E145/STS173 Workshop A The Case Method and Basics of Accounting Professors Tom Byers and Randy Komisar Stanford University Copyright © 2007 by the Board of Trustees of the Leland Stanford Junior University and Stanford Technology Ventures Program (STVP). This document may be reproduced for educational purposes only.

Workshop A Agenda Case Method Thoughts Accounting Principles Some “Accounting” Applications

The Case Method - Agenda Introduction to the Case Method Analysis Tips Write-up Tips

The Case Method of Instruction A case is a “simulation” of business life and decision-making. It usually sets the stage for a set of business problems and complex decisions. Cases present lots of information arranged in an unstructured way. Goal of case analysis is to select the relevant information, and structure it in a way that helps addressing the issues of the case and making decisions. Many times, decisions will have to be made with insufficient information – this reflects real life! Teamwork is essential for case-based learning and for the development of well grounded opinions. Disagreement is normal and even necessary, since unique solutions are rare. (please read E145 handouts on Case Analysis)

Seven Tips for Case Analysis 1-Gain a Basic Understanding of the Company What does the company sell, to whom, how, and why do people buy it? Size of revenues - How big is the business? Growth of revenue and assets – How quickly is the company growing? Profitability of the business (several measures) 2-Understand the Financial Situation of the Company Is operational cash flow positive or negative? How is the short term cash position? How much debt does the company have? 3-Benchmark the company against competitors and the industry average Measures of profitability Measures of operational efficiency How are the company’s products differentiated from competition? 4-Analyze the historical evolution of the company’s financial situation

Seven Tips for Case Analysis 5-Analyze the sustainability of growth and the cash burn rate How long will the company be able to maintain operations with the current cash position? 6- Don’t confuse symptoms with problems. Often the numbers reflect symptoms that help in diagnosing business problems. One of the most important tasks of case analysis is to identify the problems addressed by the case. 7- You should reach a clear decision on the case, which is well supported and logically consistent with the analysis. Write the assignments in concise language, using a bullet point format.

Case Write-Up Tips 1-Skip the intro. We know what question you’re answering; we have to read at least 16 answers to the same question. You’ve only one page in which to make your case, make effective use of it. 2- Build an argument. Don’t just answer the “what” question, back it up with the “why”. If you make assertions or assumptions outside of the case, justify them. We ought to be able to read your answer and create a resprentative outline of the form: “I think _________ should do/choose _______ option because – Reason X – Reason Y – Reason Z In fact, maybe make the outline first. If the outline is good enough, you can just turn it in. Content over style.

Case Write Up Tips 3-Read the case carefully and learn to filter. These cases have a lot of info, not all of it is relevant. Many of these cases were written with different case questions in mind. Some of them deal with technologies you may not be familiar with. If there’s terminology or anything in the text that you don’t quite understand, feel free to ask. The teaching team is here to help. 4-Use the study questions. At least read them. Preferably, discuss and answer them. The study questions have been carefully designed to help you narrow down the scope of the actual homework question or, at very least, to point you in the right direction. Again, if you’re not sure, ask.

Case Write Up Tips 5-Feel free to use outside knowledge. Make full use of your own and your team’s knowledge. What do you know about this particular technology or market? Between you and all of your team members, you probably know a lot more than you think you know. What would you do in this situation? From what you know of the personalities in the case, which of the decision options do you think they would prefer? 6-But, don’t just look up an answer. With point 5 in mind, don’t just look up what really happened and let historical determinism answer your question. Answer the case from the time and perspective of the personalities in the case. We don’t look for right or wrong answers, we look for well-constructed arguments.

Case Write Up Tips 7-Think through the alternatives. They won’t always be laid out in the case or the question. 8-Think about limitations as well as advantages. Argue for your choice, but recognize the risks. Every choice has tradeoffs, else these decisions wouldn’t be so interesting or so difficult. What are the big risks for each alternative and why, despite these risks, do you think your choice is the best path of action? 9-Know when to use the numbers. Hint: if we teach you financing in class and then you get a case with financing numbers in it, we probably want you to run the numbers. You’ll note that you won’t have all the values you need – you can solve for some values, others you’ll just have to guess (and justify why those numbers are reasonable).

Workshop A Agenda Case Method Thoughts Accounting Principles Some “Accounting” Applications

Basics of Accounting - Agenda Review main accounting documents and financial analysis Balance Sheet Income Statement (Statement of Operations) Statement of Cash Flows Please refer also to the Merrill Lynch document: How to Read a Financial Report Company burn rate, forecasted required capital to reach milestones, … Head count, loaded cost per employee, equipment expenses, regulatory expenses, … Business model, acquisition costs, steady state financials

Some Accounting Principles Accounting items are classified into “accounts” according to their nature, translated into monetary units, and organized in statements Basic Accounting formula: Assets = Liabilities + Equity What the company owns How the ownership of assets was financed (By third parties or by the owners)

Accounting vs. Market Value Equity: Ownership of a company is divided into stock certificates Accounting Value (or Book Value) = Equity = Assets – Liabilities Accounting Value is different from Market Value !!! Market Value = Share Price * Number of Common Shares Outstanding

Balance Sheet A financial snapshot of a company at a given point in time Current Assets (liquid in less than a year) Fixed Assets Other Assets Current Liabilities (payable in less than a year) Long-Term Liabilities (bonds issued, bank loans) Shareholders’ Equity Cash and Equivalents Accounts Receivable Inventories Property, plant and equipment (less depreciation) Intangibles (less depreciation) Investment Securities Total Assets = Accounts Payable Accrued Expenses Short Term debt Common Stock Additional Paid-in Capital Retained Earnings Total Liabilities + Shareholder’s Equity Balance Sheet of XYZ Corp December of 2005 (in thousand $)

Balance Sheet - Analysis Working Capital: measure of the amout of cash available in the short- term. Also, indication of the funds needed to operate within a given business size: = Current Assets – Current Liabilities Liquidity ratios: measures of the ability to meet short term financial obligations Current Ratio: Current Assets / Current Liabilities Acid-test: (Cash + Accounts receivable) / Current Liabilities Operational Efficiency Measures Inventory Turnover = Cost of Sales per year / Current Inventory Accounts Receivable Collection Period = accounts receivable / sales Accounts Payable Collection Period = accounts payable / cost of sales

Balance Sheet - Example These financial statement items are for Tweeter Entertainment Group at year-end on September 30, (in millions) Accounts payable$ 38.6 Property, plant & equipment Receivables 31.3 Other current liabilities 23.3 Stockholders’ equity Cash 3.3 Long-term debt 36.7 Inventories Accrued expenses 38.9 Other current assets 7.5 Other liabilities 10.5 Other assets From Kimmel et. al. Financial Information For Decision Making

Balance Sheet - Example Assets Current assets Cash$ 3.3 Receivables 31.3 Inventories Other current assets 7.5 Total current assets Property, plant & equipment Other assets Total assets$ Liabilities and Stockholders’ Equity Current liabilities Accounts payable$ 38.6 Accrued expenses 38.9 Other current liabilities 23.3 Total current liabilities Long-term debt 36.7 Other liabilities 10.5 Total liabilities Stockholders’ equity Total liab. & stock. equity$ TWEETER HOME ENTERTAINMENT GROUP Balance Sheet (in millions) September 30, 2001

Income Statement Reports the economic results of a company over a time period. It shows the derivation of earnings or losses. + Revenues - Cost of Revenue (product cost or COGS) = Gross Margin - Sales and Marketing - General and Administrative - Research & Development - Depreciation and Amortization = Operating Income (EBIT) + Interest Income(expense) net = Net Income before Taxes - Income Tax Provision - Extraordinary Items = Net Income Income Statement of XYZ Corp. – year 2005 $ % Rev.

Income Statement - Analysis When does a transaction affect income? - When it changes the economic value of the company for the owners Some Profitability Measures: Gross Margin (%) = Gross Profit / Sales Operating Margin = Operating Income / Sales Return on Sales = Net Income / Sales Return on Equity = Net Income / Shareholders’ Equity Other Important Measures Earnings Per Common Share (EPS) = Net Income / Common Shares Price Earnings Ratio (P/E) = Market Price / Earnings Per Share

Income Statement - Example The following information was taken from the 2001 financial statements of Kellogg Company. Dollar amounts are in millions. Cost of goods sold$ 4,128.5 Selling & admin. expenses 3,523.6 Interest expense Other expense 54.0 Net sales 8,853.3 Income tax expense From Kimmel et. al. Financial Information For Decision Making

Income Statement - Example KELLOG COMPANY Income Statement For the Year Ended December 31, 2001 Net sales$ 8,853.3 Cost of goods sold 4,128.5 Gross Profit 4,724.8 Selling & admin. expense 3,523.6 Income from Operations 1,201.2 Interest expense Other expense 54.0 Net Income Before Taxes Income tax expense Net Income$ 473.6

Statement of Cash Flows The Statement of Cash Flows reports cash receipts and payments over a period, separating operational, investing and financing activities. + Cash Flow from operating activities (reconciled from income statement) = income - net changes in working capital (except cash and equivalents) + depreciation and amortization + Cash Flow from investing activities + Cash Flow from financing activities = Net Change in Cash or Equivalents + Cash or Equivalents at beginning of period = Cash or Equivalents at end of period Statement of Cash Flows of XYZ Corp. – 2005 $

Statement of Cash Flows - Analysis CFIMITYM !!! (Cash Flow is More Important Than Your Mother!! ) Especially for an entrepreneurial firm... How is cash flow different from income? Income accrual is not necessarily linked to cash transactions (e.g., depreciation, sales by credit, not billed) Some activities affect cash flows but not income (e.g., investments in fixed assets, additional capital from shareholders) Growth often absorbs cash flow because of a higher need for working capital and fixed investments (Entrepreneurial firms with negative income and high growth can have a very fast cash burn rate)

Statement of Cash Flows - Example SIERRA CORPORATION Statement of Cash Flows For the Month Ended October 31, 2004 Cash flows from operating activities Cash receipts from operating activities $ 11,200 Cash payments for operating activities (5,500) Net cash provided by operating activities $ 5,700 Cash flows from investing activities Purchased office equipment (5,000) Net cash used by investing activities (5,000) Cash flows from financing activities Issuance of common stock 10,000 Issued note payable 5,000 Payment of dividend (500) Net cash provided by financing activities 14,500 Net increase in cash 15,200 Cash at beginning of period 0 Cash at end of period 15,200 From Kimmel et. al. Financial Information For Decision Making

Top 10 Accounting Principles for Entrepreneurs 1. The fundamental equation inherent in financial statements is: Assets = Liabilities + Owner’s Equity 2. The balance sheet is a snapshot at a moment in time of financial position, while the income statement reports on financial performance for a period. 3. An income statement details changes in retained earnings for the period. 4. Accounting disputes turn almost solely on valuation and timing. 5. Five key principles govern valuation: Realization (accrual), conservatism, consistency, materiality, and historic cost. Source: Hank Riggs (AeA/SEI lecture 8/16/06)

Top 10 Accounting Principles for Entrepreneurs 6. Since valuations require judgments, financial statements are necessarily only estimates. 7. “Book values” seldom equal “market values”, particularly for long-term assets and owner’s equity. 8. The lifeblood of any operation is cash. 9. Ratios are the key tool for drawing meaning from financial statements. 10. A company’s ability to finance its growth internally is a function of its return on equity. Source: Hank Riggs (AeA/SEI lecture 8/16/06)

Workshop A Agenda Case Method Thoughts Accounting Principles Some “Accounting” Applications

Operating Stacks & Common Sizing Value Chain Company Proxies

Operating Stacks GOOG (12/05) MSFT (6/06) DELL (2/06) INTC (12/05) CSCO (7/06) Revenue $6,139 $44,282 $55,908 $38,826 $28,484 COGS $2,577 $7,650 $45,958 $15,777 $9,737 Gross Profit $3,561 $36,632 $9,950 $23,049 $18,747 SG&A $855 $13,576 $5,140 $5,688 $7,200 R&D $600 $6,584 $463 $5,145 $4,067 Operating Income $2,017 $16,472 $4,347 $12,090 $6,996 Net Income $1,465 $12,599 $3,572 $8,664 $5,580 Market Cap (1/13/07) $154,610 $306,810 $59,340 $127,600 $175,620

Operating Stacks QCOM (9/06) MRK (12/05) DNA (12/05) Revenue $7,526 $22,012 $6,633 COGS $2,182 $5,150 $1,011 Gross Profit $5,344 $16,862 $5,622 SG&A $1,116 $7,156 $2,258 R&D $1,538 $3,848 $1,262 Operating Income $2,690 $5,537 $1,922 Net Income $2,470 $4,631 $1,279 Market Cap (1/13/07) $65,470 $97,240 $91,520

Common Sizing GOOGMSFTDELLINTCCSCOQCOMMRKDNA Revenue100% COGS42%17%82%41%34%29%23%15% Gross Margin 58%83%18%59%66%71%77%85% SG&A14%31%9%15%25%15%33%34% R&D10%15%1%13%14%20%17%19% Operating Income 33%37%8%31%25%36%25%29% Net Income 24%28%6%22%20%33%21%19%

Value Chain Direct to End User Cost of Goods (Supply Chain) Profit + SG&A + r&D End Conusmer $ EU Discounts Notice the little r and the big D ! Revenue List Price Source: Mark Leslie

Value Chain Resellers Cost of Goods (Supply Chain) Profit + SG&A + r&D End Conusmer $ EU Discounts Reseller Revenue List Price Source: Mark Leslie

Value Chain Distributors / Resellers Cost of Goods (Supply Chain) Profit + SG&A + r&D End Consumer $ EU Discounts Reseller Distributor Revenue List Price Source: Mark Leslie

Your Product Becomes your Customer’s COGs Value Chain OEM or IP Licensing Cost of Goods (Supply Chain) Profit + SG&A + r&D End Consumer $ EU Discounts Reseller Distributor Master Disti Cost of Goods (Supply Chain) Profit + SG&A + r&D Reseller List Price Revenue Source: Mark Leslie

Value Chain Your Acquired OEM Product or Licensed IP Cost of Goods (Supply Chain) Profit + SG&A + r&D End Consumer $ EU Discounts Reseller Distributor Master Disti Cost of Goods (Supply Chain) Profit + SG&A + r&D Reseller Cost of Goods (Supply Chain) Profit + SG&A + r&D Reseller List Price Revenue Source: Mark Leslie

Company Proxies What is a company proxy? Why is a proxy important? How do you choose a proxy? When do you use your proxy?