Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean

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3 Sentence Summary

Whether you’re responsible for meeting a budget, or funding a new project, having a basic financial understanding is critical to making smart business decisions. This book breaks down what’s in the financial statements, where assumptions and estimates come into play, differentiating cash from profit, and teaches the fundamentals of financial calculations. Financial Intelligence is a great resource for helping you “talk numbers,” and manage your business (or department) with more confidence.

5 Key Takeaways

1. Learn the business’ financial statements and you’ll understand how decisions are made.
2. Financial statements are built upon assumptions and approximations.
3. Cash has no assumptions or biases.
4. Projects are funded based on their expected ROI.
5. Careful management can improve a business’s financial picture even with no change in its revenue or costs.

Financial Intelligence Summary

You Can’t Always Trust The Numbers

• The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing

Definitions

• Revenue = When the product or service is delivered
• Income Statement = Profit and Loss Statement (P&L) = Statement of Earnings
• Operating Expenses = Costs required to keep the business going day to day. They are subtracted from revenue on the income statement and impact the bottom line immediately
• Capital Expenditures = Items that are considered long-term investments. They are found on the balance sheet. Only the depreciation of a piece of capital equipment appears on the income statement.

Spotting Assumptions, Estimates, and Biases

• Accountants use accruals and allocations to try to create an accurate picture of the business for the month

Definitions

• Accruals = The portion of a given revenue or expense item that is recorded in a particular time span. The purpose of accruals is to match revenues to costs in a given time period as accurately as possible.
• Allocations = Apportionments of cost to different departments or activities within a company.
• Depreciation = A method to spread the cost of equipment and other assets over their useful life.

Why Increase Your Financial Intelligence?

• Knowing how the numbers are used and the assumptions that go into them puts you in control of the decisions that get made

Definitions

• Goodwill = Amount paid above market value of assets during an acquisition. Includes intangible assets such as brand, reputation, and customer lists.
• Balance Sheet = Reflects the assets, liabilities, and owners’ equity at a given point in time. In other words, it shows what the company owns, what it owes, and how much it is worth.
• Cash = Money in the bank plus stocks and bonds

Profit is an Estimate

• Profit is no more and no less than the last line on the income statement. Profits are an estimate – and you can’t spend estimates. 
• The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period
• The Matching Principle = Match the sale with its associated costs to determine profits in a given period of time

Cracking The Code of The Income Statement

• Sometimes “pro forma” means that the income statement is a projection. It can also mean that an income statement excludes unusual or one-time charges
• Financially savvy managers always identify variances to budget and find out why they occurred
• Many numbers on the income statement reflect estimates and assumptions. Accountants have decided to include some transactions here and not there. They have decided to estimate one way and not another.

Definitions

• Top-line growth = Sales (revenue) growth

Revenue: The Issue is Recognition

• A sale is when the revenue has been earned
  • When a product company ships
  • When a service company performs the work

Definitions

• Sales (revenue) = The dollar value of all the products or services a company provided to its customers during a given period of time
• Earnings-per-share (EPS) = Net profit divided by the number of shares outstanding

Costs and Expenses: No Hard and Fast Rules

• Operating expenses are like cholesterol. Good operating expenses make your business strong, and bad operating expenses drag down your bottom line and prevent you from taking advantage of business opportunities
• Depreciation and amortization are often included in operating expenses
• Depreciation and amortization are more about cost allocation then about loss of value. You may completely depreciate a truck on the books, but it retains some value on the open market. Assets are rarely worth what the books say they are worth
• Be suspicious of “one-time-charges” that show up after COGS and operating expenses

Definitions

• Cost of goods sold (COGS) and cost of services (COS) = An expense category that includes all of the costs directly involved in producing a product or delivering a service
• “Above the line” = Sales and COGS. These items vary more in the short-term and often get more managerial attention
• “Below the line” = Operating expenses, interest, and taxes
• Operating Expenses = Sales, general, and administrative expenses (SG&A), or “overhead”
• Amortization = Depreciation for intangible assets, such as patents, copyrights, and goodwill.
• Non-Cash Expense = An expense shown on the income statement for a given period but was not actually paid out in cash (e.g. depreciation)

The Many Forms of Profit

• Companies with more revenue have a greater ability to survive with small profit margins (think Walmart)

Definitions

• Profit = The amount left over after expenses are subtracted from revenue
• Gross Profit = Sales – COGS
  • Gross profit must be sufficient to cover a business’s operating expenses.
  • Gross profit can be greatly affected by decisions about when to recognize revenue and by decisions about what to include in COGS
• Operating Profit (EBIT) = Gross Profit – Operating Expenses
  • Operating profit is the profit made from running the business
  • Operating profits is a good gauge of how well a company is being managed
• Net Profit = Operating Profit – (Interest + Taxes + Other Costs)
  • Net profit is the bottom line of the income statement

3 Fixes for Low Profitability

1. Increase profitable sales: Find new markets or new prospects
2. Become more efficient and lower cost of goods sold: Find inefficiencies and implement changes
3. Cut operating expenses: Usually means reducing headcount as the only short-term solution

Understanding Balance Sheet Basics

• Profitability is like a grade you receive for of course in school. Equity is like your overall grade point average. It always reflects your cumulative performance, but at only one point in time.

Definitions

• Equity = Assets – Liabilities
  • Equity is the shareholders’ stake in the company
• Assets = What the company owns
• Liabilities = What the company owes
• Equity = What the company is worth
• Fiscal Year = Any 12 month period that a company uses for accounting purposes

Assets: More Estimates and Assumptions (Except for Cash)

• All inventory costs money. It is created at the expense of cash. A company always wants to carry as little inventory as possible, provided that it still has materials ready for its manufacturing processes and products ready when customers come calling

Definitions

• Current Assets = Anything that can be turned into cash in less than one year
• Long-Term Assets = Those that have a useful life of more than one year
• PPE = Total number of dollars it cost to buy (purchase price) all of the facilities and equipment the company uses to operate the business. This includes the building, machinery, trucks, computers, and every other physical asset the company owns.
• Goodwill = The difference between the price paid for the acquired company and the net assets the acquirer actually gets

Common Type of Assets

• Cash and cash equivalents
• Accounts receivable
• Inventory
• Property, plant, and equipment (PPE)
• Less: accumulated depreciation
• Goodwill
• Intellectual property, patents, and other intangibles
• Accruals and prepaid assets

On The Other Side (Liabilities and Equity)

• The balance sheet shows how assets were obtained
• Common shares have voting rights. They may or may not pay dividends.

Definitions

• Preferred Shares = Receive dividends on their investment before the holders of common stock. They usually do not carry voting rights.
• Retained Earnings = Profits reinvested in the business instead of being paid out as dividends

The Income Statement Affects The Balance Sheet

• A change in one financial statement nearly always has an impact on the other statements
• Net profit adds to equity unless it is paid out in dividends

Cash is A Reality Check

• Cash has no assumptions or biases

Definitions

• Owner Earnings = The measure of the company’s ability to generate cash over a period of time.

Profit ≠ Cash (And You Need Both)

• Revenue is booked at sale. Cash flow reflects cash transactions.
• Expenses on the income statements do not reflect cash going out
• If the company is profitable but short on cash, then it needs financial expertise – someone who is capable of lining up additional financing
• If a company has cash but it is unprofitable, it needs operational expertise – someone capable of bringing down costs or generating additional revenue without adding cost
• A company needs to have both profit and cash – a healthy business requires both

The Language of Cash Flow

• Cash for Operating Activities = Cash that customers pay in, bills that are paid out, salaries, rent, and all other cash expenditures needed to keep the doors open and the business operating
• Cash for Investing Activities = Cash spent on the capital investments = purchase of assets
• Cash for Financing Activities = Borrowing and paying back loans and transactions with the shareholders

How Cash Connects With Everything Else

• Cash received is equal to new sales minus the change in receivables
• Depreciation must be added back in

Why Cash Matters

• If you want to make an effective managerial request, you need to familiarize yourself with the numbers that they’re looking at
• The faster receivables are collected, the better a company’s cash position
• Cash flow is a key indicator of a company’s financial health, along with profitability and shareholders equity

Definitions

• Free Cash Flow = The cash generated by operating the business minus the money invested to keep it running

Profitability Ratios: The Higher The Better (Mostly)

• Profitability is a measure of a company’s ability to generate sales and to control its expenses

Definitions

• Gross Profit Margin = Gross Profit / Revenue
  • Basic profitability of the product or service itself, before expenses or overhead are added in
• Operating Profit Margin = Operating Profit (EBIT) / Revenue
  • A good indicator of how well managers as a group are doing their jobs
• Net Profit Margin = Net Profit / Revenue
  • Aka “return on sales.” It’s what percent of every dollar a company keeps after everything else has been paid for
  • The best point of comparison for net margin is a company’s performance in previous time periods and its performance relative to similar companies in the same industry
• Return On Assets = Net Profit / Total Assets
  • Shows how effective the company is at using their assets to generate profit
  • Useful for comparing the performance of companies of different size
• Return On Equity = Net Profit / Shareholders Equity
  • Tells us what percentage of profit we make for every dollar of equity invested in the company
  • A good indication of whether or not the company is capable of generating a return that is worth the investment risk

Leveraging Ratios: The Balancing Act

• Financial analyst’s word for debt is leverage

Definitions

• Operating Leverage = Fixed Cost / Variable Cost
  • Increasing your operating leverage means adding to fixed costs with the objective of reducing variable cost
  • E.g. a manufacturer that builds a bigger, more productive factory
• Financial Leverage = Debt / Equity
• Debt to Equity = Total Liabilities / Shareholders’ Equity
  • Many companies have a debt to equity ratio considerably larger than 1
  • Interest on debt is deductible from taxable income
• Interest Coverage = Operating Profit / Annual Interest Charges
  • How much interest a company has to pay every year relative to how much it’s making
  • A high ratio generally means that a company can afford to take on more debt

Liquidity Ratios: Can We Pay Our Bills?

• Liquidity ratios tell you about a company’s ability to meet all of its financial obligations – not just the debt but payroll, payments to vendors, taxes, and so on

Definitions

• Current Ratio = Current Assets / Current Liabilities
  • Close to 1 is generally too low. You can barely cover your liabilities with the cash coming in
  • Too high signals that a company is sitting on its cash
• Quick Ratio = (Current Assets – Inventory) / Current Liabilities
  • Gives you an even better picture of how easy would be for a company to pay off its short-term debt
  • Look at the quick ratio when dealing with companies that have a lot of cash tied up in inventory

Efficiency Ratios: Making The Most of Your Assets

• Careful management can improve a business’s financial picture even with no change in its revenue or costs

Definitions

• Days in Inventory (DII) = Average Inventory / (COGS / Day)
• Inventory Turns = 360 / DII
  • Both ratios measure how efficiently a company uses inventory
  • 360 is often used as a round number for days in a year
• Days Sales Outstanding = Ending AR / (Revenue / Day) 
  • Average number of days to collect the cash from a sale. How fast customers pay their bills
• Days Payable Outstanding = Ending AP / (COGS / day)
  • How long the company takes to pay its bills
  • The higher the DPO, the better a company’s cash position, but the less happy its vendors are likely to be
• PPE Turnover = Revenue / PPE
  • How many dollars of sales your company gets for each dollar invested in property, plants, and equipment
• Total Asset Turnover = Revenue / Total Assets
  • Gauges efficiency in the use of all assets

The Building Blocks of Return on Investment (ROI)

• Future value is what a given amount of cash will be worth in the future if it is loaned out or invested

Definitions

• Required Rate of Return = The rate that a company’s management will require before they make an investment in a project – the “hurdle rate.”

Figuring ROI: The Nitty-Gritty

• Capital Projects = Expected to help generate revenue or reduce cost for more than one year. Examples include equipment purchases, business expansions, acquisitions, and the development of new products
• They are treated differently than other purchases for three reasons:
  1. They require the company to commit large amounts of cash
  2. They’re typically expected to provide returns for several years so the time value of money comes into play
  3. They always entail some degree of risk

3 Steps to ROI

• Determine the initial cash outlay. How much it will cost before it begins to generate revenue
• Project future cash flows from the investment. 
• Evaluate the future cash flows to figure the return on investment. Is it worth it?

3 Methods to Calculate ROI

• Payback Method = Initial Investment / Cash Flow Per Year
  • Simple calculation to determine how long it will take to get your money back
  • Often use the meetings to quickly determine if a project is worth exploring
  • Payback time should obviously be less than the life of the project
  • Doesn’t consider the cash flow beyond breakeven, and doesn’t give you an overall return
  • Should only be used to compare projects or to reject projects
• Net Present Value = Present Value – Initial Investment
  • If NPV > 0 using your company’s hurdle rate, then the project should be accepted as a good investment
• Internal Rate of Return
  • Similar to NPV, but rather than assuming a particular discount rate and then inspecting the present value of the investment, IRR calculates the actual return provided by the projected cash flows
  • IRR = the hurdle rate that makes NPV equal to 0
  • Does not quantify how long the company expects to enjoy the given rate of return
  • Usually makes sense to use both NPV and IRR

The Magic of Managing the Balance Sheet

• Astute management of the balance sheet is like financial magic. It allows a company to improve its financial performance even without boosting sales or lowering costs

Definitions

• Working Capital = Current Assets – Current Liabilities
  • Cash, inventory, and receivables, minus whatever a company owes in the short-term
  • The amount of working capital doesn’t change unless more cash enters the system – for example, from loans or from equity investments

Your Balance Sheet Levers

• The longer a company’s DSO, the more working capital is required to run the business
• Lower DSO and the company will have more cash at its disposal
• Managing inventory efficiently reduces working capital requirements by freeing up large amounts of cash

Homing in on Cash Conversion

• Cash Conversion Cycle = DSO + DII – DPO
  • Tells you how fast the company recovers its cash, from the moment it pays its payables to the moment it collects its receivables
• Cash to Finance A Business = Sales Per Day * Number of days in the cash conversion cycle

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