Financial Intelligence for HR Professionals

What You Really Need to Know About the Numbers

Karen Berman, Joe Knight

• Publisher: Harvard Business Review Press
• Year: 2008
• ISBN:
  9781422163306
• Topic: Business
• Subtopic: Finance
• Index: Business

As an HR manager, you're expected to use financial data to make decisions, allocate resources, and budget expenses. But if you're like many human resource practitioners, you may feel uncertain or uncomfortable incorporating financials into your day-to-day work.Using the groundbreaking formula they introduced in their book Financial Intelligence: A Manager's Guide to Knowing What the Numbers Really Mean, Karen Berman and Joe Knight present the essentials of finance specifically for HR experts.Drawing on their work training tens of thousands of managers and employees at leading organizations worldwide, the authors provide a deep understanding of the basics of financial management and measurement, along with hands-on activities to practice what you are reading. You'll discover:· Why the assumptions behind financial data matter
· What your company's income statement, balance sheet, and cash flow statement really reveal
· Which financials may be needed when you're developing a human capital strategy
· How to calculate return on investment
· Ways to use financial information to better support your business units and do your own job
· How to instill financial intelligence throughout your teamAuthoritative and accessible, Financial Intelligence for HR Professionals, empowers you to "talk numbers" confidently with your boss, colleagues, and direct reports -- and understand how the financials impact your part of the business.

Part One

The Art of Finance (and Why It Matters to HR)

1

You Can’t Always Trust the Numbers

If you read the papers regularly, you have learned a good deal in recent years about all the wonderful ways people cook their companies’ books. They record phantom sales. They hide expenses. Some of the techniques are pleasantly simple, like the software company a few years back that boosted revenues by shipping its customers empty cartons just before the end of a quarter. (The customers sent the cartons back, of course—but not until the following quarter.) Other techniques are complex to the point of near incomprehensibility. (It took years for accountants and prosecutors to sort out all of Enron’s spurious transactions.) As long as there are liars and thieves on this earth, some of them will no doubt find ways to commit fraud and embezzlement.

But maybe you have also noticed something else about the arcane world of finance, namely that many companies find perfectly legal ways to make their books look better than they otherwise would. Granted, these legitimate tools aren’t quite as powerful as outright fraud: they can’t make a bankrupt company look like a profitable one—at least, not for long. But it’s amazing what they can do. For example, a little technique called a one-time charge allows a company to take a whole bunch of bad news and cram it into one quarter’s financial results so that future quarters will look better. Alternatively, some shuffling of expenses from one category into another can pretty up a company’s quarterly earnings picture and boost its stock price. While we were writing this book, the Wall Street Journal ran a front-page story on how companies fatten their bottom lines by reducing retirees’ benefit accruals—even though they may not spend a nickel less on those benefits.

Everybody who isn’t a financial professional is likely to greet such maneuvers with a certain amount of mystification. Human resources—like most other aspects of business, including marketing, research and development, and strategy formulation—is at least partly subjective, a matter dependent on experience and judgment as well as data. But finance? Accounting? Surely, the numbers produced by these departments are objective, black and white, indisputable. Surely, a company sold what it sold, spent what it spent, earned what it earned. Even where fraud is concerned, unless a company really does ship empty boxes, how can its executives so easily make things look so different than they really are? And short of fraud, how can executives so easily manipulate the business’s bottom line?

THE ART OF FINANCE

The fact is, accounting and finance, like all those other business disciplines, really are as much art as they are science. You might call this the CFO’s or the controller’s hidden secret—except that it isn’t really a secret; it’s a widely acknowledged truth that everyone in finance knows. Trouble is, the rest of us tend to forget it. Or maybe we suspected it based on the interactions we’ve had with the finance department, but we never felt confident enough to pursue the matter. It seems like if a number shows up on the financial statements or on the finance department’s reports to management, it must accurately represent reality.

In fact, of course, that can’t always be true, if only because even the number jockeys can’t know everything. They can’t know exactly what people in human resources (and in all the other departments) do every day, so they don’t know exactly how to allocate costs. They can’t know exactly how long a piece of equipment will last, so they don’t know how much of its original cost to record in any given year. They can’t predict exact payouts for incentive plans, so they don’t know exactly how much to budget. 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. Accounting and finance are not reality; they are a reflection of reality. The accuracy of that reflection depends on the ability of accountants and finance professionals to make reasonable assumptions and to calculate reasonable estimates.

It’s a tough job. Sometimes they have to quantify what can’t easily be quantified. Sometimes they have to make difficult judgments about how to categorize a given item. None of these complications necessarily arises because they are trying to cook the books or because they are incompetent. The complications arise because accountants and financial folks must make educated guesses related to the numbers side of the business all day long.

The result of these assumptions and estimates is, typically, a bias in the numbers. Please don’t get the idea that by using the word bias we are impugning anybody’s integrity. (Some of our best friends are accountants—no, really—and one of us, Joe, actually carries the title CFO on his business card.) Where financial results are concerned, bias means only that the numbers might be skewed in one direction or another. It means only that accountants and finance professionals have used certain assumptions and estimates rather than others when they put their reports together. Enabling you to understand this bias, to correct for it where necessary, and even to use it to your own (and your company’s) advantage is one objective of this book. To understand it, you must know what questions to ask about these assumptions and estimates. Armed with that information, you can make well-considered, appropriate decisions.

In issues related to human resources, you have to make judgment calls every day. Understanding the thought process behind those decisions helps you and others see the reasoning behind your conclusions. It’s the same in finance. As an HR manager, you should strive to understand the assumptions behind the numbers that the accounting department presents.

Box Definitions

We want to make finance as easy as possible. Most finance books make us flip back and forth between the page we’re on and the glossary to learn the definition of a word we don’t know. By the time we find it and get back to our page, we’ve lost our train of thought. So here we are going to give you the definitions right where you need them, near the first time we use the word.

JUDGMENT CALLS

For example, let’s look at one of the variables that is frequently estimated—one that you wouldn’t think needed to be estimated at all. Revenue or sales refers to the value of what a company sold to its customers during a given period. You’d think that would be an easy matter to determine. But the question is when revenue should be recorded (or “recognized,” as accountants like to say). Here are some possibilities:

• When a contract is signed
• When the product or service is delivered
• When the invoice is sent out
• When the bill is paid

If you said, “When the product or service is delivered,” you’re correct; as we’ll see in chapter 6, that’s the fundamental rule that determines when a sale should show up on the income statement. Still, the rule isn’t simple. Implementing it requires making a number of assumptions, and in fact the whole question of “when is a sale a sale?” was a hot topic in many of the fraud cases dating from the late 1990s.

Imagine, for instance, that a company sells a customer a copier, complete with a maintenance contract, all wrapped up in one financial package. Suppose the machine is delivered in October, but the maintenance contract is good for the following twelve months. Now, how much of the initial purchase price should be recorded on the books for October? After all, the company hasn’t yet delivered all the services that it is responsible for during the year. Accountants can make estimates of the value of those services, of course, and adjust the revenue accordingly. But that requires a big judgment call.

Income Statement

The income statement shows revenues, expenses, and profit for a period of time, such as a month, quarter, or year. It’s also called a profit and loss statement, P&L, statement of earnings, or statement of operations. Sometimes the word consolidated is thrown in front of those phrases, but it’s still just an income statement. The bottom line of the income statement is net profit, also known as net income or net earnings.

Nor is this example merely hypothetical. Witness Xerox, which played the revenue recognition game on such a massive scale that it was later found to have improperly recognized a whopping $6 billion of sales. The issue? Xerox was selling equipment on four-year leases, including service and maintenance. So how much of the price covered the cost of the equipment, and how much was for the subsequent services? Fearful that the company’s sagging profits would cause its stock price to plummet, Xerox’s executives decided to book ever-increasing percentages of the anticipated revenues—along with the associated profits—up front. Before long, nearly all the revenue on these contracts was being recognized at the time of the sale. Suppose you worked in HR for Xerox. You probably wouldn’t have known that the revenue number wasn’t matched appropriately to actual sales. Yet that number might have been used for incentive-plan compensation and for commission checks. It might have been used to determine which salespeople needed extra training and which didn’t. And those decisions that you would have made would have been dramatically affected by the decision to change how revenue was being recognized.

Xerox had clearly lost its way and was trying to use accounting to cover up its business failings. But you can see the point here: there’s plenty of room, short of outright book-cooking, to make the numbers look one way or another. And the implications for managers who can’t ask the right questions are huge.

A second example of the artful work of finance—and another one that played a huge role in recent financial scandals—is determining whether a given cost is a capital expenditure or an operating expense. We’ll get to all the details later; for the moment, all you need to know is that an operating expense reduces the bottom line immediately, and a capital expenditure spreads the hit out over several accounting periods. You can see the temptation here. Wait. You mean if we take all those office supply purchases and call them capital expenditures, we can increase our profit accordingly? HR isn’t immune to this kind of thinking. The department is usually seen as a cost center, so anything you can do to reduce expenses might seem like a good thing. But it’s the sort of thinking that can get you into trouble. To prevent such temptation, both the accounting profession and individual companies have rules about what must be classified where. But the rules leave a good deal up to individual judgment and discretion. Again, those judgments can affect a company’s profit, and hence its stock price, dramatically.

Operating Expenses

Operating expenses are the costs that are required to keep the business going day to day. They include salaries, benefits, and insurance costs, among a host of other items. Many companies’ largest operating expense is labor costs. Understanding the components of labor costs and what drives them is a key part of finance as it relates to HR. Operating expenses are listed on the income statement and are subtracted from revenue to determine profit.

Now, we are writing this book primarily for HR leaders in companies, not for investors. So why should HR people worry about any of this? The reason, of course, is that they use numbers to make decisions. You yourself make judgments about budgets, capital expenditures, staffing, and a dozen other matters—or your boss does—based on an assessment of the company’s or your business unit’s financial situation. You are supporting parts of the organization that deal with the numbers every day—and you provide advice and information based in part on how they are doing financially. Moreover, what you do affects the financials of those departments and units. If you aren’t aware of the assumptions and estimates that underlie the numbers and how those assumptions and estimates affect the numbers in one direction or another, your decisions, advice, support, and information may all be faulty.

Financial intelligence means understanding where the numbers are “hard” (that is, well supported and relatively uncontroversial) and where they are “soft” (that is, highly dependent on judgment calls). What’s more, outside investors, bankers, vendors, customers, and others will be using your company’s numbers as a basis for their own decisions. If you don’t have a good working understanding of the financial statements and don’t know what those folks are looking at or why, you are at their mercy.

Capital Expenditures

A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure; anything less is an operating expense. Operating expenses show up on the income statement and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement. More on this in chapters 4 and 10.

2

Spotting Assumptions, Estimates, and Biases

So let’s plunge a little deeper into the “artistic” aspects of finance. We’ll look at three examples and ask some simple but critical questions:

• What were the assumptions in this number?
• Are there any estimates in the numbers?
• What is the bias those assumptions and estimates lead to?
• What are the implications?

The examples we’ll look at are accruals and allocations, depreciation, and valuation. If these words sound like part of that strange language the financial folks speak, don’t worry. You’ll be surprised how quickly you can pick up enough to get around.

ACCRUALS AND ALLOCATIONS: LOTS OF ASSUMPTIONS AND ESTIMATES

At a certain time every month, you know that your company’s controller is busy “closing the books.” The controller asks you for additional information, maybe information that seems too detailed to matter, and he or she needs it right away. Here, too, is a financial puzzle: why on earth does it take as long as it does? And why does the accounting department need all that information? If you haven’t worked in accounting, you might think it could take a day to add up all the end-of-the-month figures. But two or three weeks?

Well, one step that takes a lot of time is figuring out all the accruals and allocations. There’s no need to understand the details now—we’ll get to that in chapters 10 and 11. For the moment, read the definitions in the boxes, and focus on the fact that the accountants use accruals and allocations to try to create an accurate picture of the business for the month. After all, it doesn’t help anybody ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Table of Contents
• PREFACE
• Part One - The Art of Finance (and Why It Matters to HR)
• Part Two - The (Many) Peculiarities of the Income Statement
• Part Three - The Balance Sheet Reveals the Most
• Part Four - Cash Is King
• Part Five - Ratios: Learning What the Numbers Are Really Telling You
• Part Six - How to Calculate (and Really Understand) Return on Investment
• Part Seven - Applied Financial Intelligence: Working Capital Management
• Part Eight - Creating a Financially Intelligent HR Department (and Organization)
• APPENDIX A - Sample Financials
• APPENDIX B - Exercises to Build Your Financial Intelligence
• APPENDIX C - Kimberly-Clark and FedEx
• NOTES
• ACKNOWLEDGMENTS
• INDEX
• ABOUT THE AUTHORS