SIMPLIFYING AND ENHANCING FINANCIAL ANALYSIS IN CASES AND SIMULATIONS Developments in Business Simulations and Experiential Learning, Volume 32, 2005 SIMPLIFYING AND ENHANCING FINANCIAL ANALYSIS IN CASES AND SIMULATIONS John Washbush University of Wisconsin-Whitewater washbusj@uww.edu ABSTRACT FUNDAMENTAL STATEMENTS BALANCE SHEET (STATEMENT OF FINANCIAL POSITION) In 20 years of teaching business policy courses and using total enterprise simulations, i have been continuously unimpressed with the ability of many business students to intelligently discuss and use financial data as contained in formal financial statements. Except for accounting and some finance majors, accounting and corporate finance courses seem to have been “take, endure, and forget” courses. While many of these students may have some knowledge of standard financial ratios, their use and interpretation of these measures seems alchemical. In requiring students to analyze and discuss financial data, i became frustrated to the point of deciding to take action. However, rather than rehash standard approaches to financial analysis, i have tried to develop a more common sense approach focusing on essentials but not getting buried in technical issues. This paper presents my approach to reviewing those essentials. INCOME STATEMENT STATEMENT OF CASH FLOWS I start with the Balance Sheet because I want to remind students that the business accumulates assets that can be used (I refer to these as the “sandbox and its toys”). These come from two sources, owners and lenders. I point out that both are appropriate sources because there are some people willing to take the higher risks associated with ownership and there are some people who desire to invest under less risky conditions. I mention this, in particular, because, many students seem to view debt as consummate evil and virtually demand its abolition. This always strikes me as a bit bizarre because the first stop for most of them after graduation will be a financial institution for a loan to buy an “ego-mobile.” I also want to remind them that the balance sheet discloses the organization’s capital structure, and I want them to be able to describe and discuss that topic intelligently in case work and when playing the simulation. INTRODUCTION I gave been teaching business policy courses for about 20 years. In that time, I have been repeatedly saddened and disillusioned by the inability (or perhaps unwillingness) of the majority of business students to make sense out of and effectively use financial data in cases and simulations. Although these students have studied financial and managerial accounting and have completed corporation finance courses, they typically seem lost in the numbers. To combat this, I have prepared a brief presentation in which I remind them of the fundamentals they have already learned and offer some thoughts on how they might attack and interpret financial data. What follows is a description and discussion of that presentation. BALANCE SHEET A = L + OE A AND L ARE CLASSIFIED AS ‘CURRENT’ AND ‘LONG-TERM’ SHOWS FINANCIAL POSITION AT A SPECIFIC POINT IN TIME USEFUL IN PREDICTING AMOUNTS (AND TIMING) OF FUTURE CASH FLOWS In discussing the income statement, I want, above all, to make them comfortable with three terms (gross profit, income from operations [operating earnings], and net income. I want them to understand what each of these tells us. I am also concerned that students understand the relationship of this statement to the company’s financial condition (i.e., profits increase assets and the value of ownership while losses do the opposite). In my discussion, I will make these points: THE FINANCIAL ANALYSIS PRESENTATION I begin the presentation with a quick review of fundamental financial statements: 1. Gross profit provides insight into the efficiency of those processes used to create the product(s). 326 Developments in Business Simulations and Experiential Learning, Volume 32, 2005 2. Income from Operations (a.k.a. operating earnings and as EBIT, earnings before interest and taxes) allows us to evaluate expenditures for marketing of the product(s) and for overall administration and gives us additional insight into our efficiencies in these areas. Operating earnings also are useful in assessing the performance of various units of diversified companies. 3. In going from Income from Operations to Net Income, it is important to consider the impact of interest expense on the firm, and this provides additional insight into the appropriateness (or lack of) of the firm’s financial structure. INCOME STATEMENT PURPOSE: SUMMARY OF OPERATING ACTIVITIES OVER A PERIOD OF TIME At this point the reader is probably somewhat frustrated and is muttering under the breath, “So what is so special or unique about this—it’s just a summary of basics?” The reader’s sensibilities are correct. The meat of what I am trying to get across is contained in the next two parts of the presentation addressing financial health and financial ill health. In these two sections I want the student to step back from cold and mechanical ratios and develop a common sense approach to financial data analysis. However, before they do this, they must understand the basic structures and contents of the fundamental statements, as I have outlined above. However, these statements, over time, aided by creating and viewing simple line graphs, can paint often insightful pictures of what is going on. One can argue that effective financial management is present if a firm is growing sales and profits, if there is evidence of cost control for important cost elements, if cash flows are managed logically, and if debt is used in a sensible way. RELATION TO BALANCE SHEET (A = L + OE + REV – EXP) WHAT MAKES A FIRM FINANCIALLY HEALTHY? BASIC FORMAT: Revenues – Expenses = Net Income SALES GROWTH EXPANDED FORMAT: PROFITS (PREFERABLY GROWING) 1. Gross Profit = Sales – Cost Of Goods Sold REVENUE GROWTH > COST GROWTH 2. Income From Operations = Gross Profit – Operating Expense POSITIVE (NET) CASH FLOWS (MOSTLY FROM OPERATING ACTIVITIES) 3. Net Inc. = Inc. from Operations +/- Other Items – Inc. Taxes EFFECTIVE AND EFFICIENT CASH MANAGEMENT COST REDUCTION AND EFFICIENCIES One of my regrets is that cash flow is not addressed in most cases. One of the great benefits of total enterprise simulations is that they force students to comprehend and manage cash over a relatively broad spectrum of activities. Unfortunately, most business students don’t appreciate the importance of cash in commerce—except, perhaps when they can only make minimum payments on their credit cards. In this part of the discussion I emphasize the imperative of generating the bulk of cash in-flows, over time, from the normal operating activities of the business, and I relate investing and financing actions to the simulation they are playing. SENSIBLE USE OF DEBT On the other hand, one can argue that the firm may be headed in the wrong direction if sales and profits are stagnant or declining, if there is evidence of cost acceleration, if cash flows are poorly managed (especially if there is too much borrowing to sustain liquidity), if debt is out of control and overly costly. Again, simple line graphs can be used to do the analysis. WHAT MAKES A FIRM FINANCIALLY AT RISK? SALES DECLINES Cash Flow Statement PROFIT DECLINES COST GROWTH > REVENUE GROWTH PURPOSE: SUMMARIZE CASH RECEIPTS AND CASH DISBURSEMENTS FOR A SPECIFIC TIME PERIOD NEGATIVE (NET) CASH FLOWS INEFFECTIVE AND INEFFICIENT CASH MANAGEMENT BASIC FORMAT: COST INCREASES AND INEFFICIENCIES 1. CASH FLOWS FROM OPERATING ACTIVITIES EXCESSIVE USE OF DEBT 2. CASH FLOWS FROM INVESTING ACTIVITIES For most students, comprehending these relationships will provide them with very useful information, albeit not in the most sophisticated ways. At the very least, students are not tempted to look and financial data in a Homer Simpson manner and mutter, “Ummm, numbers!” 3. CASH FLOWS FROM FINANCING ACTIVITIES USED TO ASSIST DECISION MAKERS EVALUATE LIQUIDITY, SOLVENCY, AND FINANCIAL FLEXIBILITY Let me close with a few additional concerns and comments. Some of these are, perhaps, a bit more esoteric, 327 Developments in Business Simulations and Experiential Learning, Volume 32, 2005 328 but any business student should be able to comprehend why these issues are important. Additionally, by this time in the discussion, they should begin to see ways in which they can ask and answer substantive questions that require the use of financial data. My hope is that, regardless of major, my students understand that financial realities are vital to business success, that every member of the organization has an impact on those realities, and that understanding financial information will help them perform their responsibilities more effectively. OTHER CONCERNS MANAGING RECEIVABLES MANAGING PAYABLES ACCURATE COST ANALYSES How to create common size statements What common size statements may disclose Timely and accurate analyses of business units Reliable and ethical audits (internal & external) Awareness of and sensitivity to trends A FEW MORE THOUGHTS SPECIAL ITEMS (ON THE INCOME STATEMENT) SHOULD BE CLOSELY EXAMINED BECAUSE THEY DO NOT REPRESENT ONGOING BUSINESS ACTIVITY COMPANIES SHOULD HAVE SUFFICIENT RESERVES AND ALLOWANCES FOR BAD DEBTS AND DEFECTIVE MERCHANDISE INCOME FROM OPERATIONS (AND CASH FLOWS FROM OPERATING ACTIVITIES) TELL A GREAT DEAL ABOUT CORE BUSINESS PROCESSES, EVEN MORE ABOUT THE PERFORMANCE OF DIVISIONS CONCLUSION I wish I could say that my use of this presentation has “turned on the lights” and created wonderfully better- educated business students. I can’t make that claim. However, I do not let students off the hook. There are some things I require of them so that they will get engaged in the processes I have outlined. For example, having illustrated the power of simple graphs, I include a number of specific requirements for their use (especially in case presentations and simulation reports). In simulation reports I am quite specific in requiring students to prepare and use a number of graphs to illustrate specific relationships (e.g., sales and profits over time, sales compared to various cost factors, etc.). I regularly give quizzes on case content, and I almost always include a financial question, of some sophistication. Additionally, in the simulation reports I go beyond graphs and require the use of common-size statements, correlations, and even multiple-regression to help them more effectively understand costs and relationships in the elements of decisions. However anecdotal it may be, I do have some evidence that my students are at least coping, intelligently, with financial data and its analysis. I hope that people who teach business policy courses, but who feel a bit weak on the financial side, may find what I have said in this discussion to be useful. For those who may wish to pursue financial interpretation a bit more deeply, the chair of the accounting department at my school, whom I consulted in developing the presentation, recommends this paperback: REFERENCES Tracy, John A. How to Read a Financial Report, 6th ed. Hoboken, NJ: John Wiley & Sons, Inc., 2004 Table of Contents Volume 32, 2005 LEARNER BEHAVIOR IN THE ONLINE CLASSROOM EXPERIENCE THE EFFECTIVENESS OF A SIMULATION EXERCISE FOR INTEGRATING PROBLEM-BASED LEARNING IN MANAGEMENT EDUCATION DEMONSTRATION OF FOUR WEB-BASED SIMULATIONS THRESHOLD COMPETITOR: A MANAGEMENT SIMULATION ENTREPRENEUR: A NEW VENTURE SIMULATION MERLIN: A MARKETING SIMULATION MICROMATIX: A STRAGETIC MANAGEMENT SIMULATION LEARNING STYLES INFLUENCES ON SATISFACTION AND PERCEIVED LEARNING: ANALYSIS OF AN ONLINE BUSINESS GAME INTERNATIONAL INTERNSHIPS: DESIGN AND EXPERIENCES SIM MAP: TURNING ACTION-BASED LEARNING INTO SIMULATED CONSULTING PROJECTS NOTEL HEALTH SERVICES: A ROLE-PLAYING SIMULATION TEACHING EXPERIENTIALLY WITH THE MADELINE HUNTER METHOD: AN APPLICATION IN A MARKETING RESEARCH COURSE SIMULATING CUSTOMER LIFETIME VALUE: IMPLICATIONS FOR GAME DESIGN AND STUDENT PERFORMANCE VIRTUAL PROGRESS: SIMULATING ECONOMIC DEVELOPMENT ONLINE STRATEGIC MANAGEMENT: AN EVALUATION OF THE USE OF THREE LEARNING METHODS IN CHINA ADOPTION OF DISCUSSION-BASED TEACHING AND ASSESSMENT IN TEACHING STRATEGIC MANAGEMENT IN CHINA STUDENTS' VIEW ON THE USE OF CASE METHOD IN CHINA CHINESE STUDENTS' PERCEPTIONS OF BUSINESS GAMING EXPERIENCECSR - A CORPORATE SOCIAL RESPONSIBILITY SIMULATION CREATING DYNAMIC INTERACTION IN A VIRTUAL WORLD: ADD VALUE TO ONLINE CLASSROOMS THROUGH LIVE ELEARNING AND COLLABORATION: A DEMONSTRATION CAPABILITIES OF EXPERIMENTAL BUSINESS GAMING A COMPARISON BETWEEN SOLUTIONS AND DECISIONS IN A BUSINESS GAME VALIDATING BUSINESS SIMULATIONS: DOES HIGH PRODUCT QUALITY LEAD TO HIGH PROFITABILITY? ALIGNING ART AND EPISTEMOLOGY: ILLUSTRATIONS TO DISTINGUISH DISCOVERY FROM KNOWLEDGE BUILDING TUTORIALS USING WINK STUDENTS AS LAB RATS: THE ETHICS OF CONDUCTING NON-PEDAGOGICAL RESEARCH IN THE CONTEXT OF CLASSROOM SIMULATIONS AND EXPERIENTIAL LEARNING THE EFFECT ON GAME PERFORMANCE OF DIFFERENT MEASURES AND UNITS OF ANALYSIS IN QUANTITATIVE ANALYSIS ANALYZING AND THINKING WHILE PLAYING A SIMULATION COMPUTER BUSINESS SIMULATION DESIGN: THE ROCK POOL METHOD EXPANDING THE ROLE OF E-ROOMS IN DISTANCE LEARNING APPLICATIONS TO MANAGEMENT EDUCATION APPLICATION OF TRADITIONAL AND ONLINE JOURNALING AS PEDAGOGY AND MEANS FOR ASSESSING LEARNING IN AN ENTREPRENEURIAL SEMINAR DEVELOPING MANAGERIAL EFFECTIVENESS: ASSESSING AND COMPARING THE IMPACT OF DEVELOPMENT PROGRAMMES USING A MANAGEMENT SIMULATION OR A MANAGEMENT GAME INTERNATIONAL MANAGEMENT GAME Œ AN INTEGRATED TOOL FOR TEACHING STRATEGIC MANAGEMENT INTERNATIONALLY STUDENT EXPECTATIONS OF SIMULATIONS DISTANCE EDUCATION DELIVERY OF AN INTENSIVE SIMULATION BASED COURSE TEACHING SERVICE LEARNING USING A BUSINESS GAME ROLE-PLAY SIMULATION EDUCATIONAL PERSPECTIVE OF COLLABORATIVE VIRTUAL COMMUNICATION AND MULTI-USER VIRTUAL ENVIRONMENTS FOR BUSINESS SIMULATIONS SIMULATION PERFORMANCE & PREDICTOR VARIABLES: ARE WE LOOKING IN THE WRONG PLACES TO MEASURE THE RIGHT LEARNING? VIDEO CASE: JET-A-WAY INC. Œ FOCUSING ON DIVERSITY AND ENTREPRENEURIAL LEADERSHIP ACTIVE LEARNING: WHAT IS IT AND WHY SHOULD I USE IT? FACILITATING THROUGH COLLABORATIVE REFLECTIONS TO ACCOMMODATE DIVERSE LEARNING STYLES FOR LONG-TERM RETENTION ONLINE CUMULATIVE SIMULATION TEAM PERFORMANCE PACKAGE WHEN PROPHECY FAILS: A SMALL SAMPLE, PRELIMINARY STUDY USING EXPERIENTIAL LEARNING TO INTEGRATE THE BUSINESS CURRICULUM FORECASTING STOCK VALUE EMPLOYING PROGRESSIVE PRACTICES AND PRINCIPLES TO FACILITATE SEMINAR ROOM LEADERSHIP AMONG LEARNERS: SHARED POWER AND COLLECTIVE ACCOUNTABILITY INDIVIDUAL ACHIEVEMENT DOES NOT GUARANTEE TEAM PERFORMANCE: AN EVIDENCE OF ORGANIZATIONAL LEARNING WITH BUSINESS GAMES DECISION MAKING IN BUSINESS SIMULTION DESIGN ZUG UM ZUG 2015: COLLECTIVE BARGAINING AS A TWO-LEVEL GAME A NEW METHOD FOR MODELING INNOVATION AND R&D IN BUSINESS SIMULATIONS: ILLUSTRATED WITH A SIMULATION OF A NEW PRODUCT DEVELOPMENT PORTFOLIO DEVELOPING A MICRO SIMULATION EFFECT OF MARKET SHARE AND PRODUCTION EXPERIENCE ON COMPANY PROFITABILITY RE-DESIGNING A CURRICULUM THAT VALUES A WORK-INTEGRATED APPROACH TO STUDENT LEARNING HOW SIMULATIONS AND EXPERIENTIAL LEARNING FIT AS WE COMPLY WITH LEGISLATIVE AND AACSB ASSESSMENT GUIDELINES: HOW TO DEVELOP ACADEMICALLY SOUND COURSES THAT ALSO MEET STAKEHOLDER NEEDS EVALUATING SERVICE LEARNING: REFLECTION AND ASSESSMENT FROM THE STUDENT POINT OF VIEW SIMPLIFYING AND ENHANCING FINANCIAL ANALYSIS IN CASES AND SIMULATIONS OVERCOMING THE BUSINESS GAME COMPLEXITY PARADOX EXPLORING THE PREFERENCE IN LEARNING APPROACH AMONG THE HONG KONG UNIVERSITY STUDENTS: CASE STUDY, PROBLEM-BASED OR TRADITIONAL TEXTBOOK QUESTION AN EXERCISE FOR EXPLORING THE RELATIONSHIP BETWEEN JUNGIAN PSYCHOLOGICAL TYPES AND POLITICAL STYLE IN THE WORKPLACE EVALUATING THE DIRECTION OF RESEARCH IN ONLINE EDUCATION: ARE WE GOING ANYWHERE? AIS RAIL SYSTEM: A COMPUTER-BASED JOB-ORDER COST SIMULATION BLOOM BEYOND BLOOM: USING THE REVISED TAXONOMY TO DEVELOP EXPERIENTIAL LEARNING STRATEGIES DELIVERING A TECHNOLOGY-BASED CASE IN A TECHNOLOGICAL WAY: THE SMARTCART CASE USING THE INTERNET TO ENHANCE COURSE PRESENTATION: A HELP OR HINDRANCE TO STUDENT LEARNING TEACHING PRACTICES: A CLUSTER ANALYSIS OF STUDENTS IN HONG KONG TEACHING PRACTICES: A CLUSTER ANALYSIS OF TEACHING STAFF IN HONG KONG EVALUATING A SIMULATION WITH A STRATEGIC EXPLORATION TOOL A SYMBOLIC MODEL OF THE SIMULTANEOUS ACHIEVEMENT OF CONCRETE BENEFITS AND LEARNING BY PARTICIPATING GROUPS IN EXPERIENTIAL ACTIVITIES: ‚THE SPHERE OF EXPERIENTIAL LEARNING