How Finance Works: The HBR Guide to Thinking Smart About the Numbers

by Mihir Desai

cash holdings, equipment, and inventory.

by either borrowing money and/or raising money from their owners or shareholders.

The best first step when looking at a sea of numbers is to look for extreme numbers and then create a story about these numbers.

assets that can easily be changed into cash are called current

assets,

(a) an insurance policy during uncertain times, (b) a war chest for making future acquisitions, or (c) a manifestation of the absence of investment opportunities.

Accounts receivable are amounts that a company expects to receive from its customers in the future.

Other assets can mean many things, but are likely to be intangible assets—things you can’t put your hands on but are valuable nonetheless—things like patents and brands.

goodwill.

When a company acquires another company for more than the value of its assets on their balance sheet, that difference is typically recorded on the acquiring company’s balance sheets as goodwill.

Liabilities represent those amounts financed by lenders

to whom the company owes amounts;

shareholders’ equity, or net worth, corresponds to the funds that ...

Accrued items broadly represent amounts due to others for activities already delivered.

Preferred stock is often called a hybrid instrument because it combines elements of both debt and equity claims.

the quick ratio provides a more skeptical view of their liquidity.

leverage in finance allows owners to control assets they couldn’t control otherwise.

Leverage not only allows you to control assets you have no right to control, but it also increases your returns.

return on equity (ROE),

statement of cash flows has three parts: operating, investing, and financing sections.

you have $1 today, you can do something with it and earn a return—which means that you’ll end up with more than $1 a year from now.

First, cash is a better measure of economic returns relative to profits.

cash earned today is more valuable than cash earned tomorrow because of the opportunity cost of capital.

Mutual funds manage money on behalf of individuals and invest those funds in diversified portfolios of stocks or bonds.

These funds are large pools of money that represent the retirement assets of workers from a particular company, union, or government entity. As one example, the California Public

Sovereign wealth funds.

Hedge funds.

the most controversial—hedge funds

So hedging can help insulate an investor from sectorwide or marketwide movements and isolate the relative performance of a given company.

Traders, sometimes known as market makers or broker-dealers, ensure that there are buyers and sellers for various financial instruments.

A bid is the highest price an investor is willing to pay for a share,

while the ask is the lowest price that a seller is willing t...

know that traders deal in the short term,

salespeople sell financial instruments to investors on the buy side.

investment bankers work with companies that either want to raise capital or want to buy or sell operating assets.

(IPOs),

equity off...

debt offe...

The mergers and acquisitions (M&A) departments of investment banks help companies divest portions of their busin...

critical component of analyst compensation is a ranking system deployed by the buy side to signal sentiments about which analysts provide the best advice.

ranking system deployed by the buy side to signal sentiments about which analysts provide the best advice.

the managers of the companies do.

The problem is that we can’t necessarily trust what managers tell us. They want something from us—our capital—so they may tell us things that aren’t true in order to get it.

The problem of capital markets is a manifestation of an even more general problem known as the principal-agent problem.

Finance is all about trying to help solve that monitoring problem.

she’s implicitly telling investors that she thinks the stock is undervalued.

Equity compensation has become much more common in the last several decades but comes with its own issues.

it shows you that the capital markets are not a perfect solution to this problem but finding a way to make progress against this problem is not straightforward at all.

Because potential buyers will be skeptical and think there’s something wrong with the car that you’re not revealing.

the principal-agent problem that arises when owners are no longer managers, and asymmetric information makes monitoring and communication difficult.