Financial Intelligence, Revised Edition

A Manager's Guide to Knowing What the Numbers Really Mean

Karen Berman, Joe Knight, John Case

• Publisher: Harvard Business Review Press
• Year: 2013
• ISBN:
  9781422144121
• Topic: Business
• Subtopic: Finance
• Index: Business

Inc. magazine calls it one of "the best, clearest guides to the numbers” on the market. Readers agree, saying it’s exactly "what I need to know” and calling it a "must-read” for decision makers without expertise in finance.Since its release in 2006, Financial Intelligence has become a favorite among managers who need a guided tour through the numbers—helping them to understand not only what the numbers really mean, but also why they matter. This new, completely updated edition brings the numbers up to date and continues to teach the basics of finance to managers who need to use financial data to drive their business. It also addresses issues that have become even more important in recent years—including questions around the financial crisis and those around broader financial and accounting literacy.Accessible, jargon-free, and filled with entertaining stories of real companies, Financial Intelligence gives nonfinancial managers the confidence to understand the nuance beyond the numbers—to help bring everyday work to a new level.

Part One

The Art of Finance (and Why It Matters)

1

You Can’t Always Trust the Numbers

If you read the news regularly, you have learned a good deal in recent years about all the wonderful ways people find to cook their companies’ books. They record phantom sales. They hide expenses. They sequester some of their properties and debts in a mysterious place known as off balance sheet. 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. (Remember Enron? It took years for accountants and prosecutors to sort out all of that ill-fated company’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. A while ago, 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.

Anybody who isn’t a financial professional is likely to greet such maneuvers with a certain amount of mystification. Everything else in business—marketing, research and development, human resource management, strategy formulation, and so on—is obviously 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 they 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. We think that if a number shows up on the financial statements or 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 numbers jockeys can’t know everything. They can’t know exactly what everyone in the company does 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. 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, and 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 means that the accountants and financial folks are trying to cook the books or that they are incompetent. The complications arise because they must make educated guesses relating 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, depending on the background or experience of the people who compiled and interpreted them. 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. Armed with the information you gather, you can make informed, well-considered decisions.

. . .

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, next to 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 should revenue 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 7, 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?” is a hot topic in many fraud cases. 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.¹

. . .

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.

. . .

Imagine, for instance, that a company sells a customer a copying machine, 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 this requires a big judgment call.

Nor is this example merely hypothetical. Witness Xerox, which several years ago 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 at the time 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.

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.

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.) 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? This is the kind of thinking that got WorldCom—the big telecommunications company that went bankrupt in 2002—into so much trouble (see the part 3 toolbox for details). 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 required to keep the business going from day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses are listed on the income statement and are subtracted from revenue to determine profit.

. . .

Now, we are writing this book primarily for people in companies, not for investors. So why should these readers 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. 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 may be faulty. Financial intelligence means understanding where the numbers are “hard”—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 know what they’re 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, while 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 5 and 11.

. . .

2

Spotting Assumptions, Estimates, and Biases

So let’s plunge a little deeper into this element of financial intelligence—understanding the “artistic” aspects of finance. Even though you’re just at the beginning of the book, this will give you a valuable perspective on the concepts and practices that you’ll learn later on. 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, 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.” Here, too, is a financial puzzle: Why on earth does it take as long as it does? If you haven’t worked in finance, 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 11 and 12. 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 if the financial reports don’t tell us how much it cost us to produce the products and services we sold last month. That is what the controller’s staff is trying so hard to do, and that is one reason why it takes as long as it does.

Determining accruals and allocations nearly always entails making assumptions and estimates. Take your salary as an example. Say that you worked in June on a new product line and that the new line was introduced in July. Now the accountant determining the allocations has to estimate how much of your salary should be matched to the product cost (because you spent much of your time on those initial products) and how much should be charged to development costs (because you also worked on the original development of the product). She must also decide how to accrue for June versus July...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Contents
• Preface: What Is Financial Intelligence?
• Part One. The Art of Finance (and Why It Matters)
• 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 Company
• Appendix: Sample Financials
• Notes
• Acknowledgments
• Index
• About the Authors