The portable MBA in finance and accounting 4e by theodore grossman

Table of Contents
Title Page
Copyright Page
List of Downloadable Materials
Syllabus
Preface
Acknowledgements
About the Contributors

Part I - Financial Accounting
Chapter 1 - Understanding Financial Statements
What Are Financial Statements? A Case Study
Points to Remember about Financial Statements
Financial Statements: Who Uses Them and Why
Financial Statement Format
Guide to SEC Filings
The Notes to the Financial Statements
Financial Accounting Standards
From GAAP to IFRS
Summary and Conclusions
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
Internet Links
For Further Reading
Chapter 2 - Analyzing Financial Statements
How to Analyze Financial Statements
Using Financial Ratios
Combining Financial Ratios
The Z-Score
Summary and Conclusions
Downloadable Resources for this chapter available at

www.wiley.com/go/portablembainfinance
Internet Links
Notes
For Further Reading
Chapter 3 - Analyzing Business Earnings
The Nature of Nonrecurring Items
The Process of Identifying Nonrecurring Items
Nonrecurring Items in the Income Statement
Nonrecurring Items in the Statement of Cash Flows


Interpreting Information in the Operating Activities Section
Nonrecurring Items in the Inventory Disclosures of LIFO Firms
Nonrecurring Items in the Income Tax Note
Nonrecurring Items in the Other Income and Expense Note
Nonrecurring Items in Management‟s Discussion and Analysis (MD&A)
Nonrecurring Items in Other Selected Notes
Earnings Analysis and Other Comprehensive Income
Summarizing Nonrecurring Items and Determining Sustainable Earnings
Role of the Sustainable Earnings Base
Application of the Sustainable Earnings Base Worksheet: Pfizer, Inc.
The Pfizer Worksheet Analysis: Downloadable Tool 3.38
Summary
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
Internet Links
Annual Reports Referenced in the Chapter
Notes
For Further Reading

Part II - Financial Management
Chapter 4 - Discounted Cash Flow
Time Value of Money
Future Value
Present Value
Annuities
Amortized Loans
Summary
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
For Further Reading
Chapter 5 - Capital Structure
Risk and Return
Portfolio Risk
Capital Asset Pricing Model
Cost of Capital
Cost of Debt and Equity Capital
Weight of Debt and Equity Capital
Capital Structure Theory
Capital Structure in Practice
Bond Valuation
Equity Valuation
Conclusion
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
Online Content
Note


Chapter 6 - Planning Capital Expenditure

The Objective: Maximize Wealth
Computing NPV: Projecting Cash Flows
Initial Cash Outflow
Cash Flows in Later Years
Treatment of Net Working Capital
Depreciation
Windfall Profit and Windfall Tax
Taxable Income and Income Tax
Interest Expense
Putting the Pieces Together to Forecast Cash Flow
Guiding Principles for Forecasting Cash Flows
Computing NPV: The Time Value of Money
Discounting Cash Flows
Summing the Discounted Cash Flows to Arrive at NPV
Outsourcing and the Build/Buy Decision
The Discount Rate
Weighted Average Cost of Capital
The Effects of Leverage
Divisional versus Firm Cost of Capital
Other Decision Rules
Internal Rate of Return
Innovations in Capital Budgeting
Summary and Conclusions
Note
For Further Reading
Chapter 7 - Global Finance
Currency Exchange Rates: A Case of Individual Investing
Currency Exchange Rates: A Case in China with Country Risk
Local Partner: Robinson Investment Case
Unknown Rental Cars Borrowing Case: January 1, 1985

Theory: Interest Rate Parity
Theory: Purchasing Power Parity
Futures and Options
Summary
For Further Reading

Part III - Business Entities
Chapter 8 - Choosing a Business Form
The Consulting Firm
The Software Entrepreneur
The Hotel Venture
The Purpose of This Chapter
Business Forms
Comparison Factors


Formation of Sole Proprietorships
Formation of Partnerships
Formation of Corporations
Formation of Limited Partnerships
Formation of Limited Liability Companies
Out-of-State Operation of Sole Proprietorships and Partnerships
Out-of-State Operation of Corporations, Limited Partnerships, and Limited ...
Recognition of Sole Proprietorships as Legal Entities
Recognition of Partnerships as Legal Entities
Recognition of Corporations and Limited Liability Companies as Legal Entities
Recognition of Limited Partnerships as Legal Entities
Continuity of Life
Transferability of Interest
Control

Liability
Taxation
Choice of Entity
Conclusion
Problems
For Further Reading
Chapter 9 - Taxes and Business Decisions
The Business
Unreasonable Compensation
Making the Subchapter S Election
Acquisition
Executive Compensation
Sharing the Equity
Vacation Home
Like-Kind Exchanges
Dividends
Estate Planning
Spin-Offs and Split-Ups
Sale of the Corporation
Conclusion
Problems
For Further Reading
Chapter 10 - The Integrity of Financial Reporting
Introduction
Restatements of Previously Published Financial Statements
Asleep at the Switch
The Remedies
It‟s Not Just the Private Sector
Summary and Conclusions
Downloadable Resources for this chapter available at

www.wiley.com/go/portablembainfinance
Notes


For Further Reading

Part IV - Management Accounting
Chapter 11 - Forecasts and Budgeting
The Concept of Budgeting
Functions of Budgeting
Reasons for Budgeting
Effective Budgeting
Developing a Budget
Forecasting
Fixed Budgets versus Flexible Budgets
The Profit Plan
The Budget Review Process
Recent Trends
Internet Link
Note
For Further Reading
Chapter 12 - Cost Structure Analysis, Profit Planning, and Value Creation
Estimating Cost Structure from Publicly Available Information
Pitfalls
Profit Planning from an Internal Perspective
Pricing in CVP Analysis
Predatory Pricing
Dumping
Notes
Chapter 13 - Activity-Based Costing

Basics of Activity-Based Systems
Reflections
What an ABC Systems Is and Is Not
Lessons from Japan
Summary
Notes

Part V - Planning and Strategy
Chapter 14 - Business Planning
How This Chapter Fits in a Typical MBA Curriculum
Who Uses This Material in the Real World
The Story of Your Business
Types of Plans
From Glimmer to Action: The Process
The Story Model


The Business Plan
Conclusion
Other Resources
Internet Links
Notes
For Further Reading
Chapter 15 - Financial Management of Risks
What Went Wrong: Case Studies of Derivatives Debacles
Size of the Derivatives Market and Widespread Use
The Instruments
How to Choose the Appropriate Hedge
Summary and Final Recommendations
Notes

For Further Reading
Chapter 16 - Business Valuation
Three Approaches to Value
Different Types of Buyers
An Overview of the Business Valuation Process
The Fundamental Position of the Firm
Financial Statement Analysis
Ratio Analysis
Comparison to Industry Averages
Valuation Methods
Debt-Free Analysis
Cost of Capital
Adjustments to Earnings for Valuation Purposes
Income Approach: Discounted Cash Flow Method
Discount Rate for the Valuation Model
Market Approach: Publicly Traded Guideline Companies Method
Reconciliation of Valuation Methods
Adjustment for Illiquidity
Valuation Conclusion for Acme
Valuing Minority Interests
Business Valuation Standards
Value Engineering
Summary
Notes
For Further Reading
Chapter 17 - Profitable Growth by Acquisition
Definitions and Background
Recent Trends and the Performance Record of Mergers and Acquisitions
Anatomy of a Successful Acquirer: The Case of Cisco Systems Inc.
Creating Value in Mergers and Acquisitions

Some Practical Considerations


Successful Postmerger Implementation
Summary and Conclusions
Notes
References
Chapter 18 - Outsourcing
Motivation to Outsource
Domestic versus Offshore Outsourcing
Issues with Using Offshore Providers
Risks and Challenges of Outsourcing
Determining Success
Outsourcing a Process or a Project
Summary
Internet Links
Notes
For Further Reading

Part VI - Advanced Topics
Chapter 19 - Information Technology and You
Introduction
Hardware
Software
Networking
Data
The Future—Today, Tomorrow, and Next Week
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
Note

For Further Reading
Chapter 20 - Information Technology and the Firm
Historical Perspective
Information Systems
Organizational Productivity
Managing IT Resources
Information Technology Strategy
Conclusion
Downloadable Resources for this chapter available at
www.wiley.com/go/portablembainfinance
Internet Links
Note
For Further Reading
Chapter 21 - Careers in Finance
Overview: What Is the Marketplace for MBAs?


Career Opportunities in Finance
Your Career Plan/Your End Game
Aiming for Your Goals
Implementing Your Strategy
Networking
Assessing Opportunities
Closing Thoughts: Coping with the Challenges
Notes
Glossary
Index

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eISBN : 978-0-470-52631-6


List of Downloadable Materials
For access to the following list of downloadable materials for The Portable MBA in Finance and
Accounting, Fourth edition, please visit www.wiley.com/go/portablembainfinance
Understanding Financial Statements Balance Sheet: Liabilities + Equity
Analyzing Financial Statements: Direct Competitor Comparison Worksheet
Analyzing Financial Statements: Financial Statement Ratio Analysis

Adjustment Worksheet for Sustainable Earnings Base
Adjustment Worksheet for Sustainable Earnings Base, Pfizer, Inc.
Discounted Cash Flow: Using Excel to Solve Financial Formulas
Discounted Cash Flow Web
Capital Structure Problems and Solutions
The Integrity of Financial Accounting: Sarbanes-Oxley and Fraudulent Financial Reporting
Information about the Sarbanes-Oxley Act and Corporate Governance and Financial Reporting
Ethics and the Golden Rule
Information Technology and You
Information Technology and the Firm


Syllabus
How Chapter Topics in This Book Track the Core MBA Curriculum
If one were to review the core curriculum for first-year students offered by most of the major MBA
programs, one would find, in one form or another, the following courses:
• Financial Accounting
• Management Accounting
• Financial Management
• Business Law and Business Entities
• Planning and Strategy
• Information Systems
• Operations Management
• Decision Support or Management Sciences
• Marketing
• Managerial Economics
• Organizational Behavior
• Entrepreneurial Thinking
Of course this varies from school to school; however, the vast majority follow this pattern, including
Harvard University, the University of Michigan, Babson College, Stanford University, Columbia

University, and many others.
While this book makes no attempt to cover the entire core curriculum, it does cover most, if not all,
of the accounting and finance topics, as well as several others. The following table compares the
chapter topics with the typical courses that would be in an MBA program.


Preface
Since the third edition of this book was published in late 2001, much has happened to reshape the
business world as we now know it. Our financial system almost collapsed. Stalwarts like Lehman
Brothers and Merrill Lynch ceased to exist because they had assumed huge risk in financial
instruments that were vastly overvalued. The mortgage market collapsed and along with it went a host
of financial companies and banks that had invested in subprime mortgage-backed securities. Bernie
Madoff went from obscurity to become a household name after allegedly bilking investors out of
approximately $50 billion in the largest-ever Ponzi scheme. The stock market lost 35% of its value.
Personal 401(k) retirement accounts were devastated, and people had to rethink their retirement plans.
Companies planning to use their stock to finance the purchase of acquisitions found that the value of
their stock had plunged. Credit became tight and financing difficult.
As a result of the Enron scandal, corporate governance has become a hot topic, with potential
liability for CEOs and CFOs and with much increased and highly expensive and cumbersome added
requirements for internal control imposed by the 2002 Sarbanes-Oxley Act.
All of these issues have created a new financial world that requires special skills for a manager to
succeed. Do you have those skill sets?
Do you know how to accomplish these important business tasks?
• Understand financial statements.
• Measure liquidity of a business.
• Analyze business profitability.
• Differentiate between regular income and extraordinary items.
• Predict future bankruptcy for an enterprise.
• Prepare a budget.
• Do a break-even analysis.

• Figure out return on investment.
• Compute the cost of capital.
• Put together a business plan.
• Legitimately minimize income taxes payable by you or your business.
• Decide what your obligations are as an officer or director of the company.
• Determine the implications of outsourcing a product, a function, or a project either
domestically or internationally.
• Manage foreign currency exposure.
• Evaluate a merger or acquisition target.
• Serve as a director of a corporation.
• Build a successful e-business.
• Understand and use financial derivatives.
• Use information technology for competitive advantage.
• Value a business.
These are some of the key topics explained in this book. It is a book designed to help you learn the
basics in finance and accounting, without incurring the considerable time and expense of a formal
MBA program. The book consists of valuable, practical how-to information, applicable to an entire
range of businesses, from the smallest start-up to the largest corporations in the world. Each chapter of
the book has been written by an outstanding expert in the subject matter of that particular chapter.


Some of these experts are full-time practitioners in the real world, and others are business school
professors with substantial real-world experience who also serve as part-time management
consultants. Most of these professors are on the faculty of Babson College, which is famous for its
major contributions to the field of entrepreneurship, and which year after year is at the top of the
annual list of leading independent business schools compiled by U.S. News & World Report and the
University of Maryland‟s University College, a leading Internet university with 100,000 students,
including 3,000 MBA students.
The first edition of this book was published in 1992, the second edition in 1997, and the third in
2001. All of the editions, hardback and paperback, have been highly successful, and have sold many,

many copies. In addition, the book has been translated into Chinese (Cantonese and Mandarin),
Indonesian, Portuguese, Russian, and Spanish. We are delighted that so many readers in various
countries have found this book useful. Now, the entire book has been updated for the fourth edition.
New chapters have been added on the following subjects:
• Discounted Cash Flow.
• Analyzing Financial Statements.
• Capital Structure.
• The Integrity of Financial Reporting.
• Outsourcing.
• Careers in Finance.
Also, there are six new authors, substantial revisions of several chapters, and complete updates of
the remaining chapters.
Some of the chapters include additional online materials that will reinforce the materials contained
in the chapters. Please go to www.wiley.com/go/portablembainfinance.com to access the online
materials that are designated for this book.
This book can be read, and reread, with a great deal of profit. Also, it can be kept handy on a nearby
shelf so you can pull it down and look up answers to questions as they occur. Further, this book will
help you to work with finance and accounting professionals on their own turf and in their own jargon.
You will know what questions to ask, and you will better understand the answers you receive, without
being confused or intimidated.
Who can benefit from this book? Many different people, such as:
• Managers wishing to improve their business skills.
• Engineers, attorneys, chemists, scientists, and other technical specialists preparing to take
on increased management responsibilities.
• People already operating their own businesses, or thinking of doing so.
• Businesspeople in nonfinancial positions who want to be better versed in financial matters.
• BBA or MBA alumni who want a refresher in finance and accounting.
• People in many walks of life who need to understand more about financial matters.
Whether you are in one, some, or even none of these categories, you will find much of value in this
book, and the book is reader-friendly. Frankly, most finance and accounting books are technically

complex, boringly detailed, or just plain dull. This book emphasizes clarity to nonfinancial readers,
using many helpful examples and a bright, interesting style of writing. Learn, and enjoy!

THEODORE GROSSMAN JOHN LESLIE LIVINGSTONE


Acknowledgments
A book like this can result only from the contributions of many talented people. We would like to
thank the chapter authors who make up this book for their clear and informative explanations of the
powerful concepts and tools of finance and accounting. These people dedicate their lives to educating
others in the complexities of their disciplines. In this ever-changing world of technology, strategy,
economic cycles, geopolitical events, and the Internet, while most of the underlying concepts remain
fixed, the applications are ever changing, requiring the authors to constantly rededicate themselves to
their professions. We thank our editor, Michael Grossman, for his reviewing of the materials from the
perspective of an MBA student.
We dedicate this book to our wives, Ruthie Grossman and Trudy Livingstone, and to our children
and grandchildren. They provide the daily inspiration to diligently perform our work and to have
undertaken this project.
T. G.
J. L. L.


About the Contributors
Richard T. Bliss has been involved in corporate financial analysis since 1987 and is currently on the
finance faculty at Babson College. He teaches at the undergraduate, MBA, and executive levels,
specializing in the areas of corporate financial strategy and entrepreneurial finance. Prior to coming to
Babson, Dr. Bliss was on the faculty at Indiana University, and he has also taught extensively in
Central and Eastern Europe, including at the Warsaw School of Economics, Warsaw University, and
the University of Ljubljana in Slovenia.
With publications in the areas of corporate finance, emerging markets, entrepreneurship, and

banking, Dr. Bliss has an active research agenda. His work on the impact of bank mergers on CEO
compensation has been cited in Fortune magazine and numerous other business publications and was
published in the Journal of Financial Economics.
Dr. Bliss holds a PhD in finance from Indiana University. He also received his MBA in finance/real
estate from Indiana University and graduated with honors from Rutgers University, earning a BS
degree in engineering and a BA degree in economics.
Ralph J. Constantino is associate director of the MBA Center for Career Development, F.W. Olin
Graduate School of Business, Babson College. He has had over 30 years of senior-level professional
experience in the financial services industry. Prior to joining Babson, he served as the managing
director for strategic marketing and product development for State Street Global Advisors, where he
drove international initiatives in Hong Kong and Australia and played a leading role in the formation
of CitiStreet LLC, a joint venture between State Street and CitiCorp. He was also the senior vice
president and chief investment officer for the Schoolhouse Capital business unit that built solutions for
the 529 college savings marketplace. Before his tenure at State Street Corporation, he held senior-level
positions with the Abu Dhabi Investment Authority, Chase Consulting Group, Mercer Meidenger
Hanson, Equitable Capital Management Company, Smilen and Safian, and Citibank. Aside from his
corporate experience, Mr. Constantino has also served as a member of the adjunct faculty at New
York University, Loyola University, the American Institute of Banking, and Bentley University. He is
also a featured speaker at professional conferences in the United States, Europe, and Asia. He has also
appeared on the Nightly Business Report and major print media. He holds a BS degree in economics
and business administration from Wagner College as well as a master‟s degree in economics from
Rutgers University.
Michael A. Crain, CPA/ABV, CFA, ASA, CFE, MBA, is a practitioner specializing mostly in
business valuation and forensic accounting in Fort Lauderdale, Florida. He holds several certifications
related to valuation: Chartered Financial Analyst awarded by the CFA Institute, Accredited Senior
Appraiser in business valuation from the American Society of Appraisers, and Accredited in Business
Valuation awarded by the American Institute of Certified Public Accountants (AICPA). Mr. Crain is a
past chairman of the AICPA business valuation committee, and he has been a member of the
committee that develops the examination given to CPAs who seek the AICPA‟s certification in
business valuation. He teaches a business valuation course at Florida Atlantic University. Mr. Crain

has received several awards, including the AICPA Journal of Accountancy Lawler Award for best
article of the year, and has been inducted into the AICPA business valuation hall of fame. His articles
have been published in practitioner journals, and he has spoken to national audiences. He is currently
working on doctorate research at the Manchester Business School, University of Manchester, England.


Dawna Travis Dewire is a member of the full-time faculty at Babson College in Massachusetts. She
teaches courses in information systems design, database development, and process reengineering. Ms.
Dewire is the author of five books and has been the editor of The James Martin Report, the Year 2000
Practitioner, and the quarterly Journal of Information Systems Management. Prior to joining Babson
College, she was on the full-time faculty at Bentley College. Ms. Dewire‟s professional experience
includes positions with Information Resources, Inc., TRW United-Carr Division, Blue Cross/Blue
Shield, and the State of New York. Ms. Dewire holds a BS in mathematics and an MS in computer
science from the University at Albany-State University of New York and an MBA from Northeastern
University.
James A. Elfter currently resides in East Seaham, a suburb of Newcastle, New South Wales,
Australia. Jim has an MBA from the University of Maryland University College and an undergraduate
degree from Governors State University in Illinois. Since 2006, he has been working for the
University of Maryland‟s Graduate School of Management and Technology as a graduate faculty
assistant. Jim retired from General Motors after more than 30 years of service in various managerial
capacities and international assignments. He has lived and worked in Greece, Egypt, Yugoslavia,
Brazil, Canada, and Australia, where he is enjoying semiretirement.
Steven P. Feinstein is an associate professor of finance at Babson College. He has earned a PhD in
economics from Yale University and a BA degree in economics from Pomona College, and he also
holds the Chartered Financial Analyst (CFA) designation. His research and teaching specialties are in
the fields of investments and capital markets. In addition to his teaching and research, Professor
Feinstein provides consulting services and expert testimony on a variety of financial topics, most
frequently securities litigation. Past and present clients include the United States Securities and
Exchange Commission, the National Association of Securities Dealers, the Internal Revenue Service,
the attorney general of the State of Illinois, State Street Bank, and numerous law firms.

Theodore Grossman is a member of the faculty of Babson College, where he teaches information
technology and accounting. He lectures on various information technology topics such as Web
technologies, e-commerce, strategic information systems, managing information technology, and
systems analysis and design. He also performs extensive consulting for food and nonfood retailers and
suppliers of technology products to the retail industry. He is called on frequently to act as an expert
witness in complex litigation in matters relating to technology and cyber law. Prior to joining Babson
College, he was the founder and CEO of a computer software company for the retail industry. He
holds a BS degree in engineering from the University of New Hampshire and an MS in management
from Northeastern University. Mr. Grossman was a contributor to the second edition of this book and
is an editor of both the third and fourth editions.
Robert F. Halsey has a BA, MBA, and PhD from the University of Wisconsin-Madison. During his
business career, Dr. Halsey managed the commercial lending division of a large Midwestern bank and
served as the chief financial officer of a privately held retailing and manufacturing company. Prior to
joining the faculty of Babson College, he taught at the University of Wisconsin-Madison, where he
received the Douglas Clarke Memorial teaching award. His teaching and research interests are in the
area of financial reporting and include firm valuation, financial statement analysis, and disclosure
issues. Dr. Halsey is the author of Advanced Financial Accounting (forthcoming in 2009 by
Cambridge Business Publishers) and a co-author of Financial Accounting for MBAs, third edition
(Cambridge Business Publishers), MBA Financial & Managerial Accounting (Cambridge Business
Publishers), and Financial Statement Analysis, ninth edition (McGraw-Hill). He has published in


Advances in Quantitative Analysis of Finance and Accounting, the Journal of the American Taxation
Association, and Issues in Accounting Education.
William C. Lawler is the leadership professor, strategy and accounting, F.W. Olin Graduate School
of Business, Babson College. He is also the director of the Consortium for Executive Development at
Babson Executive Education. His teaching and research focus on two areas: financial footprints of
business unit strategy and the impact of new technologies on cost systems design. Dr. Lawler has
written several papers and given numerous professional presentations. His primary focus is on aiding
operational managers in understanding the financial consequences of their decisions. He has run

seminars on this topic for such diverse groups as telecom managers in China, production managers in
the Czech Republic, and R&D managers in the United States. Dr. Lawler consults with a number of
companies, ranging from small biotechs to Fortune 100 technology companies, concerning the design
and use of cost information systems for management decision support rather than external financial
reporting. His most recent publications in this area are a chapter, “Understanding the Financial
Footprint of Strategy,” in Strategy, Innovation, and Change (Oxford University Press, 2008), and
chapters on activity-based costing and profit planning in the fourth edition of The Portable MBA in
Finance and Accounting.
Les Livingstone is the MBA Program Director in Economics, Finance and Accounting at the
University of Maryland University College, a leading Internet university with 100,000 students,
including 3,000 MBA students. ( He earned MBA and PhD
degrees at Stanford University and is a CPA (licensed in New York and Texas). Since 1991 he has
directed his own consulting firm, specializing in damage estimation for large-scale commercial
litigation and in business valuation. He has served as a consulting or testifying expert in many cases,
and has testified in federal and state courts in Arizona, California, Florida, Georgia, Illinois,
Massachusetts, New York, Rhode Island, and Texas. He has also testified before federal government
agencies, including the Federal Trade Commission (FTC) Federal Energy Regulatory Commission
(FERC), as well as the Public Utilities Commission of Texas. Web site .
Richard P. Mandel is associate dean of the Undergraduate School and associate professor of law at
Babson College, where he teaches a variety of courses in business law and taxation on the
undergraduate, graduate, and executive education levels and has served as chair of the finance division
and acting dean of the Undergraduate School. He is also of counsel to the law firm of Bowditch and
Dewey, of Worcester, Framingham, and Boston, Massachusetts, where he specializes in the
representation of growing businesses and their executives. Mr. Mandel has written a number of
articles regarding legal issues encountered by small businesses. He holds an AB in government and
meteorology from Cornell University and a JD from Harvard Law School.
Tracee Petrillo is director, MBA Center for Career Development, and assistant dean, F. W. Olin
Graduate School of Business, Babson College. She has over 15 years of corporate and higher
education experience. Prior to receiving her MBA at Babson in 2000, she had been in operations
management, business development, and corporate sales in the hospitality industry working for

organizations such as Disney, Doubletree, and Sheraton. After her Babson MBA, she worked at Keane
Consulting Group as an operations consultant. She returned to Babson as program manager of the twoyear MBA program in 2003. Subsequently she became the director of the office of program
management before becoming assistant dean of the graduate school. During this time, she led the
transition of the experiential learning function to the graduate school leading the corporate business
development program for the experiential learning programs, and implemented new processes for both
programs. In addition to her Babson MBA, she holds a BA degree from Union College. She is


proficient in Spanish and German, and has traveled extensively, including time living abroad in both
Germany and Spain. In Madrid, she studied at Sampere Language School.
Michael J. Riley is a professor at the University of Maryland University College, teaching MBAs. He
is a board member of Church Mutual Insurance Company and chairs the audit committee of the
Architect of the Capitol, an agency of the U.S. Congress. Previously, Dr. Riley earned his doctorate of
business administration from Harvard University (1977), his MBA from the University of Southern
California (1972), and his BS from the United States Naval Academy (1965). Dr. Riley has served as
CFO of the United States Postal Service, CFO of Lee Enterprises, CFO of United Airlines, and
treasurer of Michigan Bell Telephone Company. During his tenure, the Postal Service posted the
largest increase in profits of any organization in the world (1995) and remained consistently profitable
during the remainder of his service. He has consulted with companies, government agencies, and a
major union. He has taught at Harvard University, Boston University, the University of Connecticut,
the University of Michigan, and George Mason University. His articles have appeared in major
magazines and newspapers, including the Wall Street Journal. Dr. Riley began his career as a Navy
pilot, earning the Air Medal for service in Vietnam.
Virginia Earll Soybel teaches financial accounting and financial statement analysis in both the
graduate and undergraduate programs at Babson College. She earned her MBA and PhD at Columbia
University and taught at the Amos Tuck School of Business at Dartmouth College before coming to
Babson in 1995. Professor Soybel‟s research focuses on the effects of alternate reporting methods on
corporate financial statements and ratios, the time series behavior of financial ratios, and the political
process of accounting standard-setting. Her publications include articles in Strategic Management
Journal and in the Journal of Accounting and Public Policy.

Craig A. Stephenson has been a member of the faculty at Babson College since 1997. He has
experience in the CFO organizations of Phillips Petroleum, Texas Instruments, and Dell. He teaches in
the undergraduate, graduate, and executive education programs, and he specializes in corporate
finance and financial strategy. He has also been on the faculty at the University of Colorado, the
University of Wisconsin, and MIT‟s Sloan School of Management. Professor Stephenson received his
PhD from the University of Arizona, his MBA from the University of Texas, and his BS from the
University of Colorado. He is also the recipient of an honorary degree from the Babson College
graduating class of 2004, awarded to the undergraduate professor of the year. He is a member of the
Institute of Management Accountants, and is a certified management accountant.
Andrew Zacharakis is the John H. Muller Jr. chair in entrepreneurship and the director of the Babson
College Entrepreneurship Research Conference, the leading academic conference on entrepreneurship
worldwide. He previously served as chair of the entrepreneurship department at Babson College from
2003 to 2005 and as acting director of the Arthur M. Blank Center for Entrepreneurship at Babson
College from 2003 to 2004. In addition, Dr. Zacharakis was the president of the Academy of
Management, entrepreneurship division, an organization with 1,800 members, from 2004 to 2005. He
also served as an associate editor at the Journal of Small Business Management (2003-2006). His
primary research areas include the venture capital process and entrepreneurial growth strategies. Dr.
Zacharakis is the co-author of five books, The Portable MBA in Entrepreneurship, third edition;
Business Plans That Work; How to Raise Capital; Entrepreneurship, The Engine of Growth; and a
forthcoming textbook titled Entrepreneurship. The editors of Journal of Small Business Management
selected “Differing Perceptions of New Venture Failure” as the 1999 best article. His dissertation The
Venture Capital Investment Decision received the 1995 Certificate of Distinction from the Academy
of Management and Mr. Edgar F. Heizer, recognizing outstanding research in the field of new


enterprise development. Dr. Zacharakis has been interviewed in newspapers nationwide, including the
Boston Globe, the Wall Street Journal, and USA Today. He has also appeared on the Bloomberg Small
Business Report and been interviewed on National Public Radio. He has taught seminars to leading
corporations, such as Boeing, Met Life, Lucent, and Intel. He has also taught executives in countries
worldwide, including Spain, Chile, Costa Rica, Mexico, Australia, China, Turkey, and Germany. Dr.

Zacharakis received a BS (finance/marketing) from the University of Colorado, an MBA
(finance/international business) from Indiana University, and a PhD (strategy and
entrepreneurship/cognitive psychology) from the University of Colorado. Professor Zacharakis
actively consults with entrepreneurs and small business startups. His professional experience includes
positions with The Cambridge Companies (investment banking/venture capital), IBM, and Leisure
Technologies.


Part I
Financial Accounting
1
Understanding Financial Statements
Les Livingstone

What Are Financial Statements? A Case Study
Gail was applying for a bank loan to start her new business: Nutrimin, a retail store selling nutritional
supplements, vitamins, and herbal remedies. She described her concept to Hal, a loan officer at the
bank.
Hal: How much money will you need to get started?
Gail: I estimate $80,000 for the beginning inventory, plus $36,000 for store signs, shelves, fixtures,
counters, and cash registers, plus $24,000 working capital to cover operating expenses for about two
months. That‟s a total of $140,000 for the start-up.
Hal: How are you planning to finance the investment of $140,000 for the start-up?
Gail: I can put in $100,000 from my savings, and I‟d like to borrow the remaining $40,000 from the
bank.
Hal: Suppose the bank lends you $40,000 on a one-year note, at 15% interest, secured by a lien on the
inventory. Let‟s put together projected financial statements from the figures you gave me. Your
beginning balance sheet would look like what you see on the computer screen:
Nutrimin

The left side shows Nutrimin‟s investment in assets. It classifies the assets into “current” (which
means turning into cash in a year or less) and “noncurrent” (not turning into cash within a year). The
right side shows how the assets are to be financed: partly by the bank loan and partly by your equity as
the owner.
Gail: Now I see why it‟s called a “balance sheet.” The money invested in assets must equal the
financing available—it‟s like two sides of the same coin. Also, I see why the assets and liabilities are
classified as “current” and “noncurrent”—the bank wants to see if the assets turning into cash in a year
or less will provide enough cash to repay the one-year bank loan. Well, in a year there should be cash
of $104,000. That‟s enough cash to pay off more than twice the $40,000 amount of the loan. I guess
that guarantees approval of my loan!
Hal: We‟re not quite there yet. We need some more information. First, tell me: How much do you
expect your operating expenses will be?
Gail: For year 1, I estimate as follows:

Hal: We also have to consider depreciation on the store equipment. It probably has a useful life of 10
years. So each year it depreciates 10% of its cost of $36,000. That is $3,600 a year for depreciation. So
operating expenses must be increased by $3,600 a year from $96,400 to $100,000. Now, moving on,
how much do you think your sales will be this year?
Gail: I‟m confident that sales will be $720,000 or even a little better. The wholesale cost of the items
sold will be $480,000, giving a markup of $240,000—which is 33 % on the projected sales of
$720,000.
Hal: Excellent! Let‟s organize this information into a projected income statement. We start with the
sales, and then deduct the cost of the items sold to arrive at the gross profit. From the gross profit we
deduct your operating expenses, giving us the income before taxes. Finally we deduct the income tax
expense in order to get the famous “bottom line,” which is the net income. Here is the projected
income statement shown on my computer screen:
Nutrimin

Gail, this looks very good for your first year in a new business. Many business start-ups find it
difficult to earn income in their first year. They do well just to limit their losses and stay in business.
Of course, I‟ll need to carefully review all your sales and expense projections with you, in order to
make sure that they are realistic. But first, do you have any questions about the projected income
statement?
Gail: I understand the general idea. But what does “gross profit” mean?
Hal: It‟s the usual accounting term for sales less the amount that your suppliers charged you for the
goods that you sold to your customers. In other words, it represents your markup from the wholesale
cost you paid for goods to the price for which you sold those goods to your customers. It is called
“gross profit” because your operating expenses have to be deducted from it. In accounting, the word
gross means “before deductions.” For example, “gross sales” means sales before deducting goods
returned by customers. Sales after deducting goods returned by customers are referred to as “net
sales.” In accounting, the word net means “after deductions.” So, “gross profit” means income before
deducting operating expenses. By the same token, “net income” means income after deducting
operating expenses and income taxes. Now, moving along, we are ready to figure out your projected
balance sheet at the end of your first year in business. But first, I need to ask you: How much cash do
you plan to draw out of the business as your compensation?
Gail: My present job pays $76,000 a year. I‟d like to keep the same standard of compensation in my
new business this coming year.
Hal: Let‟s see how that works out after we‟ve completed the projected balance sheet at the end of year
1. Here it is on my computer screen:
Nutrimin


Gail, let‟s go over this balance sheet together. It has changed, compared to the balance sheet as of
January 1. On the “Liabilities and Equity” side of the balance sheet, the net income of $84,000 has
increased capital to $184,000 (because earning income adds to the owner‟s capital), and deducting
drawings of $76,000 has reduced capital to $108,000 (because drawings take capital out of the
business). On the “Assets” side, notice that the equipment now has a year of depreciation deducted,
which writes it down from the original $36,000 to a net (there‟s that word “net” again) $32,400 after

depreciation. The equipment had an expected useful life of 10 years, now reduced to a remaining life
of nine years. Last, but not least, notice that the cash has increased by only $11,600 from $24,000 at
the beginning of the year to $35,600 at year-end. This leads to a problem: The bank loan of $40,000 is
due for repayment on December 31. But there is only $35,600 of cash available on December 31. How
can the loan be paid off when there is not enough cash to do so?
Gail: I see the problem. But I think it‟s bigger than just paying off the loan. The business will also
need to keep about $25,000 cash on hand to cover two months‟ operating expenses and income taxes.
So, with $40,000 to repay the loan, plus $25,000 for operating expenses, the cash requirements add up
to $65,000. But there is only $35,600 cash on hand. This leaves a cash shortage of almost $30,000
($65,000 less $35,600). Do you think that will force me to cut down my drawings by $30,000, from
$76,000 to $46,000? Here I am, opening my own business, and it looks as if I have to go back to what
I was earning five years ago!
Hal: That‟s one way to do it. But here‟s another way that you might like better. After your suppliers
get to know you, and do business with you for a few months, you can ask them to open credit accounts
for Nutrimin. If you get the customary 30-day credit terms, then your suppliers will be financing one
month‟s inventory. That amounts to one-twelfth of your $480,000 annual cost of goods sold, or
$40,000. This $40,000 will more than cover the cash shortage of $30,000.
Gail: That‟s a perfect solution! Now, can we see how the balance sheet would look in this case?
Hal: Sure. When you pay off the bank loan, it vanishes from the balance sheet. It is replaced by
accounts payable of $40,000. Then the balance sheet looks like this:
Nutrimin


Now the cash position looks a lot better. But it hasn‟t been entirely solved: there is still a gap between
the accounts payable of $40,000 and the cash of $35,600. So, you will need to cut your drawings by
about $5,000 in year 1. But that‟s still much better than the cut of $30,000 that had seemed necessary
before. In year 2, the bank loan will be gone, so the interest expense of $6,000 will be saved. Then you
can use $5,000 of this savings to restore your drawings back up to $76,000 again.
Gail: That‟s good news. I‟m beginning to see how useful projected financial statements are for
business planning. Can we look at the revised projected balance sheet now?

Hal: Of course. Here it is:
Nutrimin

As we see, cash is increased by $5,000 to $40,600—which is sufficient to pay the accounts payable of
$40,000. Drawings are decreased by $5,000 to $71,000, which provided the $5,000 increase in cash.
Gail: Thanks. That makes sense. I really appreciate everything you‟ve taught me about financial
statements.
Hal: I‟m happy to help. But there is one more financial statement to discuss. A full set of financial
statements consists of more than the balance sheet and the income statement. It also includes a cash
flow statement. Here is the projected cash flow statement:
Nutrimin