did the company
decide to use their
profit for?
Statement of
Retained Earnings
How much cash did the
company generate and
spend during the period?
Statement of
Cash Flows
What is the company’s
financial position at
the end of fiscal period?
Balance Sheet
End of fiscal period (December 31, 2006)
Figure 2.2
Information reported on the financial
statements.
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