“Financial intelligence. Like most disciplines and skill sets, must not only be learned but be practiced and applied.”
Financial Intelligence: Short Summary
Financial Intelligence by Karen Breman and Joe Knight with John Case is written for anyone who wants to understand the meaning behind financial numbers. Not the easiest book to read but provides a good understanding of accounting and financial principles.
You Can’t Always Trust the Numbers
Operating Expenses: Costs required to keep the business running from day to day.
Capital Expenditure: The cost of purchasing an item that is considered a long-term investment e.g computer systems, equipment.
Operating expenses reduce profit, whereas capital expenditure does not impact profit directly.
Spotting Assumptions, Estimates, and Biases
Accrual: The portion of revenue or expense item that is recorded in a particular period
Allocations: Apportionment of costs to different departments or activities within a company
Depreciation: The method accountants use to allocate the cost of equipment and other assets to the total cost of products shown on the income statement
Why Increase Your Financial Intelligence?
Money paid by a company to acquire another company – the value of the assets acquired = Goodwill
A balance sheet reflects the assets, liabilities, and owner’s equity at some point in time.
Cash: Money that a company has in the bank, along with anything that can be turned into cash e.g stocks and bonds.
Here are some practical benefits of gaining financial intelligence:
- Increased ability to critically evaluate your company
- Utilizing numbers and financial tools to make and analyze decisions
Company gains when members gain financial intelligence:
- Strength and balance throughout the organization
- Better decisions
- Greater alignment
Some roadblocks to being financially savvy include the following:
- You hate math, you fear math and you don’t want to do math
- The accounting and finance departments withhold all the information from the rest of the organization
- Your boss doesn’t want you to ask questions about how the numbers work
- You don’t have time
The Rules Accountants Follow- and Why You Don’t Have To
GAAP: Generally Accepted Accounting Principles. This is applicable in the United States
GAAP based financial statements are based on the following principles:
- Monetary units and historical cost. Figures in the balance sheet must remain true to their historical cost, even when the market value changes
- Conservatism. Company accounts should be conservative when recording revenues and costs
- Consistency. Each caption has to be consistent across time
- Full disclosure. You cannot withhold information in your accounting reports
- Materiality. You are not required to detail information when it does not impact the financial results I.e. you don’t need to count every pencil in your company when you count your assets
Most companies have the following members in their accounting and finance department:
- Chief Financial Officer (CFO): Oversees all financial functions. Is involved in the management and strategy of the company from a financial perspective
- Treasurer: Responsible for building and maintaining bank relationships, managing cash flow, forecasting, and making capital structure relationships
- Controller: Providing accurate and reliable financial reports
Profit Is An Estimate
Any income statement begins with sales.
The income statement tries to measure whether the products or services a company provides are profitable when everything is added up.
Profit is turned into cash.
Cracking the Code of The Income Statement
An income statement may not be directly labeled as ‘income statement’ at the top.
It can instead be labeled as a Profit and Loss Statement (P&L) statement, operating statement, statement of operations, operations of earnings, or earnings statement.
Sales or Revenue is a category in an income statement.
A lot of the numbers on the income statement reflect estimates and assumptions. An income statement may or may not contain footnotes to explain those estimations and assumptions.
Revenue: The Issue is Recognition
Sales or Revenue: Value of all products or services a company provided to its customers during a given period
Costs and Expenses: No Hard and Fast Rules
Cost of Goods Sold (COGS) and Cost of Service (COS): Includes all costs directly involved in producing a product or service.
Above the line, Below the line: The line = Gross profit. Above the line = Sales, COGS, and COS. Below the line = Operating expenses + interest + taxes
Noncash Expense: An expense charged to a period on the income statement but isn’t paid out in cash e.g depreciation of an item
The Many Forms of Profit
Revenue – COGS/COS = Gross Profit
Revenue – Expenses = Profit
Gross Profit – Operating Expenses = Operating Profit
Operating profit is key to the health of a company
Net Profit: What is left after all costs and expenses are subtracted from revenue
Sales – Variable costs = Contribution Margin
Understanding the Balance Sheet Basics
Balance Sheet: A statement of what a business owns and what it owes at a particular time
Equity: The shareholder’s stake in the company as measured by accounting rules
Owns – owes = net worth
Owns = owes + net worth
Assets – liabilities = owner’s equity
Assets = liabilities + owner’s equity
Fiscal Year: The 12 months used by a company for accounting purposes
Assets: More Estimates and Assumptions (except for cash
Types of Assets:
- Cash and cash equivalents
- Accounts Receivable (A/R)
- Property, Plant, and equipment (PPE) Less Accumulated depreciation
- Intellectual property, patents, and other intangibles
- Accruals and Prepaid assets
An acquisition occurs when one company buys another.
Intangibles: Valuable resources that cannot be touched or spent e.g employees’ skills, customers lists, proprietary knowledge, patents, brand names, reputation, strategic strengths, and so on
On The Other Side: Liabilities and Equity
Types of Liabilities:
- Current portion of long term debt
- Short term loans
- Accounts payable
- Accrued expenses and other short term liabilities
- Deferred revenue
- Long term liabilities
Dividends: Funds distributed to shareholders taken from a company’s equity
Retained Earnings: Profits that have been reinvested in the business instead of being paid out as dividends
Why The Balance Sheet Balances
Every transaction that affects one side of the balance sheet (assets) always affects the other (liability + owner’s equity) as well.
When you buy a $1M building with a loan you increase your Assets by $1M, and your Liabilities by $1M.
The Income Statement Always Affects The Balance Sheet
A good manager needs to be aware of how both cash and profits affect a balance sheet.
The balance sheet answers the following questions:
- Is the company solvent? (Do the assets outweigh the liabilities?)
- Can the company pay its bills?
- Has the owner’s equity been growing overtime?
A balance sheet helps to show whether a company is financially healthy.
Owner Earnings: The measure of the ability of a company to generate cash over a while
Profit is not the same as Cash (and you need both)
Revenue is booked at the sale and expenses are matched to revenue.
If you sell tires, you first need to buy them from your suppliers. But as these tires were not sold yet, they are not considered a cost. They are considered inventory. When a customer buys a tire from you, you record both Revenue and Cost at the same time.
You have to record revenue the moment you make the sale, even though your customer might only pay you 90-days later.
Capital expenditures don’t count against profit.
The Language of Cash Flow
Inflows: Cash moving into a business
Outflows: Cash moving out of a business
Types of cash flow:
- Cash from/used in operating activities
- Cash from/used in investing activities
- Cash from/used in financing activities
Financing a company: Getting a company the cash it needs to start up or expand
If a company has extra cash and believes that its stock is trading at a price that is lower than it ought to be, it may buy back some of its shares.
How Cash Connects with Everything Else
A simple way to calculate cash flow is by looking at the income statement and two balance sheets.
In a financial context, reconciliation means getting the cash line on a company’s balance sheet to match the actual amount of cash the company has in the bank.
Why Cash Matters
Knowing your company’s cash situation will help you understand what is going on now, where the business is headed, and what senior management priorities are likely to be.
You affect cash.
Managers who understand cash flow tend to be given more responsibilities and tend to advance more quickly than those who only focus on the income statement.
Free cash flow is what remains when the net capital expenditure is subtracted from the operating cash flow.
Profitability Ratios: The Higher The Better (Mostly)
Numbers in financial statements by themselves don’t reveal the whole story. Ratios add more perspective and clarity to financial statements.
Profitability ratios help you assess a company’s ability to generate profits.
The gross margin shows the basic profitability of the product or service itself before expenses are handed in.
The operating margin shows how well managers as a group are doing their jobs.
The net profit margin tells a company how much it gets to keep out of sales after everything else has been paid for.
Return on Assets (ROA) tells you what percentage of money invested in the business was returned to you as profit.
Return on Equity (ROE) tells us what percentage of profit we make for equity invested in the company.
The Investor’s Perspective: The “Big Five” Numbers and Shareholder Value
The Big Five: The key metrics that investors look at to assess a company’s financial performance or its attractiveness as an investments
The Big Five are:
- Revenue growth from one year to the next
- Earnings per share (EPS)
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Free cash flow (FCF)
- Return on total capital(ROTC), Return on Equity (ROE)
Figuring ROI: The Nitty-Gritty
Here are the steps to analyzing capital expenditure:
- Determine the initial cash outlay
- Project future cash flows from the investment
- Evaluate future cash flows
You need a clear cash-flow map to understand what is the proper return on your investment.
The Magic of Managing the Balance Sheet
Working Capital = Current assets – current liabilities
Working Capital: The money a company needs to finance its daily operations
Financial Literacy and Corporate Performance
Here are some benefits of a healthy business:
- Offers valuable products and services to customers
- Providing employees with stable jobs, pay raises, and opportunities for advancement
- Pays a good return to its shareholders
- Helps the economy grow, keeps communities strong, and improve our standards of living
Financially intelligent managers contribute to a business’s health by making better decisions.
Organizations that practice openness will always be more successful than their less open counterparts.
Financially savvy managers are flexible and able to be in tune with the unexpected.
Financial Literacy Strategies
Strategies to promote financial literacy in small companies include:
- Consistent training
- Weekly “Numbers” Meetings
- Reinforcements: Scoreboards and other visual aids
Strategies to promote financial literacy in large companies include:
- Leadership support
- Assumptions and follow up