All businesses need money. Even non-profit organizations need money to survive. Yet, most managers without finance or accounting training are lost with business numbers. This book by Karen Berman and Joe Knight help employees, managers and leaders to make sense of financial numbers and to use them more effectively in their work. In this Financial Intelligence summary, we’ll outline the concept of financial literacy, how to read key financial statements, analyze the numbers and improve your company’s financial health. Do get more details from our complete book summary bundle.
The Importance of Financial Intelligence
Financial intelligence refers to the ability to measure financial success and understand how the numbers reflect or affect a company’s performance. It can be distilled into 4 key skillsets:
• Understanding the basics of financial management, including key financial terms and how to read financial statements.
• Learning the art of presenting and interpreting numbers. In order to capture a company’s performance using limited data, financial professionals must make judgement calls, assumptions, and estimates. Financially intelligent managers know how to ask the right questions and see past numerical biases to grasp what’s really happening.
• Knowing how to analyze the numbers in depth and make informed decisions.
• Seeing the financial results in the context of a bigger picture, e.g. economic, competitive, technological forces.
Financial literacy offers many advantages:
• At a personal level, it improves your chances of career success and advancement. You can assess a company’s performance and prospects, use numbers to make better decisions, and present your proposals more convincingly.
• At an organizational level, it empowers employees to manage resources more wisely, make better decisions, contribute to the company’s financial health, and manage external stakeholders (e.g. bankers and investors) more effectively. A healthy business can in turn provide jobs, shareholder returns, and contribute to the community and economy.
In this free summary, we’ll give an overview of what every business leader should know about financial numbers and management accounting. Do get the full Financial Intelligence summary (click here for the full 19-page summary) for a detailed breakdown of each of of these ideas/sub-topics.
Why You Shouldn’t Trust the Numbers
Numbers don’t tell the full story. Financial numbers are only an approximation of reality, since they involve assumptions (e.g. how long a new machine will last) and estimates (e.g. how much of an engineer’s time is spent on different projects).
It’s also possible to manipulate the numbers legally to present a business in better light, or to illegally doctor the numbers for fraud or embezzlement.
Accounting rules and standards may also differ. At the time this book was published in 2013, accountants in the USA follow the Generally Accepted Accounting Principles (GAAP). The rest of the world uses Interpretations of Financial Reporting Standards (IFRS). Do check out our full Financial Intelligence book summary for some examples of key GAAP principles.
Key Financial Statements
THE INCOME STATEMENT
The income statement shows a company’s revenues, expenses, and profit for a specific period (e.g. a month, quarter, or year). It’s also known as a profit and loss (P&L) statement or a statement of earnings.
There are 3 main categories: Sales/Revenue, Costs/Expenses, and Profit/Income. You may also notice comparative data to show the variance between budget vs actual numbers, or the current vs last period. Generally, it’s more useful to compare variances as a percentage, and you should investigate any number with a huge variance. Footnotes are what the accountants believe you should know.
Profit = Revenue – Expenses
The key issue with revenue is when/how a sale is recognized. Expenses can also be recorded in many ways, and you can change the profitability numbers just by changing what’s recorded under COGS vs opex, or how you depreciate your high-value assets.
In our full Financial Intelligence summary (click here for detailed text, graphic and audio summaries), we’ll explain:
• Components in each of the 3 categories: revenues, expenses and profits. These include the revenue, above/below the line items, backlogs, deferred revenue, Cost of Goods Sold (COGS), Operating expenses (opex), depreciation and amortization, one-time charges, the “matching principle” and 3 main types of profit (gross profit, operating profit and net profit)
• How you can improve your profitability by understanding the items on your income statement.
THE BALANCE SHEET
The balance sheet shows a company’s assets (what it owns), liabilities (what it owes) and shareholders’ equity at a specific point in time.
Owners’ Equity = Assets – Liabilities.
In our full 19-page summary, we’ll break down the components in each category, including:
• Current and long-term assets like cash & cash-equivalents, accounts receivable (A/R), inventory, property, plant and equipment (PPE), goodwill and intangibles, accruals and prepaid assets.
• Current and long-term liabilities, including accounts payable (A/P), accrued expenses, deferred revenue, and long-term loans, deferred bonuses or taxes.
• Owners’ equity (or shareholders equity) is similar to a person’s net worth, i.e. what you own minus what you owe. For a company, this includes the value of stocks/shares, and retained/accumulated earnings.
The balance sheet always balances because whatever you own or create (e.g. cash, inventory) must come from somewhere (e.g. money from shareholders or bank loans). A transaction will always affect both sides of the balance sheet. A sale that goes into the income statement also increases cash or A/R in the balance sheet. Every dollar in the COGS or opex also affects cash or accrued expenses.
The balance sheet also contains vital information about a company’s health. Check out our full summary on insights to be found in the balance sheet, and why managers who don’t grasp the relationship between numbers may unintentionally hurt the company.
CASH FLOW STATEMENTS
Profit ≠ cash. Profits are merely customers’ promise to pay, whereas cash represents real monetary transactions. The 2 numbers can differ because:
• There’s usually a time-lag from the time a product is delivered till the time a client pays. Clients may also default on their payments.
• Profits = sales – expenses. Yet, it’s hard to match sales with expenses, e.g. you may pay for your materials, rent and manufacturing long before you sell the product.
• Capital expenditures affect your cash flow but not your profit.
Ultimately, cash is a great reality check for a company’s financial health. And, you need both profit and cash. In our complete Financial Intelligence summary (get full summary bundle here):
• We’ll illustrate how a company can grow, earn profits and still go bankrupt. Or, a company can have lots of cash but be losing money. For each situation, you need a different solution, and that’s where financial intelligence comes in.
• We’ll also touch on the main types of cash inflows/outflows that you can find in a cash flow statement.
Analyzing the Numbers & Improving Financial Health
ANALYZING THE NUMBERS
To truly analyze a company’s health and potential, absolute numbers alone aren’t enough. You must use ratios to supplement your analysis.
Ratios show the relationship between 2 numbers, to allow various comparisons, e.g. changes over time, budget vs actual, or comparison with industry averages. However, remember that the biases, estimates, and assumptions in numbers are also reflected in the ratios. Track ratios over time to see trends.
In our complete book summary, we’ll explain (i) the various ratios used to evaluate a company’s performance, including: profitability ratios, leverage ratios, liquidity ratios and efficiency ratios, and (ii) the time value of money and how to calculate Returns on Investment (ROI)
MANAGING WORKING CAPITAL
Working capital is the money required for a company’s daily operations. Once you understand the various statements and concepts above, you can actually improve your company’s financial health without increasing sales or decreasing costs–by converting inputs/outputs into cash more efficiently.
Working capital = current assets – current liabilities.
In our full Financial Intelligence summary, we’ll illustrate how every item in current assets and liabilities is part of a typical production cycle, and how specifically you can improve your cash conversion cycle by (i) reducing days sales outstanding (DSO), (ii) reducing inventory levels, and/or (iii) increasing days payable outstanding (DPO).
BUILDING A FINANCIALLY INTELLIGENT COMPANY
The ultimate goal is to make financial transparency a part of your culture and processes. When employees can make sense of the numbers and see the big picture, they can make better decisions and better support the company’s financial goals. Having financially-intelligent managers in all functions (e.g. HR, operations) also balances out the decision-making power. In our complete Financial Intelligence summary, we’ll also address how companies can develop financial literacy within their organization.
Other Details in the “Financial Intelligence” Book
This book explains various finance/accounting terms and principles, the grey areas and issues to look out for, and how managers can use financial numbers to become more effective at work. Besides the key ideas outlined in this summary, the book also includes sample financial statements and short case studies to illustrate how the numbers can be calculated and analyzed. Do get a copy of the book for the full details, get our full Financial Intelligence book summary bundle for an overview of the various ideas and tips, or check out more details at financialintelligencebook.com.
Learn to make sense of financial numbers: Make better decisions and improve your company’s financial health!