Financial Analysis with Microsoft Excel

Timothy R. Mayes and Todd M. Shank Published by Dryden Press ISBN: 9 780030 155024 Reviewed by Marjory Forbes and Brian R Doughty Department of Finance and Accounting Glasgow Caledonian University Introduction The purpose of the book is to integrate financial management and Excel spreadsheet techniques by encouraging student thinking rather than providing pre-built templates. The Preface provides background to the use of spreadsheets in the business world. The text is written for Excel 7.0. No difficulties were encountered when testing with this with Excel 5. This is intended to be a supplementary not a primary text and is similar to an Introductory Financial Management textbook. However, the authors see the depth of the book on the financial management side as providing potential for use as a primary text. Emphasis is placed on the self-teaching approach and concentration on the interpretation of results. Particular mention is given to statistics and management science tools in this respect, and it is assumed that students will have familiarity of basic accounting and statistics. The chapters are progressive in terms of financial management content, and contain objectives and summaries. The authors anticipate that more interest can be generated from using this book with its self-teaching/self-paced approach than from a traditional lecture. This is especially true in the case of non-finance students. The intended audiences are students on first year undergraduate financial management courses, first year MBA courses, or any course which is case-oriented with extensive use of spreadsheets The book begins by introducing spreadsheet basics and moves on through Basic Financial Statements, Cash Budgets to Capital Budgeting and its attendant risks. Each chapter is preceded by a list of learning objectives with a summary of the major Excel functions being discussed at the end of each. Spreadsheet Basics including mathematical operators and order of precedence are covered in Chapter 1. The techniques used to Format Charts are possibly “too heavy” for Spreadsheet Basics but nevertheless, the principles explained are common to many facilities in charting. Unfortunately, the instructions leave the reader with a chart dissimilar to the exhibit, in terms of formatting, and without direction as to how to change it.

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The reader will have spent much time in developing the worksheet before instructions on saving are given. These should have been placed much earlier in the text to provide the reader with the opportunity of saving his/her work and coming back to it a later time. Conclusion on the Basics There are many good examples in this chapter which are spoilt by a few inconsistencies and incomplete instructions. The authors claim that “Programming requires the student to ... confront many issues...” and that “...the book concentrates on spreadsheet building skills ... to think and understand”. It is believed that some of these confrontations at this basic stage will unnerve many students who will be unsure of what to do next particularly when the instructions do not quite lead them where they expect to be. The chapter would be good value in a supervised class with the tutor overriding these problem areas. The contents of the later chapters are summarised below. Beyond the Basics The Basic Financial Statements, Income Statement, Balance Sheet and Cash Flow Statement using Exhibits as references are built. This requires students to produce an Income Statement, Balance Sheet and Cash Flow statement. The chapter is well written introducing students to the essentials of these reports. However it does not address the issues of terminology. For example, the Income Statement can commonly be referred to as the Profit and Loss Account, Accounts Payable as creditors and Accounts receivable as debtors. No definition of these terms is given, regardless. Fiscal Year may also be termed Tax Year. There is an assumption that students have a familiarity with these concepts and others e.g. depreciation methods, breakdown of cost of goods sold. The Cash Budget The cash budget is described and its use in the planning of short-term borrowings and timing of expenditures is emphasised. The example used is well stated with the exception that the opening balance is not given as an assumption at the start and is only “discovered” in the course of completing the chapter. The problems associated with determining the short-term borrowing are addressed and consideration is given to using the cash budget for timing large expenditures. The chapter develops to cover adding of interest and investment of excess cash, and the calculations for cumulative investing/borrowing and cumulative interest income/expense are explained adequately. The student is not told to adjust the formula for unadjusted cash balance and ending cash balance to reflect the effects of short-term interest income/(exp.) and Current Investing. It is most unlikely that novices would be able to resolve this difference on

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their own, making a self-teaching approach difficult. Integration could be better in this section too. The problem associated with determining the short-term borrowing is addressed and the spreadsheet solution of using a logical test (IF statement) to calculate this is introduced. The description of this statement would probably need some further explanation and it is likely that only the better students will grasp this immediately. The chapter on Evaluating Performance with Financial Ratios explains the purpose of ratios and who would use them. The categories covered are liquidity, efficiency, leverage, coverage and profitability ratios. Examples are based on the workbook created for Chapter 2, Basic Financial Statements. The contents in this chapter are well presented and the explanations and examples are appropriate. The last section interprets the various ratios to give a company profile. This involves trend analyses and comparison with industry averages. It stresses that no ratio can be taken in isolation and that the whole topic is very subjective. A useful ratio formula summary is given at the end of the chapter. As far as the Excel implementation is concerned, this is a well presented chapter although inconsistency between text and illustration again prevailed. Care with the instructions is also necessary. Financial Forecasting Again, progression and integration is achieved by use of the workbook created for Chapter 2, Basic Financial Statements. The Percent of Sales Method is used for forecasting of the income statement, forecasting assets on the balance sheet and forecasting liabilities on the balance sheet. When forecasting liabilities, current liabilities, long-term liabilities and owner’s equity are reviewed. Spontaneous sources of financing and discretionary sources of financing are then introduced. After the forecasting example the balance sheet does not square and this is used to indicate to the student the need for discretionary financing. Other forecasting techniques covered are the Trend function, regression analysis and an assessment of risk by calculating a firm’s beta coefficient using regression analysis. This section on Linear Trend Extrapolation uses Excel to determine a sales forecast based on certain mathematical procedures. Students are asked to enter historic data to a new sheet and then prepare an XY chart. The resulting chart gives rise to a need to determine a linear trend. The Excel function TREND is used to do this. The student is then taken through the stages of using Excel to insert the trendline on the chart, including displaying the straight line equation which Excel generates!

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Regression Analysit is handled without any mathematical exposition. Using a file supplied by the authors, the student can, with care, create a scatter plot using the chart wizard. A few anomalies were encountered. The student is invited to enter the regression line on the chart. Break-even and Leverage Analysis This chapter considers decisions that managers make regarding the cost structure of the firm which in turn impact on methods of financing the firm and pricing the firm’s products. Variable and fixed costs are introduced and are presented graphically. Break-even point is defined specifically as the unit sales required for earnings before interest and taxes to be equal to zero i.e. operating break-even point. A simple example is given in which the contribution margin per unit and percentage is introduced. The example lends itself to “what if” questions but this is not provided and would assist in emphasising interpretation skills. Other Break-even Points covered are the sales units required to earn a given level of income before interest and tax, but is not really a break-even point. A cash break-even point is also calculated by eliminating any non-cash expenses from the fixed costs, notably depreciation. Nothing is required in Excel at this stage but some implementation might have enhanced integration. Under Leverage Analysis Business Risk and Financial Risk are defined before calculations are performed for the degree of operating leverage, the degree of financial leverage and the degree of combined (Total) leverage for Spuds and Suds, (i.e. not the original workbook). The Time Value of Money This looks at general formulas for future value and present value of a single amount, for annuities and the NPV and IRR for streams of uneven cash flows. The problem of nonannual compounding periods is mentioned. The inverse nature of the relationship between FV and PV is stated. There is a good manual example of annuities and the distinction between regular and deferred annuities is made. NPV is well covered. However, PVF or FVF components of formula are not highlighted and there is no mention of financial tables which students could use to check figures manually. Discounting, and opportunity costs are not explicitly defined. At times, the terms discount rate and interest rate are used interchangeably but this convention is not explained. In solving for ‘yield’ in uneven cash flow streams, an illustration of manual calculation would prove useful. The theoretical weaknesses of IRR are inadequately covered, but is elaborated on in the Chapter on Capital Budgeting.

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The section on non-annual compounding periods is short on manual examples and answers to calculations are not given for students to receive feedback on their understanding.

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Valuation and Rates of Return The concepts of value, risk-return trade-off and CAPM, share valuation and bond valuation are dealt with and in general the chapter explains the material very well. However, definitions are lacking at times e.g. time to maturity, beta, principal, par value. Value Line is not explained. With respect to share valuation, it is not totally clear which formulas are the Constant Growth Model and which are the Gordon Model. However, manual examples of the Gordon Model are very clear. There is a good discussion on how to convert terms from annual to semi-annual for bond valuation. Self-teaching for this chapter may prove difficult due to the challenging nature of the topic. Once again, problems exist which have occurred in earlier chapters and are largely avoidable - such as incorrect range details, no use of function wizard and incomplete instructions. The Cost of Capital section includes hurdle rates, WACC and its components, marginal WACC and flotation costs. This chapter is well covered, and uses a new set of examples. Capital Budgeting This chapter covers payback, discounted payback, NPV, PI, IRR and MIRR along with sensitivity analysis and producing an optimal capital budget. Overall, this chapter covers the theory well, using Supreme Shoe Company as the illustration. Under NPV, it is stated that all positive NPV projects must be accepted, which is correct if there is no capital rationing, but this assumption is not stated at this point in the text. Risk, Capital Budgeting and Diversification This the final chapter and uses a new set of data viz. the Freshly Frozen Fish company. Statistical concepts are reviewed e.g. continuous and discrete probability distributions, expected values, variance/standard deviation and risk-adjusted discount rates, portfolio risk, return and diversification. The chapter focuses on populations where the distribution is discrete and known, but alternatives for samples where probability distribution are unknown are referred to. Complex theory and formulas are presented well. Certainty equivalence is reviewed, and Decision Trees and Monte Carlo Simulation are covered although not requiring Excel work. Again, it is assumed students know the basics and some areas could provide more explanation e.g. Finding the NPV form Decision Trees, and definitions e.g. utility function, diversification (it is defined, but at the end of the chapter). In the Excel models some assumptions/explanations regarding formula would help. Having said that, in places, the Excel instructions might help some students understand the finance theory more easily.

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Conclusions on FAME Financial Management coverage was comprehensive and progression was achieved. The extent of interpretation was appropriate. Overall the integration of financial management concepts with Excel skills worked well. The book is appropriate for its intended audience. However, if the audience includes non-finance students but with the assumption that these students will have a basic knowledge of accounting and statistics, then these students may need greater assistance when working through the book. On occasion, American terms are used without footnotes to provide English equivalents. Footnotes could also have been used for definitions or references which are assumed to be known by the student. Some chapters do take two to three hours to complete and any course would need to allow time for this when integrating the book into an existing programme. It is recommended that the book it is suitable as a supplementary text, with tutor support, as students may have difficulties using it as a primary text on a self-taught basis. Marjory Forbes and Brian R Doughty Department of Finance and Accounting Glasgow Caledonian University

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