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

by Karen Berman and Joe Knight

This outstanding book teaches corporate financial literacy to nonfinancial employees. There are 33 short chapters grouped into sections covering the income statement, the balance sheet, cash, ratios, return on investment, and working capital. “You’ll learn how to decipher the financial statements, how to identify potential biases in the numbers, and how to use the information in the statements to do your job better.”

“Accountants in the United States rely on a set of guidelines known as Generally Accepted Accounting Principles, or GAAP (pronounced gap) for short… Companies take those guidelines and apply a logic that makes sense for their particular situations. The key, as accountants like to say, is reasonableness and consistency… The rest of the world—more than one hundred countries—uses… International Financial Reporting Standards, or IFRS.”

“The most important GAAP guideline that accountants rely on for recording or recognizing a sale is that the revenue must have been earned. A products company must have shipped the product. A service company must have performed the work… Project-based companies typically have rules allowing partial revenue recognition when a project reaches certain milestones… The ‘sales’ figure on a company’s top line always reflects the accountant’s judgments about when they should recognize revenue. And where there is judgment, there is room for dispute—not to say manipulation.”

“In general, depreciation is the ‘expensing’ of a physical asset, such as a truck or a machine, over its estimated useful life… Depreciation is a prime example of what accountants call a noncash expense… The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be allocated over the truck’s life, a little at a time.”

“Amortization is the same idea as depreciation, but it applies to intangible assets… R&D expenses that do not result in an asset likely to generate revenue should be recorded as an expense on the income statement… Amortization is fine if the R&D is actually expected to generate revenue, but not if it isn’t.”

What can a cash flow statement reveal? The authors walk us through a sample. “Operating cash flow is considerably higher than net income. Inventory declined, so it’s reasonable to suppose that the company is tightening up its operations. All of this makes for a stronger cash position. We can also see, however, that there is not a lot of new investment going on. Depreciation outweighed new investment, which makes us wonder if management believes that the company has much of a future. Meanwhile, the company is paying its shareholders a healthy dividend, which may suggest that they value it more for its cash-generating potential than for its future.”

“Ratios help you understand whether the numbers you’re looking at are favorable or unfavorable…

  • You can compare ratios with themselves over time…
  • You can also compare ratios with what was projected…
  • You can compare ratios with industry averages.”

“There are four categories of ratios that managers and other stakeholders in a business typically use to analyze the company’s performance: profitability, leverage, liquidity, and efficiency.”

“Remember the devil is in the details in ROI analysis. Anyone can make the projections look good enough so that the investment seems to make sense. Often it makes sense to do a sensitivity analysis—that is, check the calculations using future cash flows that are 80 percent or 90 percent of the original projections, and see if the investment still looks good. If it does, you can be more confident that your calculations are leading you to the right decision.”

“The three concepts you’ll be using in analyzing capital expenditures are future value, present value, and required rate of return… They’re simply ways to calculate the time value of money.”

“Astute management of the balance sheet… speeds up the cash conversion cycle… Companies that can generate more cash in less time have greater freedom of action; they aren’t so dependent on outside investors or lenders… Learn to manage working capital better, and you can have a powerful effect on both your company’s profitability and its cash position… The three working capital accounts that nonfinancial managers can truly affect are accounts receivable, inventory, and (to a lesser extent) accounts payable.”

“The key ratio that measures accounts receivable… is days sales outstanding, or DSO—that is, the average number of days it takes to collect on these receivables… in other words, how fast customers pay their bills… The longer a company’s DSO, the more working capital is required to run the business… It follows that the more people who understand DSO and work to bring it down, the more free cash the company will have at its disposal… Quality problems and late deliveries often provoke late payment.”

“Reducing DSO even by one day can save a large company millions of dollars per day.”

“Managing inventory efficiently reduces working capital requirements by freeing up large amounts of cash… Salespeople… The more that salespeople can sell standard products with limited variations, the less inventory their company will have to carry… Engineers… A proliferation of product versions puts a burden on inventory management. When a product line is kept simple, with a few interchangeable options, inventory declines and inventory management becomes a less taxing task… Production departments… Decisions about how much to build of a particular part have an enormous impact on inventory requirements. Even the layout of a plant affects inventory: an efficiently designed production flow in an efficient plant minimizes the need for inventory.”

“When demand is slow… the plant manager must consider the company’s cash as well as its unit costs. A plant that continues to turn out product in these circumstances is just creating more inventory that will sit on a shelf taking up space… Any large company can save millions of dollars of cash, and thereby reduce working capital requirements—just by making modest improvements in its inventory management.”

The book covers some common ways that unscrupulous executives cook the books. “According to a 2007 study by the Deloitte Forensic Center, 41 percent of fraud cases pursued by the Securities and Exchange Commission between 2000 and 2006 involved revenue recognition… A second example of the artful work of finance—and another one that often plays a role in financial scandals—is determining whether a given cost is a capital expenditure or an operating expense. (The Deloitte study notes that this issue accounted for 11 percent of fraud cases between 2000 and 2006.)”

The authors also explain how executives at Waste Management Inc. (WMI) inflated pretax earnings by $716 million by playing games with depreciation. “Of course, the whole tangled web eventually came unraveled, as fraudulent schemes usually do.”

Berman, Karen, Joe Knight, and John Case. Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean. Boston: Harvard Business Review Press, 2013. Buy from Amazon.com

Disclosure: As an Amazon Associate I earn from qualifying purchases. I received a review copy of this book.

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