SoBrief
Books Finance How Finance Works
How Finance Works
The HBR Guide to Thinking Smart About the
Numbers
by Mihir Desai 2019 288 pages
4.51 500+ ratings
Finance Business Economics
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Key Takeaways
1. Financial Analysis: Ratios Reveal
Performance
Ratios make interpretation possible because single numbers
in isolation are meaningless.
Ratios provide context. Financial analysis uses ratios to make sense of raw
numbers, comparing them to other relevant figures. For example, a profit of
$10 million is meaningless without knowing the revenue or assets used to
generate it. Ratios like profit margin (net profit/revenue) or return on assets
(net profit/total assets) provide a more meaningful picture of a company's
performance.
Balance sheet and income statement. Financial analysis draws on both the
balance sheet (assets, liabilities, and equity) and the income statement
(revenue, costs, and profits). Ratios can be used to assess a company's
liquidity (ability to meet short-term obligations), efficiency (how well it uses
assets), profitability (how much it earns), and leverage (how much it uses
debt).
Liquidity ratios: current ratio (current assets/current liabilities), quick
ratio (current assets - inventory/current liabilities)
Efficiency ratios: inventory turnover (cost of goods sold/inventory),
receivables collection period (365/sales/receivables)
Profitability ratios: net profit margin (net profit/revenue), return on
equity (net profit/shareholders' equity)
Leverage ratios: total debt/total assets, long-term debt/capitalization
Ratios are not static. Ratios are not static; they should be compared across
time and across companies within the same industry. For example, a high
inventory turnover is good for a grocery store but not for a bookstore. By
comparing ratios, you can identify trends, strengths, and weaknesses in a
company's performance.
2. The Finance Perspective: Cash and
the Future
Many think that financial analysis and ratios are what
finance is all about. In fact, it’s just the beginning.
Cash is king. Finance prioritizes cash over accounting profits because cash
is less susceptible to manipulation and better reflects a company's true
economic performance. While accounting emphasizes net profit, finance
focuses on cash flows, particularly free cash flow (FCF), which is the cash
available to capital providers after all expenses and investments.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and
Amortization) is a measure of cash generated by operations.
Operating cash flow considers working capital and noncash expenses.
Free cash flow (FCF) is the cash available to capital providers after all
expenses and investments.
Future matters more than the past. Finance is fundamentally forward-
looking, emphasizing the importance of future cash flows over past
performance. The time value of money dictates that a dollar today is worth
more than a dollar tomorrow, so future cash flows must be discounted to
their present value. This is done using a discount rate, which reflects the
opportunity cost of capital.
Discounted cash flow (DCF) analysis. DCF analysis is a method for valuing
assets by discounting their expected future cash flows to their present
value. This method is used to determine if an investment is worthwhile and
how much it is worth. The discount rate is a critical component of DCF
analysis, as it reflects the riskiness of the investment.
3. The Financial Ecosystem:
Intermediaries and Information
The world of finance—of hedge funds, activist investors,
investment banks, and analysts—can seem baffling and
somewhat opaque.
Complex web of players. The financial ecosystem is a complex web of
interconnected players, including companies, institutional investors (mutual
funds, pension funds, hedge funds), sell-side firms (investment banks,
broker-dealers), analysts, and the media. These players interact with each
other through trades, information sharing, and the provision of services.
Information asymmetry. A key challenge in capital markets is asymmetric
information, where some players (e.g., company insiders) have more
information than others (e.g., investors). This information asymmetry
creates opportunities for some to profit at the expense of others.
Equity research analysts play a central role in the financial ecosystem
by providing information and recommendations to investors.
Institutional investors, such as hedge funds, use various strategies to
manage risk and generate returns.
Investment banks facilitate capital raising and M&A transactions.
Incentives matter. The incentives of each player in the financial ecosystem
can influence their behavior. For example, analysts may be biased toward
positive recommendations to maintain relationships with companies, and
hedge fund managers may take on excessive risk to maximize their
compensation. Understanding these incentives is crucial for navigating the
complexities of capital markets.
4. Sources of Value Creation: Beating the
Cost of Capital
The most critical questions in finance relate to the origins of
value creation and how to measure it.
Value creation is about returns. Companies create value by generating
returns on their investments that exceed their cost of capital. The cost of
capital is the minimum return that investors expect for bearing the risk of
investing in a company. If a company's returns are less than its cost of
capital, it is destroying value.
The DuPont framework. The DuPont framework breaks down return on
equity (ROE) into three components: profitability (net profit/revenue),
productivity (revenue/total assets), and leverage (total assets/shareholders'
equity). This framework helps to identify the sources of a company's ROE
and how it can be improved.
Profitability: How much profit a company generates for every dollar of
revenue.
Productivity: How efficiently a company uses its assets to generate
revenue.
Leverage: How much a company uses debt to finance its assets.
Risk and return. Investors demand higher returns from companies that they
perceive to be riskier. Risk is measured by beta, which reflects how much a
stock moves with the market. The capital asset pricing model (CAPM) is
used to calculate the cost of equity, which is the risk-free rate plus beta
times the market risk premium.
5. The Art and Science of Valuation:
Discounted Cash Flows
Valuation is a critical step in all investment decisions.
Valuation is both art and science. Valuation is a process that combines
rigorous financial analysis with subjective judgment. While discounted cash
flow (DCF) analysis provides a framework for valuing assets, it relies on
assumptions about future cash flows, discount rates, and terminal values,
which are all subject to uncertainty.
Discounted cash flow (DCF) analysis. DCF analysis is the gold standard for
valuation, as it explicitly considers the time value of money and the
riskiness of future cash flows. The process involves:
1. Forecasting future free cash flows (FCF).
2. Determining the appropriate discount rate (WACC).
3. Discounting the future cash flows to their present value.
4. Calculating a terminal value to capture the value of cash flows beyond
the forecast period.
5. Summing the present values of all cash flows and the terminal value to
arrive at the enterprise value.
Multiples as a shortcut. Multiples, such as price-to-earnings (P/E) or
enterprise value-to-EBITDA (EV/EBITDA), provide a quick and easy way to
compare companies. However, multiples are based on historical data and
may not accurately reflect future performance. They also rely on the
assumption that comparable companies are truly comparable.
6. Capital Allocation: Investing or
Distributing Cash
Finally, we’ll examine a fundamental problem that
preoccupies financial managers at every company—what to
do with excess cash flows.
Capital allocation is key. Capital allocation is the process of deciding how
to use a company's excess cash flows. This is a critical decision for CEOs
and CFOs, as it determines how a company will grow and create value for
its shareholders. The decision tree involves:
1. Investing in positive NPV projects (organic or inorganic growth).
2. Distributing cash to shareholders (dividends or share buybacks).
Organic vs. inorganic growth. Organic growth involves investing in a
company's existing operations, while inorganic growth involves mergers and
acquisitions (M&A). M&A can be faster but also riskier due to integration
challenges and the potential for overpayment.
Dividends vs. share buybacks. Dividends and share buybacks are two
ways to distribute cash to shareholders. While the mechanics of these
transactions are value-neutral, they can send different signals to the
market.
Dividends are a regular cash payment to shareholders.
Share buybacks involve a company repurchasing its own shares.
Agency costs and signaling. The choice between dividends and buybacks
can be influenced by agency costs (the potential for managers to act in
their own interests rather than shareholders') and signaling (the information
that a company conveys to the market through its actions).
Last updated: January 20, 2025
Review Summary
4.51 out of 5
Average of 500+ ratings from Goodreads and Amazon.
How Finance Works receives overwhelmingly positive reviews for its
accessible approach to complex financial concepts. Readers praise
Desai's clear explanations, real-world examples, and interactive
elements. Many find it valuable for beginners and those seeking to
refresh their knowledge. The book is lauded for demystifying finance,
providing practical insights, and offering a comprehensive overview
of key principles. Some readers note that later chapters become
more technical, but overall, the book is highly recommended for its
ability to make finance understandable and engaging.
About the Author
Mihir Desai is a respected finance expert and educator known for his
ability to make complex financial concepts accessible to a wide
audience. As a professor at Harvard Business School and Harvard
Law School, Mihir A. Desai has extensive experience teaching
finance and related subjects. His research focuses on corporate
finance, international finance, and tax policy. Desai has published
numerous academic articles and books, including "The Wisdom of
Finance" and "How Finance Works." He is recognized for his
innovative teaching methods and his efforts to bridge the gap
between academic finance and practical business applications.
Desai's work often explores the intersection of finance, law, and
public policy.
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