Business Financial Intelligence: A Mindset And Skillset Few People Have And All Organizations Need. 2i104l

A mindset and skillset few people have and all organizations need.

What your CFO absolutely needs you to know...

This clear and concise book will help you better understand the universal language of business and will demystify the financial terminology and concepts that are used to measure an organization’s performance.

Do you want to go to the highest high of your organization? Would you like to enhance your business acumen so any employer in any industry in any part of the world can see your value? If so, this book is a must-read and, more importantly, a must-do.

A recovering ant, Paul serves as your guide—breaking the complexity of business down into simple, memorable, and often humorous steps.

Can you imagine an organization where everyone working in the business is working as if they owned the business? Imagine what that would do to that company’s income, expenses, assets, and liabilities.

That’s called having an intrapreneurial spirit. That’s called business financial intelligence—a mindset and skillset few people have and all organizations need.

ISBN: 978-1-7363718-1-7

Published by: Scholars Gate Publishing 27433 Tourney Road, Suite 120 Valencia, CA 91355

Printed in the United States of America

Paperback book ISBN: 978-1-7363718-0-0 Hardback book ISBN: 978-1-7363718-3-1 E-book ISBN: 978-1-7363718-1-7 Audio book ISBN: 978-1-7363718-2-4

Editing by Amy Leskowski and Samuel Kelly Book design by Joshua Fleck Audio book produced by Koren Young

Copyright © 2021 Paul Butler All rights reserved, including the right of reproduction in whole or in part or in any form.

About the Author

Paul Austin Butler

CGMA, CIMA

Paul Butler is a chartered global management ant (CGMA) and a chartered management ant (CIMA). Originally from England, he worked for Hilton International Hotels and Marriott International as a regional finance director and first came to the United States as the director of marketing and financial services for Hilton Honors when Hilton’s worldwide headquarters was in Beverly Hills, California.

In 2006, Paul started Newleaf Training and Development—a staff-training and leadership-development company that serves clients across the United States and around the world.

A teacher at heart, Paul also serves as a faculty member within the business department of the Master’s University in Santa Clarita, California. He lives in Valencia, California, and has been married to his wife, Gaynor, since 1994. They have two adult children.

ABOUT

Newleaf Training and Development delivers seminars, keynotes, coaching, and online solutions to help people and organizations better manage themselves, lead others, and build business financial intelligence.

Newleaf’s clients include Caltech, Chubb Insurance, Citrix, Hilton Grand Vacations, Lockheed Martin, McGraw Hill, NASA Jet Propulsion Laboratory (JPL), and Pepperdine University.

Newleaf Training and Development is headquartered in Valencia, California. Visit newleaftd.com for further details on their training and development services as well as information for other Newleaf office locations.

Why I Wrote This Book

I wrote this book mainly with employees in mind, although much of it can be applied to the working world of an entrepreneur. In fact, from an entrepreneurial perspective, one of the main reasons most small businesses fail within their first five years is not a lack of ideas but a lack of business financial intelligence.

Based on their technical competence alone, employees can make only so much of a contribution to their organizations and get only so far in their careers.

Over and above their technical areas of expertise, employees need to be good at managing themselves. Self-management comes in the form of self-control, time management, a positive attitude, good interpersonal skills, and a spirit to serve both internal and external customers superbly. Employees who are good at managing themselves are likely to be promoted to lead others.

Two things stick in my mind that my father said to me about business. The first is “Get rid of the mullet!” I protested, trying to explain it was “business in the front, party in the back.” But I accepted his wise words, and the mullet went. The second thing is “A person will never be good at influencing others until they can manage themselves.” Isn’t that essentially what leadership is—managing self and influencing others?

But is there anything else? Even if we’re exemplary at managing self and exceptional at influencing others, can we make an even-greater contribution as employees? The answer is yes, and that’s why I wrote this book.

Business financial intelligence is a mindset and skillset few people have and all organizations need. It doesn’t matter whether the company is privately held or publicly traded, whether it’s an educational institution, a government entity, or a nonprofit. Every organization needs to ensure that its income is higher than its expenses and that its assets are larger than its liabilities, or it won’t be doing business for long. , all organizations are in business, as they’re providing products or services in exchange for money, which is the definition of commerce.

Employees operate systems, processes, and procedures—they help deliver products and services to customers and, in doing so, directly impact the income, expenses, assets, and liabilities of their organizations. If the income is greater than the expenses, the employees are helping create profits for the organization, which helps the business continue. If the assets are greater than the liabilities, the employees are improving the equity of the organization, which helps attract and retain investors.

Can you imagine an organization where everyone working in the business is working as if they owned the business? Imagine what that mindset and skillset would do to that company’s income, expenses, assets, and liabilities.

That’s called having an intrapreneurial spirit.

From my experience as an employee for almost twenty years and as a business owner since 2006, I’d suggest that an employee who’s technically competent, is exemplary at managing self, is exceptional at influencing others, and has an intrapreneurial spirit is worth that employee’s weight in gold. Organizations don’t want to let these people go. This type of employee is what’s referred to as talent, and organizations will do whatever they can to develop, promote, engage, and reward such worthwhile employees.

I’ve observed how most training companies teach techniques, but techniques have to be ed and consistently applied to make a sustainable difference to people and organizations. To be blunt, this is why most training doesn’t work over the long haul—after the training event has finished, people go back to their real world of work, and unless they’re constantly hounded to apply or rewarded for applying the new techniques, they forget most of what they heard. Techniques, you see, are temporal.

Conversely, at Newleaf Training and Development, all our programs are based upon principles. I’m no psychologist (, I’m a recovering ant), but I know that principles are absolute (meaning they’re true), universal (meaning they apply to all people all the time), and objective (meaning they exist with or without our acceptance or agreement). Principles are also timeless (meaning they don’t come in and then soon fall out of vogue). I’ve found that we can help people and organizations be their best not by teaching techniques but, rather, by uncovering principles.

Once employees align their mindsets with principles, they innately want to improve their skillsets. They become self-directed learners, and in the case of business financial intelligence, they begin to think and behave like business owners. They see how their day-to-day activities impact their organization’s money-making model, and they adjust their behaviors accordingly.

The principle that underpins our business financial intelligence program is that a fully engaged employee will treat the organization’s resources as his or her own. This principle comes from the Holy Bible: “And if you are not faithful with other people’s things, why should you be trusted with things of your own?” (Luke 16:12 New Living Translation).

I hope you enjoy this book. I’ve kept it short and to the point. In today’s fast-

moving world, I find that few people will sit and read a book, and even fewer people will read a long one. It makes me chuckle when I hear people say they read the first two or three habits of The 7 Habits of Highly Effective People by the late Dr. Stephen R. Covey, or that they never got to the “great” part of Jim Collins’s Good to Great. So this is an intentionally short read.

I finish the book with “So, What’s Next?” Why? I’ve found that many business books are all theory, often written by people who’ve never had a real job with real responsibilities—consultants who’ve never actually done the work of those whom they’re trying to influence to do work better. The “So, What’s Next?” section is meant to inspire you to apply the learning to your immediate surroundings. I also encourage you to teach these concepts and principles to others. It’s often said that the best way to learn something is to do it or teach it— preferably both. I hope the closing chapter will prompt you to do and teach.

The world of commerce is rapidly changing. Outsourcing is becoming more common. Organizations are forever rightsizing, downsizing, and reengineering. As you go up the traditional organizational pyramid, the jobs get fewer and fewer—no one in business has the time or appetite for fictional theories.

My hope is that this little book will serve as a practical guide for you. Business financial intelligence can help you enhance your present contribution, gain a promotion, move across departments, and traverse industries. Hey, it may even encourage you to start your own business one day. But before you do that, you do already run your own business—the business of being an employee.

Endorsements

Truly understanding financial literacy is the key to creative managerial leadership or, simply stated, to business success. Paul has captured this critical literacy without employing too many words. He has uniquely reduced financial understanding into digestible bites (e.g., ‘MVP,’ ‘The 3 Rs,’ ‘The 7 Components of Financial Intelligence’), allowing greater retention of concepts and clarity of application—something rarely achieved by other authors of this critical science.

George M. Sims PhD, Department Chair, Undergraduate and Graduate Business Studies

This is not your average financial guide. Paul’s witty humor, influential encouragement, and business financial intelligence expertise make financial statement misunderstandings less daunting to me as an employee. I highly recommend this book as a must-read, especially for those who wish to strengthen their ‘intrapreneurial spirit.’ This book can guide you to become an invaluable asset to your employer.

Lauren Sowa, Sales Associate

I took finance for non-managers in college, but I have never felt confident having the numbers talk. Now I do. This book has equipped me to have more effective discussions with win-win outcomes. Numbers are crucial, and the bottom line is where most of our great ideas in human resources can die because we don’t fully understand the financial ramifications. I am going to use this as my personal cheat sheet moving forward!

Stephanie Hancock, Human Resources Manager

I wish someone had taught me these principles before I was promoted into a leadership role. Kudos to Paul Butler for providing a solution to a problem that many leaders and organizations do not even realize they have—a lack of business financial intelligence. This book provides a simple yet sufficient overview of key financial principles and does a great job of explaining why all aspiring leaders (not just finance people) should know these things. I am now more confident and better equipped to understand and impact my organization!

Jesse Weldon, Healthcare Manager

Reading, this book is like having a conversation with Paul Butler. It’s not your typical professorial textbook filled with complicated and foreign concepts that become exponentially more difficult as you read on. Rather, it’s an appropriate blend of practical lessons, ing vernacular, finance principles, an ever-present sense of humor, personal stories, and real-life examples, that demystify—and simplify—the components necessary to ensuring an organization’s success. The intricacies of the book, and their accompanying , become straightforward through relatable examples, breaking down what is seemingly complex into manageable, bite-sized takeaways.

I met Paul over a decade ago, and his Business Financial Intelligence lessons are etched in my mind. He has facilitated our executive retreats, led multiple BFI sessions for groups of our sales professionals, and traveled to share these easyto-follow principles with hundreds of our leaders and employees from across the U.S. and Canada.

Natalie Bazarevitsch, Senior Vice President

Author Paul Butler has written a practical and engaging guide that breaks down and demystifies finance and ing. A great read for anyone trying to improve their financial intelligence, and a must-read for managers who want to learn how they can make a difference in their business.

David Tessier, Company President

Paul has given the ing and financial world a shakedown with this concise and pithy read that clarifies some of the most fundamental and critical concepts found in business. If you are an entrepreneur looking to keep track of the used in an enterprise and show your banker or ant you know what they are saying, this book will help you with your business intelligence. And too, for you financial and ing buffs, you will find that the ease with which Paul explains some of the most familiar concepts will provide you with the tools of the trade that will allow you to be more articulate with your associates, bosses, and clients. This is a book that will be a friendly reference for years to come.

Dwight Ham, Business Department Chair

This book is a quick and easy read to help simplify the understanding of financial statements and will help teammates better communicate during planning and review of our company’s performance. I am confident this will help management teams understand how their actions impact the health of their business.

Matt Borg, Financial Controller

What a pleasant read! It is a delight to read a financial book that is so concise, so engaging, and yet so informative. Paul has a gift to draw in the reader with humor yet deliver key points so succinctly. I would recommend this book for colleges and universities but also believe it should be shared with the key team throughout businesses of any size and type.

Tony Watson, Vice President, Business Improvement

Paul has been a great consultant and partner to me for over ten years. He has been a tremendous in deg and delivering sessions to develop teams I have led in the hospitality and the technology space. I am so thrilled to see him publish some of these principles he has developed to provide greater access to this knowledge. His in-person and virtual sessions are always met with positive outcomes, and his fun yet effective training style shines through these pages.

Annie Brown, Global Head of Diversity and Inclusion

Disclaimer Paul Butler, Newleaf Training and Development, and its associated officers, directors, shareholders, owners, employees, agents, representatives, suppliers and service providers (collectively “the Author”) provide the content of this book for informational purposes only. Use of and access to the information, materials, services, and other content available in this book (“Content”) are subject to these of use and all applicable laws. The Content is for informational purposes only; you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained in this book constitutes a solicitation, recommendation, endorsement, or offer by the Author or any third-party service provider to buy or sell any services in this or in in any other jurisdiction in which such solicitation or offer would be unlawful under the laws of such jurisdiction.

All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in this book constitutes professional and/or financial advice, nor does any information constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. The Author is not a fiduciary by virtue of any person’s use of or access to the book or Content. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of any information or other Content before making any decisions based on such information or other Content. In exchange for using the Content, you agree not to hold the Author, its s or any third-party service provider liable for any possible claim for damages arising from any decision you make based on information or other Content made available to you.

Dedication This book is dedicated to my wife, Gaynor, who encouraged me to keep going after failing my first set of ing exams in England by one point (yes, just one point) and also said yes a few years later, in 2006, when I suggested we sell everything and move to the United States to start our own company.

Contents

Chapter 1 | MVP: Margin × Velocity × People

Chapter 2 | The Three Levels of Profit

Chapter 3 | The Three Rs

Chapter 4 | The Working-Capital High-or-Low Game

Chapter 5 | Current Assets, Current Liabilities, Fixed Assets, and LongTerm Liabilities

Chapter 6 | Debits, Credits, and Normal Balances

Chapter 7 | The Primary Financial Statements

Chapter 8 | The Differences and Similarities between Management ing and Financial ing

Chapter 9 | Accruals and Prepayments

Chapter 10 | Depreciation and Amortization

Chapter 11 | Capital-Investment Appraisal

Chapter 12 | The Six Benefits of a High Stock Price

Chapter 13 | The Seven Components of Business Financial Intelligence

Closing | So, What’s Next?

MVP: Margin × Velocity × People

In sports, people often talk about an MVP (most valuable player). The letters M, V, and P make me think of a helpful way to reduce the complexity of all organizations into a simple formula: margin × velocity × people.

Let’s break it down further.

Net margin is how much you make in profit after deducting all expenses from your sales. It’s the bottom line. Net margin is expressed as a percentage or currency. The next chapter talks more about margin and the three ways to measure it—gross, operating, and net.

Whereas margin is how much you make, velocity is how many times you make it. Velocity can be expressed as speed, productivity, optimization, or utilization. Chapter 13 addresses how we measure velocity in business.

For a manufacturer, velocity is the speed at which raw material is converted into work in progress and then into finished goods and sold. For a retailer, it’s how fast the inventory is sold.

, raw materials, work in progress, and finished goods (aka inventory, for a retailer) tie up cash and heighten the risk of obsolescence, damage, or theft the longer an organization holds onto them.

For a service business, velocity is the ability to utilize labor in the most efficient and effective manner possible. Service businesses utilize human resources to produce organizational results.

Leaders of service businesses often say, “Our greatest asset is people.” Well, technically, from an ing perspective, people aren’t assets—they’re expenses, and any future obligations connected to them, such as pensions, are liabilities—but we appreciate the rhetoric.

In a perfect world, every organization—whether it’s a manufacturer, retailer, or service provider—wants to be in the business of both high margin and high velocity. In reality, some are high margin with relatively low velocity whereas others are high velocity with relatively low margin.

Having a fully engaged workforce optimizes margin and velocity because it’s people who help drive the results. Yet if any of the three elements is failing, results will be suboptimal.

Think about it—if margin is suppressed because of competition or an outdated product or service, velocity (e.g., volume of sales) will reduce. If margin and velocity are down, it can be hard to attract or retain high-quality people. If morale is suffering, velocity and margin will continue to suffer.

Great organizations (regardless of what type) are always trying to improve margin, increase velocity, and fully engage people.

When it comes to the people part of the equation, organizations need to be reminded of the glue that bonds people together—trust. Trust is character (who you are) and competence (what you do). If you’re a colleague (or leader) of high character and high competence, people will trust you. If you’re not—not so much.

So, MVP may mean “most valuable player” in sports, but in the sport of business, it’s a good way to remind us that all organizations are in business and that the complexity of commerce can be distilled into a formula of margin × velocity × people.

I’m personally not into tattoos, but if I were, I think I’d have “margin × velocity × people” inked over my heart. Maybe I’ll try a henna version first.

The Three Levels of Profit

Gaynor and I have been blessed with two children—our daughter, Brodie, and our son, Henry. Ever since they became teenagers, we’ve sometimes questioned that blessing, but nonetheless, one of their wonderful teenage phrases that has stuck in my mind is this: “Too many words,” which they’d often say to us when we were trying to explain something—usually something they didn’t want to hear!

I often think of the phrase “Too many words” when I consider the number of times finance folks use different words for the same thing.

Gross profit, gross income, and gross margin all mean the same thing: the sales (also known as revenue, income, or fees earned) minus the cost of goods sold.

And there’s another funny phrase: cost of goods sold, which can sometimes be referred to as cost of merchandise sold or cost of goods consumed. We’ll talk about this in a minute—bear with me.

I’m a simple man from simple Central England who likes simple ways of explaining seemingly complicated concepts that are commonly heard but also commonly misunderstood.

Have you heard of Starbucks? It’s a small boutique independent coffee shop

brand that’s just starting up. (That’s a joke, by the way.) Well, picture yourself going into Starbucks and ordering your favorite beverage. Let’s say you pay five dollars for it. To Starbucks, the five dollars is revenue, also known as income, also known as sales, and—across the pond, in the UK—often called turnover. I can hear you asking, What about gross profit, gross income, and gross margin? Well, before we proceed, let’s simplify things by using gross profit, revenue, and cost of goods sold.

Cost of goods sold is simply the cost of the materials consumed within the sale. So, going back to our Starbucks example, that would be the cup (if it’s a disposable cup), the sleeve, the lid, the stirrer, and the liquid inside the cup. The materials cost Starbucks about one dollar—but hold that thought.

Revenue minus the cost of goods sold equals gross profit. So, five dollars minus one dollar equals a gross profit of four dollars. You’re welcome. Easy-peasy lemon squeezy.At this point, you might be thinking that the cost of goods sold isn’t, in our example, only the materials consumed but also the labor used to produce the beverage. And you’d be right if we were talking management ing rather than financial ing.

Management ing is a methodology of reporting information for the attention of—guess who? Managers! So if I were a finance person at Starbucks, I’d want to direct managers’ attention to how much a drink costs to make— materials and labor. These are what we call direct costs. These are the two big costs managers can influence and control through good . . . management. Get it?

But in financial ing, where we’re recording a transaction and reporting information to external s (not internal s, such as management), we count only the materials consumed within the cost-of-goods-sold calculation. Think about it—it’s kind of logical: the barista hasn’t been consumed as part of the sale, as the barista is still behind the counter—not inside your cup!

So we’re good with revenue, right? And we’re good with cost of goods sold? And we’re good with gross profit? We’re not out of the Starbucks store yet, though.

Operating profit, operating income, and operating margin all mean the same thing: the gross profit minus the operating expenses.

So look around with me inside our virtual Starbucks: What are some of the operating expenses that are deducted from gross profit to get us down to, say, operating profit? What do you see, hear, and feel inside our virtual Starbucks?

I can see equipment and furniture being used. The u of those fixed assets (we’ll talk about fixed assets in chapter 5) is called depreciation (which we’ll talk about in chapter 10).

I can see people using the Wi-Fi, and I guess Starbucks has to pay for that. There are the utilities—things like heat and lights—which are operating expenses. And, of course, there’s the store rent or mortgage. There may be some marketing funding at the local-store level. Yep, we deduct all those operating expenses from the gross profit, and then we’re down to operating profit. Are you tracking? Good. Now let’s go to Seattle.

Why Seattle? Well, Starbucks’s corporate headquarters is there. That’s where they started, in 1971—the same year most people’s shirt collars reached their shoulder blades. Anyway, back to Seattle.

Imagine you’re a store manager for Starbucks. Your responsibility ends at operating profit. Now take your virtual bag of operating profit and drop it on the doorstep of the corporate headquarters of Starbucks. What other costs are inside the headquarters that need to be deducted from the sum of operating profits to get you down to the proverbial bottom line—net profit, net income, and net margin?

What do you see, hear, and feel inside the corporate headquarters? I can see plenty of overhead—you know, the folks in legal, human resources, information technology, and all the C-suite (the folks with the word chief before their job title). What else? Well, like the stores, the headquarters also has things like depreciation on fixed assets, utilities, rent or mortgage, and Wi-Fi costs.

At the corporate level, there are some costs that are usually not charged back to the individual business units, such as amortization (which I’ll demystify), dividends (if the company pays dividends), and taxes. Deduct all of these from operating profit, and we get down to net profit, net income, and net margin.

Hey, you’ll never guess what! Net profit, net income, and net margin all mean the same thing.

Net profit, net margin, and net income are also referred to as earnings for the earnings per share (EPS) and the earnings before interest, tax, depreciation, and amortization (EBITDA) calculations. I’ll demystify both of those in subsequent chapters too.

Potentially confusing people even further, net profit, net margin, and net income are also referred to as return for return on asset (ROA), return on equity (ROE), and return on investment (ROI) calculations. Guess what? We’ll discuss those in the next chapter.

So what did we cover in this chapter?

1. There are three levels of profit: gross, operational, and net.

2. Gross profit is the same as gross income and gross margin.

3. Operating profit is the same as operating income and operating margin.

4. Net profit is the same as net income and net margin.

5. Net profit is also the same as return and earnings.

6. Depreciation is the expense of u fixed assets.

7. The 1970s had some pretty dreadful fashions.

I hope I’ve simplified the language of finance just a little, a smidgen, a tiny bit, an element, a small amount. (I can hear Brodie and Henry protesting with that delightful phrase, “Too many words!”)

The Three Rs

ants tend to use a lot of jargon, and, sadly, this often leads to misunderstanding when non-ants are afraid to reveal that they don’t understand it.

In this book, I’ll address some of the most commonly heard but misunderstood . My guess is you’ve heard some or all of these, but do you understand them?

Let’s deal with the R ones first: ROE, ROA, and ROI. I refer to these metrics as the three Rs. Do you from chapter 2 what the R (return) meant? Yep, that’s net margin, also known as net profit or net income. So, the numerator— that’s the R—in all three of these metrics is net margin.

It’s easy to what the numerator is because we have the word on between return and the rest of each phrase (i.e., return on equity, return on assets, and return on invested capital). Think of the word on as indicating what’s on the top line. Make sense?

ROE equals net margin divided by shareholders’ equity. , shareholders and stockholders are interchangeable . ROE indicates how much profit the company is generating for shareholders. The result is expressed as a percentage. For example, let’s say a company has generated net margin of $1 million from shareholder funds of $10 million; therefore, that company has generated a 10 percent ROE. Many people get confused, thinking ROE indicates an actual

payment of interest that subsequently occurs between a company and its shareholders. This isn’t the case. ROE is just an indicator of how efficient a company is being with the shareholder funds entrusted to it.

But how good is good enough? In our example, is 10 percent good enough? Well, shareholders will compare this 10 percent with other stocks they hold. They’ll also compare it to the general stock market. They’ll even compare it with interest they could earn as an alternative, especially when the stock market is volatile or interest rates are high. When such conditions exist, some shareholders are attracted to more secure interest-bearing investments.

So how does ROA differ from ROE? The A stands for assets, so all ROA is doing that’s different from ROE is comparing the net margin the company generated to the assets it owns rather than to the equity the shareholders own because they own the company. They’re both productivity measures, as we’re comparing an output (net margin) to an input (assets or equity). Going back to our example—if a company generated $1 million of net margin last year, the ROA would be 5 percent if the company had assets of $20 million. Again, how good is good enough?

Some companies will be measured primarily by ROE and some by ROA. Can you see why? If one company is asset heavy—let’s say it’s because it’s a manufacturer, so it owns expensive machinery—it makes the most sense for shareholders to measure the efficiency of the company’s performance primarily by calculating ROA. Conversely, if an organization is more service based (e.g., an insurance company), it’ll own assets, but nowhere near as many as an assetheavy manufacturer; therefore, shareholders will be interested primarily in ROE rather than ROA.

That leaves ROI, or return on invested capital (sometimes shortened to return on investments). The primary objective of a for-profit organization is to maximize shareholder wealth, sometimes referred to as shareholder value. Therefore, a

company might invest in activities that have nothing to do with its core business if those activities deliver a high ROI.

See, if a company can yield only, say, 5 percent return on its core operations because it’s in a low-margin-percentage business (e.g., retail) but has incredibly high volume (like Walmart does), it’ll be generating a large amount of cash. Such companies have an obligation to do something with all that excess cash. One of the options is to invest in activities that have nothing to do with their core operating activities. ROI simply measures the profit the company has earned in comparison to the investment assets the company (and hence the shareholders) owns. So those are the three Rs: return on equity, on assets, and on investments.

The Working-Capital High-or-Low Game

Working capital is a term that’s commonly heard yet commonly misunderstood. What adds more confusion is that some people use the term operating cycle to describe the same concept.

Working capital comprises six elements: raw materials, work in progress (sometimes abbreviated as WIP), finished goods, s receivable, s payable, and cash.

Manufacturing businesses have all six—they convert raw materials through manufacturing processes into final products, which they sell. Retailers don’t have raw materials or work in progress; they buy finished goods and call them inventory. Service businesses don’t have raw materials, work in progress, or finished goods, because they sell time—not products.

s receivable means selling products or services “on ,” which means allowing some time, referred to as a credit term, before the customer must pay. For many organizations, this is a normal course of doing business. One of the advantages of a retail business, and sometimes a service business, is it often receives cash payment (or the equivalent of cash, such as a debit-card or creditcard payment) as soon as it provides the product (or service).

s payable is the opposite of s receivable. s payable means items are purchased from vendors, and the vendors assign a period of time for payment. One company’s s receivable is another’s s

payable and vice versa.

Let’s categorize each of these elements as either an asset (what we own) or a liability (what we owe). Raw materials, work in progress, and finished goods are assets. s receivable is an asset because we own the right to that money (because someone owes us).

s payable is the only liability in this cycle, as it’s money we owe others. Cash (sometimes referred to as bank) is an asset because it’s money we have in the bank, and we own it.

Can you see why these six elements collectively are referred to as working capital? The best way to think about them is to consider that they are what we have to work with to make the business work. I personally have always thought we could add people, machines, and—if we have them—intangible assets (such as patents, royalties, trademarks, and goodwill) into the working-capital mix, but the ing textbooks still refer to working capital as just these six.

So we know what the six elements of working capital are and that manufacturing businesses have all six. We know that retail businesses have only four of them. We also know that service businesses have only three of them.

Now let’s play the working-capital high-or-low game. Sound like fun? This is definitely the kind of game you can play with friends on a Saturday night.

, manufacturers have two stages of production (raw materials and work in progress) before their goods are finished for sale. For simplicity, we can consolidate raw materials, work in progress, and finished goods into inventory.

Therefore, let’s play the working-capital high-or-low game with four labels: inventory, s receivable, s payable, and cash.

Now, ask yourself whether you want these items to be high or low, starting with inventory. Do you want to tie up as much working capital as possible in inventory—running the risk of damage, theft, spoilage, or obsolescence—or would you prefer to keep inventory as low as possible while still being able to meet the demand from your customers when they place an order or walk into your store? Obviously, you want to keep your inventory as low as possible while still being able to meet the demand. Perhaps one of the only reasons you’d bulk up on inventory would be if you were offered a substantial discount, but you’d also need to be confident you’d be able to sell those items quickly to avoid the aforementioned risks.

What about cash? Do you want your cash to be as high as possible, earning zero or close to zero interest, or would you prefer to keep your cash as low as possible while still being able to pay your bills as they fall due? Obviously, you want to keep your cash balance as low as possible while still being able to pay your bills in a timely manner. If a business doesn’t pay in a timely manner, it runs the risk of hurting its credit score, meaning when it does borrow money, it’s likely to pay a higher interest rate because the lenders regard the risk of nonpayment or late payment to be higher. Where there’s a higher risk, there’s a higher rate. Shareholders, for example, will get frustrated if the business in which they own stock (also known as shares) is sitting on too much cash. They want to see the company’s treasury department put that cash to work for them.

Let’s turn to s receivable. Do you want it to be as high as possible or as low as possible? Another way of thinking about this is to consider if you want to give your customers as long as possible to pay or if you want to collect, as quickly as possible, what’s owed to you. Obviously, you want to collect your s receivable as quickly as possible. It’s preferable for a business to get a deposit up front for work and then ensure that it bills its customer on the day of delivery, keeping the credit (days) as low as possible. If a payment goes

past due, a business should consider charging interest on the debt, because, as they say, time is money. (This is a difficult one, of course, in the spirit of positive customer relations.)

Finally, let’s discuss s payable. High or low? Should you pay your vendors (suppliers is the interchangeable term here) as quickly as possible or pay on the date the debt falls due? Well, you really want to hold onto your cash as long as possible, so if you’ve agreed to forty-five days, pay on day forty-five. The only scenario where you’d want to pay a vendor early would be if you negotiated an early-payment discount. Every dollar you can save on a vendor’s invoice goes to your bottom line, and the vendor may be interested in receiving your cash that little bit quicker. By the way, therein lies a simple money-making model—collect your receivables faster than you pay your payables.

So there you have it—the six elements of working capital. Can you see how, ultimately, the other five elements all impact cash, positively or negatively? If you didn’t know this before, can you now see how these six elements become four for a retailer and just three for a service business? And, as if it could get any better, you have a game you can now play with friends on a Saturday night—the working-capital high-or-low game! You’re welcome.

Current Assets, Current Liabilities, Fixed Assets, & Long-Term Liabilities

Do you from chapter 4 how five of the elements were assets and one was a liability? Next, we need to discuss how assets and liabilities are categorized and therefore how they’re often referred to on the balance sheet. , part of our agenda is to demystify the language of business. It’s useful for a business owner or an employee to be able to read the balance sheet.

Just as a book is divided into chapters, the balance sheet is divided into three main sections: assets (what the business owns), liabilities (what the business owes), and equity (what the business owes the owner or owners because they own the business).

The equity is the delta, the difference between the assets and the liabilities. In personal finance, we call this net worth. In business finance, there’s always another word before equity, and which word that is helps us see what type of business it is: Owner’s equity is the correct term for a proprietorship. Member’s or ’ equity is what we say for a limited liability company (LLC). And, hey, you’ll never guess what partners’ equity signifies. Yep, that’s a partnership. Shareholders’ (or stockholders’—they’re interchangeable ) equity is the phrase we use for a corporation.

So, back on track with the title of this chapter, current implies time. Current means “less than a year” in balance-sheet language. Current assets are those items that, if they’re not already cash, are expected to be converted into cash or used up in less than a year. Examples of current assets are cash, s

receivable, inventory (, a service business won’t have inventory), and supplies. People often ask if inventory and supplies are the same—the answer is no. Inventory is what we own that we plan to sell. Supplies are what we own (such as stationery) that we’ll use up. In the next chapter, we’ll discuss the ing for when something gets used up and—wait for it—get into debits and credits. Are you excited?

In chapter 7, we’ll discuss accruals and prepayments, including the ing behind the u of something (like insurance) that we’ve prepaid. The prepayment would be a current asset on our balance sheet. As it gets used up, the current asset decreases and our expenses (on the profit-and-loss , P&L, statement of operations, or income statement—which are interchangeable names for the same report) increase. Whereas current assets are those items we own that we expect to convert into cash or get used up in less than a year, current liabilities are those items we expect to have to pay for (out of our current assets) in less than a year. Examples of current liabilities are s payable (monies we owe to our vendors), wages payable (monies we owe to hourly employees), salaries payable (monies we owe to salaried employees), and bank loans (the portion that’s due in less than a year). The term net current assets is often used in management meetings to describe the result of deducting the current liabilities from the current assets. So if a company had $10 million in current assets and $4 million in current liabilities, the net current assets would be $6 million.

Fixed assets are those items that will last us more than a year and are physical or tangible. Buildings, land, equipment, furniture, and fixtures would be fixed assets. According to GAAP (generally accepted ing principles), there are four tests that an item has to to be treated as a fixed asset: The item must exist physically. It must be used in the normal operations of the business. It must be long-lived (meaning more than a year). And it must not be offered for sale. If it were offered for sale (like a car in a dealership showroom), it would be inventory, not fixed assets. Get it?

You may have heard the term intangible assets. These are items that a business

may own but that don’t exist physically, such as patents, royalties, trademarks, or goodwill. In chapter 10, we’ll discuss how fixed assets are depreciated and how intangible assets are amortized. And finally, long-term liabilities are those items we’ll be paying back over more than a year, such as a mortgage or a five-year bank loan. Easy-peasy. So I hope that clarifies (if you didn’t know already) what current assets, current liabilities, fixed assets, and long-term liabilities are on the balance sheet.

Debits, Credits, and Normal Balances

This is perhaps the most exciting chapter! Joking aside, I’m astounded at the number of senior leaders across organizations as well as business owners who don’t understand debits, credits, and normal balances. Some of you may be thinking, “Hang on, Paul—you’re talking bookkeeping now, not business financial intelligence.” And you’d be right. But to be candid, most leaders and owners don’t come across as very financially intelligent when they’re in a meeting and demonstrate their ignorance of this subject.

, the objective of this little book isn’t to turn you into an ant. But as an emerging leader, as a present leader within your organization, or certainly as a business owner, you do need to understand this, and it’s not complicated at all. I’ve found that most ants aren’t great teachers. I’ve also observed that many ing professors at colleges, universities, and even business schools have never had a real job with real responsibilities and are therefore often unable to relate ing principles to the real world of work.

Are you excited? Feel like you want to master debits, credits, and normal balances once and for all? Get the kettle on—we’ll be done in ten minutes. Here we go . . .

There are only five major s in business—I refer to them as parents. Every other is the child of a parent. Child s have only one parent. For example, cash is the child of an asset. Cash can’t be the child of an asset and the child of, say, a liability. That would be a pretty messed-up family.

So what are those five parent s? Assets, liabilities, equity, income, and expenses. , assets are what the business owns. Liabilities are what the business owes other people (such as employees, banks, and vendors). Equity is what the business owes the owners because they own the business. Income is what the business earned. Expenses are what the business used.

Would you like some extra credit? (Forgive the pun.) Did you notice which tense I stated the assets, liabilities, and equity in? Present tense. What about income and expenses? Past tense. This is why the balance-sheet s (assets, liabilities, and equity) are referred to as permanent s whereas the incomestatement s, also known as profit-and-loss s (income minus expenses), are referred to as temporary s. At the end of the ing period (normally monthly), the bottom line of the income statement, which will either be net profit (sometimes called net income) or net loss, is closed and carried into the statement of equity.

If the business made a profit, that’s good news for the owners, as equity increases. If the business suffered a loss, it sucks to be an owner, as equity decreases. We’ll talk more about financial statements in the next chapter.

, equity is always preceded by another word that tells you what type of organization we’re talking about, as we read in the previous chapter.

Now that we’re clear on the five parent s, what do we mean by debits and credits? I find the easiest way to explain debits and credits is to describe them as levers that either increase or decrease the . One pushes the up, and the other brings the down.

Every transaction in a business impacts at least two s—sometimes three or four but, most commonly, two. For example, if we’re a service business, then

when we provide our services and someone pays us immediately, we’ve earned income, so our income goes up and, because we were paid immediately, our cash goes up. Here, we can see how just two s are impacted—income (what we earned) and cash (what we own).

What about if we give the client a period of time to pay us? Well, if we’ve provided the service, we can still treat it as income (because we’ve earned it), but instead of cash increasing, a different asset—s receivable (which is what we own, as we own the right to that money)—increases. When the client eventually pays us, s receivable goes down and our cash goes up. Get it?

Let’s look at a transaction that impacts three s immediately, not just two. Imagine you purchase a vehicle for your business and put a deposit down of $5,000, with the other $25,000 being on a loan with the dealership. Your assets increase by $30,000 (the child would be, say, vehicles, because you own the vehicle even though you haven’t fully paid for it). Your cash decreases by $5,000, and your notes payable—we’ll get to that in a minute—increases by $25,000. Can you see that there are three s impacted by this transaction? Two of them are asset s (vehicles and cash), and the third is a liability (notes payable).

In case you’re not familiar with it, notes payable is the we use if the debt, which normally incurs interest, is to be paid back over a series of installments. s payable is the we use if we’re purchasing something from a vendor (also known as a supplier) and paying them in, say, thirty days. Notes payable and s payable are both liability s.

What about a transaction that impacts four s? Let’s do it! Imagine a retail store. When it sells a product (e.g., a loaf of bread), its inventory (which is an asset) goes down. Its cost of goods sold, which is an expense , increases.

, expenses are what we’ve used—in this case, to fulfill the customer’s “request” for a loaf of bread. That’s two transactions, which have just recorded the product coming off the shelf and through the cash . What about the customer’s payment? Well, you know that one already—income goes up (the store has earned it because it’s provided the product), and if the customer pays immediately, cash goes up. If the customer pays by debit or credit card, this is recorded as an asset, as the retailer owns the right to that money. Usually within a few hours, the banking process will reduce the debit- or credit-card and increase the cash balance. Make sense?

So, quite simply, debits and credits are the ways s are moved. Warning— don’t fall into the trap of thinking that one of them increases s (i.e., credits) and the other decreases s (i.e., debits), as it doesn’t work like that. You’ll get yourself into a pickle if you think that way.

So before we discuss what pushes up or brings down assets, liabilities, equity, income, or expenses, let’s be clear on what we mean by the term normal balance. A normal balance is the side that increases when you add to it. I’ll repeat that—a normal balance is the side that increases when you add to it. May I say that again? A normal balance is the side that increases when you add to it. Do you get the impression that this is a definition worth memorizing?

So here’s a methodology for looking at normal balances. Are you ready? I’ll give you the script to recite, and after that, I’ll provide the logic as to why these statements are true. Here we go . . .

The normal balance of an asset is a debit; therefore, an asset increases with debits and decreases with credits.

The normal balance of a liability is a credit; therefore, a liability

increases with credits and decreases with debits. The normal balance of an equity is a credit; therefore, an equity increases with credits and decreases with debits.

The normal balance of an income is a credit; therefore, an income increases with credits and decreases with debits. It really doesn’t have debits unless a customer receives his or her money back, as the business would debit income and credit cash (or credit in-store credit).

The normal balance of an expense is a debit; therefore, an expense increases with debits and decreases with credits. It really doesn’t have credits unless the business has made a mistake and placed the transaction in the wrong expense . (The business would have to credit the incorrect to then debit the correct .)

We’re nearly done, but allow me to explain the logic to what I’ve said. Hang with me as I help you understand the why behind the statements I’ve made about normal balances.

You may have heard of a journal and a T- in the context of ing. A journal is just a recording of a transaction. , each transaction is usually going to impact two s. The T- is the two sides of a journal, the debit and credit sides.

Here’s the T-. Can you guess why it’s called a T-? Yep, because it looks like the letter T. Genius!

Now, let’s put Debit and Credit at the top, Debit on the left and Credit on the right—we’ll get to why in a minute.

Next, let’s place the five parents into this table, knowing what we know about how each one increases.

This is a great visual for what we’ve covered—for example, how the normal balance of an asset is a debit; therefore, an asset increases with debits and decreases with credits. Can you follow that logic for the other four parents? Maybe if you put the kettle on again and treated yourself to a cookie? Cookies always help.

that every is a child of one of these parents, so each one behaves the same as its parent. For example, can you see where s receivable would live (under Debit) and how it would behave (increasing with debits and decreasing with credits)? How about s payable (under Credit, increasing with credits and decreasing with debits)? Shareholders’ equity (under Credit, increasing with credits and decreasing with debits)? Wage expenses (under Debit, increasing with debits and decreasing with credits)? Fees earned (under Credit, increasing with credits and decreasing with debits)?

Do you want to know why debits are on the left and credits are on the right? To answer that, we need to look at assets, liabilities, and equity.

The ing equation forces assets to equal liabilities plus equity. That’s logical, right? I mean, if you own a home that’s worth $300,000 and you have a mortgage of $100,000 (your liability), your equity in the home must be $200,000. Assets must equal liabilities plus equity. The balance sheet must balance.

So imagine there’s a big equal sign (=) through the top of our T-:

This is really helpful, as you may have heard the expression “For every debit, there must be a credit” (or “For every credit, there must be a debit,” which is saying the same thing but the other way around). You may have heard the term double-entry bookkeeping, which again means the same thing—each transaction always impacts at least two (“double”—get it?) s.

Can you see the ing equation in the table? Assets must equal liabilities plus equity. Don’t extend this analogy down a row, though, as you certainly don’t want your expenses to match your income, or else you won’t be in business for long!

Since assets have a normal balance of a debit and therefore increase with debits, our debits are on the left because assets are on the left of the ing equation. Likewise, because liabilities and equity have a normal balance of a credit and therefore increase with credits, our credits are on the right because liabilities and equity are on the right of our ing equation. A good way to that debits are on the left and credits are on the right is Washington, DC, or DC Comics.

And there you have it. I hope you understand debits, credits, and normal balances a lot more than you did at the start of the chapter.

, there are only five parent s, and every other is a child of just one of these five parents. Once you know where an lives (with one of the five parents), you know how it’s going to behave when you interact with it (debits and credits).

The Primary Financial Statements

As managers advance in their careers, their organizations may give them access to financial statements. Employees of publicly traded companies can easily access statements online—and so can anyone else, for that matter. Business owners get financial statements from their ants.

My observation, sadly, has been that few people understand financial statements. The purpose of this chapter is to simplify what can read as complex.

Factors that complicate the reading of financial statements include the following:

If a company is publicly traded on a stock exchange, the statements may look more complex due to the various requirements of the governing body over that exchange (here in the States, that’s the Securities and Exchange Commission, or SEC). Some reports may be produced in a manner that leans more toward management ing than financial ing or vice versa. I explain more in the next chapter about the similarities and differences between these two methods of reporting. Some organizations give the same reports different titles, so readers get unnecessarily confused—I’ll address this. To be frank, I’ve found that some ants aren’t great communicators of

information. They sometimes, innocently or intentionally, make financial statements appear more complicated than they actually are.

There are four statements that we call primary financial statements:

Income statement Statement of equity Balance sheet Cash flow statement

You’ll never guess why they’re called primary financial statements. Yep, because they provide the core information about an organization’s financial performance. Let’s address the issue of how some are given different names yet actually mean the same thing, like how the income statement is sometimes called the statement of operations, profit-and-loss , or P&L. This report just shows three items: income, expenses, and profit or loss. The organization makes a profit, of course, if the income is greater than the expenses.

The statement of equity usually varies only by having one word before equity— this could be owner’s, if the organization is a proprietorship owned by one person; member’s or ’, if the organization is an LLC; partners’, if the organization is a partnership; and finally, shareholders’ (or stockholders’), if the organization is a corporation. This statement simply records the changes in equity. Equity increases when the owner, member or , partners, or shareholders put money into the business, and equity decreases when they take money out. If the business makes a profit, equity increases (because that profit is

owed to the owner, member or , partners, or shareholders), and equity goes down when the business makes a loss, as someone (the owner, member or , partners, or shareholders) has to eat that loss.

The balance sheet is rarely called anything else—though I once saw it referred to as the statement of financial condition. Even in Italy, it’s called a balance sheet, but Italians just pronounce it differently, emphasizing the ba-. Go on, try it yourself—I know you want to. “BAA-lance sheet.” This report contains only three items also: assets, liabilities, and equity. Isn’t that the ing equation? that? Assets must equal liabilities plus equity. That’s why the BAAlance sheet must BAA-lance.

The cash flow statement is called the cash flow statement—I don’t believe I’ve ever heard it called anything else. Fun fact—there’s recorded evidence of the income statement, statement of equity, and balance sheet from over two thousand years ago, but how long do you think the cash flow statement has been around? Not two thousand years, for sure. The cash flow statement has been around only since the mid-1970s, and it’s a beautiful report, as it tracks the cash that flows in and out of the business in three areas: operating, investing, and financing activities.

You might now have these two questions:

If these are primary statements, what are the secondary statements? Do the statements have to be presented in a certain sequence?

To answer the first question, secondary statements are for publicly traded

companies—reports like notes to the financial statements and the management discussion and analysis report. The titles of these reports give the game away as to why they’re called secondary statements—yep, because they provide ing information to what’s in the primary statements. For example, something may look strange on the balance sheet, and there may be an indicator next to the number, such as “Note 17.” Well, note 17 would be within the notes to the financial statements, explaining the number, the reasoning, and sometimes the calculation.

To answer the second question, yes, the statements do have to be presented in a certain sequence—, organizations work on an operating cycle and normally report information on a monthly basis to management and owners if they are privately held. If the company is publicly traded, these are presented quarterly (and you may have heard of Form 10-Q—that’s SEC code for quarterly financial statements). Of course, months become quarters, and quarters become years. The annual reports of a publicly traded company are called Form 10-K, which, again, is an SEC codification.

The sequence is income statement, statement of equity, balance sheet, and cash flow statement. Here’s a mnemonic to help us : IEBC—In England, Be Cool. You could say, In Europe, Be Cool or In Encino, Be Cool, but neither sounds, well, as cool. The I is the income statement. The E is the statement of equity. The B is the balance sheet. And the C is the cash flow statement.

These statements aren’t presented in this sequence for some random reason. They have to be presented in this sequence, as they follow on one another. We start with the income statement (the I in our mnemonic). , this report shows just three items—income, expenses, and profit or loss. Expenses are listed from highest to lowest, as management, owners, and investors are, of course, most interested in what the organization spent the most money on. Likewise, income is often reported from highest to lowest, as those readers are most interested in where the highest income came from.

The profit or loss from the income statement will either increase equity (if the organization made a profit) or decrease equity (if the organization suffered a loss). This change in equity impacts the statement of equity (the E in our mnemonic). , when the owner puts money (or capital) in, equity increases, and when the owner takes money out (which we call drawing or a withdrawal in a proprietorship, partnership, or LLC), equity decreases. Shareholders in corporations don’t take money out of the company in the same manner as proprietorships, partnerships, or LLCs but may take a dividend if approved by the board of directors.

Now let’s move on to the B in our mnemonic—the balance sheet. The closing equity from the E statement helps the balance sheet, well, balance. Assets are listed in the order of their liquidity, meaning cash is always reported first, and then subsequent assets are organized by the speed at which they’re likely to turn into cash or get used up (in the case of prepaid expenses).

So, s receivable would be logical to report next and then, maybe, inventory (if the organization carries inventory). Liabilities are organized by immediacy, meaning how quickly they must be paid. Therefore, wages payable and salaries payable are normally listed first and then s payable. Are you seeing that we can’t write the statement of equity until the income statement is finalized and that we can’t get the balance sheet to balance until we conclude on the statement of equity?

And finally, we have the cash flow statement (our C). This wonderful financial statement was created (yes, I did say the words wonderful and financial statement in the same sentence) because the balance sheet doesn’t trace how cash flows—it’s just a snapshot at a specific time. If you were to ask your ant where the cash on the balance sheet came from, the ant couldn’t tell you without the cash flow statement.

Have you noticed the pattern of threes in our statements?

The income statement has income, expenses, and profit or loss. The statement of equity has capital, drawings, and profit or loss. The balance sheet has assets, liabilities, and equity. The cash flow statement has operating, investing, and financing activities.

A good way of ing the structure of the cash flow statement is Oranges In Florida—OIF. Operating, investing, financing: OIF! All organizations generate or spend cash in one of these three ways. The difference between an organization’s normal operating income and operating expenses is going to positively or negatively impact its operating cash flow. The change in the levels of s receivable, inventory, and s payable is going to positively or negatively impact cash flow. That’s the O of the cash flow statement—the operating activities, or the normal day-to-day activities of the organization. But an organization can also choose to invest in an item that has nothing to do with the normal operating activities of the business. When the company purchases that item, there’s an outflow of cash, and when it sells that item, there’s an inflow of cash. The net of these two movements is the I—the investing activities of the organization. Further, an organization needs funding to continue in business. When an organization borrows money from a bank, there’s an inflow. When it pays down some of that debt, there’s an outflow of cash. Likewise, when an owner, member, partner, or shareholder puts money into the business (capital), there’s an inflow of cash. When an organization pays back the owner, member, or partner, there’s an outflow. When the company pays a dividend to a shareholder, there’s an outflow. The net of these two movements is the F—the financing activities of the organization.

Now watch this—it’s a wonderful thing:

The cash flow statement starts with the profit or loss (from the income statement) and reconciles back to the cash that’s on the balance sheet. Did you catch that? It reconciles the net income to the cash that’s on the balance sheet by tracking the inflows and outflows of operating, investing, and financing activities. I love my wife. I love my children. But I tell you what—a good cash flow statement can move me to tears. It’s such a beautiful report!

And there you have it—the four primary financial statements, which I hope are now much clearer to you.

The Differences and Similarities between Management ing and Financial ing

I’ve found that the differences and similarities between management ing and financial ing can often cause confusion as people try to build their business financial intelligence.

Let’s first look at why there are differences between the two. It mainly has to do with who the is. Financial ing is presented primarily for external s, such as shareholders, debt investors, and government entities. Yes, internal s utilize financial ing reports, but the reports’ primary purpose is for people outside the business. Conversely, management ing is presented exclusively for the internal —that’s why it’s called management ing. So, whereas management ing is used exclusively by managers, financial ing is used primarily by external s but can also be used by the managers of the business. This is why financial ing is often referred to as public ing and management ing is often referred to as private ing.

The primary purpose of financial ing is to report on past performance, while management ing is prepared to influence future performance.

For example, a financial ant would present the income statement to investors, but a management ant may present information on the productivity of a factory, a retail store, or a group of employees (e.g., in a call center) as a basis for discussion with managers as to how the productivity might

be improved.

So let’s look at some of the other specific differences between the two. Financial ing is prepared according to GAAP, but management ing doesn’t have to be prepared according to GAAP. Financial ing is objective, but management ing can be subjective as well as objective. Financial ing is presented on the entirety of the organization’s performance, while management ing can be presented on the whole or just on part of the business.

Here are a couple of examples to provide some clarity on these differences:

A management ant may be asked to provide a report comparing the performance of one part of the business (e.g., sales, expenses, or inventory turnover). A financial ant would prepare information according to the entirety of the business.

For a publicly traded company, a financial ant will prepare a calculation of EPS (earnings per share) at the bottom of the company’s income statement. Conversely, a management ant may use this information in some internal management report and may do an internal calculation that compares the performance of the EPS to similar companies in similar industries over time.

Some of the language and the treatment of certain items within financial ing is different than management ing, so the confusion is compounded. For example, in financial ing for a retail business, the cost of goods sold would never include labor, but in management ing, the cost of labor is built into the cost of goods sold.

Some of the ways items are described are different between the two, which adds to the confusion. For example, in management ing, we refer to direct labor and direct materials, which are the two prime costs used up by the business to deliver the product to the customer. So at Starbucks, the management ants are able to report on the costs that are traceable to the sale of the product. This can be very useful information for management.

So if sales were $100,000 for the day, what was the cost of the labor to produce those sales, and what was the cost of the product consumed by the customer (and therefore taken from the store’s inventory) that day? Financial ing wouldn’t present store-by-store information on a daily basis like this and would present only the income statement (according to GAAP) for the quarter or year.

Can you see how, in this last example, the report provided by management ants is able to influence management decisions by store, by shift, and by hour, while the financial ing report for the whole company for, say, a year is just too big and too general for the individual store manager or regional manager to use to influence how the store does things the next day?

The similarities between the two kinds of ing have mainly to do with the translation of language. In financial ing, our cost of goods sold is just the inventory that was given up to fulfill the customer order, if the business is a merchandising or retail business. In management ing, we don’t use the phrase cost of goods sold, as we will call it direct materials and add to it direct labor, the cost of the labor that produced the product.

Both management and financial ing will report income from operations, which is essentially the profit at the operational level, before deducting all the related headquarters expenses. Headquarters costs are often referred to as SG&A (selling, general, and istrative expenses)—basically the overhead. In management ing, these are referred to as period costs.

In summary, I’ve found that many leaders get confused between the two types of reporting. Here are the three key differences:

The : management ing focuses on the internal while financial ing focuses on the external . The purpose: management ing is trying to influence management behavior while financial ing is trying to influence investor behavior. The whole or the part: management ing can report on the whole but most commonly reports on just one part of the business. In contrast, financial ing reports only on the totality of the business.

I hope this has helped clarify the similarities and differences between the two types of reporting methodologies in business.

Accruals and Prepayments

Over the years, I’ve observed how the words accruals and prepayments can cause one of three reactions in otherwise great leaders: leaders either break out in a panicky sweat, pretend they understand the words, or show excitement because they do understand them.

My goal in this chapter is to move more leaders into the third category. Why do leaders need to understand accruals and prepayments? Isn’t that something the ants do? The answer is that as leaders progress in their careers, they’re often given partial or full income-statement responsibility and partial or full balance-sheet responsibility for their departments or business areas. Accruals and prepayments can have a significant impact on the income statement and balance sheet.

At the foundational level, what causes confusion is that most leaders don’t understand that there are two types of ing methodologies—the cash basis of ing and the accrual basis of ing.

Only very small businesses use the cash basis of ing, and that’s because they’re often paid immediately for what they’ve sold. The exchange of cash is instantaneous—there’s no time delay between the purchase and the payment. I have a friend who’s a florist. When she and her husband come to our house for dinner, they have to leave by about 6 p.m. Why? Well, it’s because she has to be at the flower markets downtown by 3 a.m. She pays for her inventory in cash. She sells the flowers the same day across three market stalls, and her customers pay her by cash or a cash equivalent (such as a debit card or credit card).

To amplify this point, let me tell you about the last time my florist friend and her husband visited. For fun, I asked her if she and I could play the word-association game. I’d say four words (in two sets of two), and she’d respond with the first thought that came to her mind for each set. She said, “Let’s do it!”

I said, “Here are your first two words: s receivable.”

She was silent. When I nudged her for a response, she meekly replied, “I don’t know what you mean.” Why? Because she doesn’t use s receivable.

I then said, “Well, let’s try round two. Ready?” She confidently said she was, probably hoping for an easier question. I hit her with s payable, and she looked at me as if I lived on the moon. Why? Because she doesn’t use s payable.

See, what she uses, without even realizing it, is the cash basis of ing— where she records the expenses of her cost of goods sold only when she purchases the flowers from the market. She doesn’t regard them as inventory. She records the sale when she receives the cash, because she doesn’t sell anything on . People don’t pay deposits to her, and the only thing she pays for in advance is her car insurance, but she just treats it as an immediate expense and an outflow of cash.

Whereas very small companies tend to use the cash basis of ing, large organizations use the accrual basis of ing, where we record the income (the sale) only when it’s been earned, regardless of whether or not we’ve been paid yet. Likewise, we record the purchase of an asset when it’s been purchased, regardless of whether or not we’ve paid for it yet.

Under the accrual basis of ing, there are four types of adjustments we may have to make at the end of the month to ensure our income, expenses, assets, and liabilities are correctly stated. Two of the adjustments are accruals, and two are prepayments.

The two accruals are accrued revenue (where we’ve sold something but haven’t yet been paid for it, so we have an receivable) and accrued expenses (where we’ve purchased something but haven’t yet paid for it, so we have an payable).

The two prepayments are unearned revenue (where we’ve been paid in advance, such as receiving a deposit) and prepaid expenses (where we’ve prepaid someone else, such as paying for something up front, like insurance before we’ve actually used it).

Let’s double-click on each of these to ensure you understand them. , our goal is for you to be a leader who understands them, not to turn you into an ant!

I’ve italicized some words to add emphasis.

Let’s start with accrued revenue.

Here’s the skinny: Accrued revenues are really assets that cause an inflow of cash when they’ve been received.

Here’s an example: If a business sells its products or services on , the business will increase income (credit) because it has earned it (as it provided the product or service) and increase s-receivable assets (debit). When the client pays, the business will increase (debit) cash assets and decrease (credit) s-receivable assets because the client doesn’t owe the business anymore. Why are we doing this? Because of this matching concept: we’re trying to match the income (what we’ve earned) for the month with the expenses (what we’ve used) for the month to get an accurate profit or loss for the business. We treat the sale as income even though we haven’t yet received payment because we provided the product or service.

Now let’s look at accrued expenses.

Here’s the skinny: Accrued expenses are really liabilities that cause an outflow of cash when they’re paid.

These are simply recording the fact that we’ve used something but haven’t yet paid for it. Here’s an example: Let’s say we have a business and pay our employees every two weeks. Imagine they worked for us for the last two weeks of January but we don’t process our payroll until the fifth of February. Under the matching concept, we record the salaries or wages expense in January (debit) and recognize the salaries- or wages-payable liability in January (credit). When we pay the employees, we simply reduce cash assets (credit) and reduce salariesor wages-payable liabilities (debit). Why are we doing this? Because of the matching concept, where we’re trying to match the income (what we’ve earned) for the month with the expenses (what we’ve used) for the month to get an accurate profit or loss for the business. The payroll is an allowable expense for tax purposes, but we can treat as an expense only that which has been used. , we’re taxed on the income statement, not the balance sheet.

Here’s another example: When we buy something (e.g., inventory) from a vendor and the vendor gives us, say, thirty days to pay the invoice, we increase (debit) inventory assets and increase (credit) s payable. When we pay the vendor, we reduce (credit) cash assets and reduce (debit) s-payable liabilities, as we don’t owe the vendor anymore.

What about unearned revenue? Let’s do it.

Here’s the skinny: Unearned revenues are really liabilities that turn into income when earned.

For example, if a client pays us a deposit, our cash assets increase (debit), but we can’t treat that as income yet because we haven’t earned it. Therefore, we increase (credit) unearned-revenue liabilities. Why is the deposit a liability? What do we owe? Well, we owe the client the product or service, which we haven’t provided yet. When we provide the product or service, we increase (credit) income because we’ve earned it and reduce (debit) the unearned-revenue liability because we don’t owe it anymore (or we owe less, if we’re earning it in stages). Why are we doing this? Because of the matching concept, where we’re trying to match the income (what we’ve earned) for the month with the expenses (what we’ve used) for the month to get an accurate profit or loss for the business. We want to treat as income only that which we’ve earned. If we treated it all as income initially, before earning it, we’d have inaccurate monthly income statements and we’d pay tax on profits (income minus expenses) that we haven’t yet earned.

Can you see the difference between unearned revenues and accrued revenues? Unearned revenues for where we received cash up front but haven’t yet earned it, whereas accrued revenues for where we’ve earned the income but haven’t yet received the cash.

And here’s our last one—prepaid expenses.

Here’s the skinny: Prepaid expenses are assets that turn into expenses when used.

For example, when you buy car insurance for, say, six months, your cash assets go down (credit) but your prepaid-insurance assets go up (debit). Why? Because you now own six months of insurance coverage. , expenses are what the business has used, so as time es, the business uses up some of the car insurance. Therefore, after one month, what you own decreases and what you’ve used increases. So your prepaid-insurance assets go down (credit), and your insurance expenses increase (debit). This adjusting process repeats until the prepaid-insurance assets are all used up. Why are we doing this? Because of the matching concept, where we’re trying to match the income (what we’ve earned) for the month with the expenses (what we’ve used) for the month to get an accurate profit or loss for the business. The insurance is an allowable expense for tax purposes, but we can treat as an expense only that which has been used rather than what we own. , we’re taxed on the income statement, not the balance sheet.

Can you see the difference between accrued expenses and prepaid expenses? Accrued expenses for where we’ve received the goods or services but haven’t yet paid for them, whereas prepaid expenses for where we haven’t yet received the goods or services but have paid for them.

Keep this in context—why are we doing this? It’s certainly not to keep ants busy, as most of these transactions are automated now.

We use accruals and prepayments to ensure that our income, expenses, assets, and liabilities are accurately reported. Under the accrual basis of ing,

, we record income only when it’s been earned. Under the accrual basis of ing, , we record expenses only when they’ve been used.

It’s imperative that our income and expenses are correctly stated, because income minus expenses equals profit. If our income is overstated, we’ll pay too much tax, as our profits will be overstated; and the opposite is true if our income is incorrectly understated. If our expenses are overstated, our profits will be understated, so our tax calculation will be incorrect. Likewise, if our expenses are understated, we’ll report too much profit; hence, the tax on profits will be inaccurate.

, assets are what we own and liabilities are what we owe. The difference between these two is our equity. If our assets or liabilities are incorrectly reported, the equity (the money owed to the owner, partners, , or shareholders) will be inaccurate.

So, in summary, that there are only four types of potential adjustments at the end of the month if your organization uses the accrual basis of ing. Two are accruals, and two are prepayments. Still confused? You could always become a florist. Your ing life would be simpler, at least, but who wants to be up and at the vendors by 3 a.m. every morning?

Depreciation and Amortization

I’ve found that people commonly misunderstand depreciation and amortization. If an organization has many fixed or intangible assets, depreciation or amortization can be a significant expense line within the income statement.

So what really is depreciation, and how does it differ from amortization?

First of all, let’s discuss what they have in common. Both are mechanisms we use because of the accrual basis of ing. Due to the matching concept (which is part of the accrual basis of ing), we’re required to show the expenses (what we’ve used) to generate the revenues (what we’ve earned) within the same period of time. The concepts of depreciation and amortization help record the proportion of a fixed or intangible asset that was used up in the last ing period (normally recorded monthly or at least annually).

Depreciation and amortization are both connected to assets—depreciation aligns with fixed assets, and amortization aligns with intangible assets. If necessary, take a quick peek back at chapter 5 for the definitions of fixed and intangible assets.

There are three types of depreciation methodologies: straight-line depreciation, the units-of-output method (sometimes called the units-of-production method), and the double-declining-balance method. What these three methods all have in common is their goal of accurately recording how much of the asset has been

used up (and therefore how it needs to be recorded as an expense in the income statement and as a reduction in asset value on the balance sheet).

The most common method is straight-line depreciation, because most organizations have fixed assets—assets that are physical, used in the normal operations of the business, and not offered for sale (such as computers, furniture, and buildings). GAAP defines the number of years certain types of assets should be depreciated over. There has to be a governing principle (such as GAAP) to dictate this, as we can easily see that the higher the depreciation expense, the lower the profit—and the lower the taxes. Likewise, if a business is positioning itself for sale, business ownership may be tempted to understate the depreciation in order to overstate the profits of the business and the asset value.

When the usage of the asset fluctuates between periods of time, the units-ofoutput method provides a more accurate matching of expense to revenue. For example, if we used a machine for more hours this year (or drove a vehicle more this year), wouldn’t it be accurate to say the machine (or vehicle) is being used up more this year than last year? The units-of-output method is able to for that variance in usage, which is something straight-line depreciation isn’t designed to do.

The double-declining-balance method is most often used by high-tech companies. Why? Well, technology changes so quickly that the asset is likely to have no real residual value—meaning it’s likely to be worth nothing when the new technology arrives on the scene. It’s sometimes referred to as an accelerated method of depreciation. Effectively, the double-declining-balance method doubles the straight-line depreciation rate and ignores the residual value.

, amortization is doing the same thing as depreciation—recording the reduction in the value of an asset. Amortization recognizes the reduction in the value of intangible assets (such as patents, royalties, trademarks, and goodwill), whereas depreciation recognizes the reduction in the value of fixed assets.

I’ve found that the concept of goodwill is also often misunderstood. Most commonly, people think goodwill has to do with charitable donations. Nope, that’s not it. Goodwill is the price one company pays above the net asset value of a company it acquires. Here’s an example of goodwill: Let’s say company A purchases company B for $10 million but the net asset value of company B is $7 million (net assets being assets minus liabilities). Well, company A gives up $10 million and brings the net assets onto its balance sheet for $7 million. The fixed assets start to be depreciated over their estimated useful lives according to GAAP. What about the $3 million? The $3 million is goodwill—it’s the brand , you could say, that company B has managed to build up over the life of its business existence before being acquired by company A. The goodwill on company A’s balance sheet is an intangible asset—company A can’t touch or feel it, but company A now owns it; therefore, it’s amortized rather than depreciated.

I hope this chapter clarifies the similarities between depreciation and amortization. People often misunderstand the concept of amortization because, here in the US, we use the word amortization in conjunction with a home loan, which is not the same as amortizing intangible assets in a business. And few people understand the three types of depreciation due to the dominance of the straight-line method.

Stay focused on the big picture—why do we depreciate or amortize assets? It’s necessary under the accrual basis of ing for us to record expenses in the period they’ve been used, regardless of when we initially purchased the assets. This matching of income and expense in the correct period helps us arrive at an accurate profit or loss for the period, which is what we’re taxed on.

Capital-Investment Appraisal

As people progress in their careers, they’re likely to find themselves in positions where they’re required to review capital-investment projects for approval.

First of all, let’s ensure that we understand what’s meant by a capital investment, which is sometimes referred to as a capital expenditure. When an organization purchases a fixed asset, the asset is defined as a capital investment. , a fixed asset is something that’s used in the normal operations of the business, isn’t offered for sale, is long-lived (i.e., will last for more than a year), and is tangible (i.e., you can touch and feel it).

When an item can be treated as a capital expenditure, it can be ed for on the balance sheet as an asset; therefore, the only impact to expenses (and hence profit) is the reduction in value, recorded as a depreciation expense. The asset is depreciated over its estimated useful life according to GAAP.

To help decide whether a capital investment is a good idea or not, ants use a variety of methods. Two of the most common methods recognize the time value of money, and the other two most common methods don’t.

So what do we mean by the time value of money? Well, I’m sure you’d agree with me that if I owed you $1,000, you’d rather have that money paid back to you today than in, say, twenty years. This is for two reasons: First, what you could do with that $1,000 twenty years from now is a lot less than what you

could do with that $1,000 today, because of inflation. Second, the only way you would possibly be open to the idea of me paying you back over, say, twenty years, is if you could charge me interest. So money clearly does have a time value.

Let’s start with the two capital-investment appraisal methods that don’t recognize the time value of money: ing rate of return and cash payback.

The ing rate of return (ARR) method, sometimes referred to as the average rate of return method, is expressed as a percentage. It’s calculated by taking the average annual net income expected from the investment and dividing it by the average investment. One of the advantages of this method is that it’s relatively easy to understand and to calculate. It also has the advantage of calculating the total return over the life of the project, whereas the cash payback method doesn’t.

The cash payback method calculates how quickly the net income from the investment matches the investment cost. The answer is measured in time (e.g., three years). Similar to the ARR method, this method is relatively easy to understand and to calculate. The main disadvantage is that it ignores total project returns because it calculates only the time it takes for the inflow to match the outflow.

Both the ARR and cash payback methods may be sufficient appraisal techniques if the investment is relatively low for the organization or if the appraisal period is relatively short (e.g., one to three years).

Even for longer-term or larger projects, these two methods may be used as a first screening. But for such projects, we’ll also want to use one of the two methods that recognize the time value of money: net present value and internal rate of

return.

The net present value (NPV) method discounts back all the future net cash inflows and outflows of the investment project in present-day , using the organization’s weighted average cost of capital. This begs the question—What’s weighted average cost of capital?

All organizations, regardless of whether they’re privately held or publicly traded, have two sources of potential funding debt and equity. The cost of debt is the interest rate the organization pays on its debt. Let’s say an organization has 20 percent of its capital structure in debt that it pays an average of 5 percent to—the cost of debt within the capital structure would be 20 percent multiplied by 5 percent, which equals 1 percent.

Now let’s look at equity. The rewards equity shareholders receive are dividends (if the company pays dividends, as not all companies do) and share-price growth. Now, although share-price growth isn’t a cost to the business, it’s an expectation —a notional goal the company needs to hit—or a guidance, as its often called by institutional investors. Let’s say that’s 10 percent. If 20 percent of the organization’s capital structure is comprised of debt capital, the other 80 percent must be equity. Therefore, the real cost of equity to the business is 80 percent multiplied by 10 percent, which equals 8 percent.

Hang with me. If we know that the overall cost of debt to the business is 1 percent and the overall cost of equity to the business is 8 percent, the weighted average cost of capital is simply 1 percent plus 8 percent, which equals 9 percent.

The weighted average cost of capital is sometimes referred to as the opportunity cost, cost of doing business, cost of money, cost of capital, or hurdle rate. I like

the image of a hurdle rate, as it implies that we have to make more than 9 percent in our capital-investment projects or else we’re destroying shareholder value. If the profit we generate from the project is greater than the 9 percent number, we’re creating shareholder value.

You may have heard of the phrase economic value added (EVA). This is another way of referring to shareholder value—meaning if our actual return (net income) is greater than the hurdle rate, we’ve added economic value. If the profit we generate from the project is less than our hurdle rate, we’re not creating shareholder value but rather destroying shareholder value.

The NPV is always stated in dollars. We want the NPV to be at least positive (, it discounts back all the future net cash inflows and outflows of the investment project in present-day using the organization’s hurdle rate, so we want the inflows to be greater than the outflows). If we’re comparing two or more potential projects, we obviously want to pursue the one with the highest NPV because our purpose as a for-profit venture is to maximize shareholder wealth.

Finally, let’s look at internal rate of return (IRR). The word rate gives us a clue that the answer will also be reported as a percentage. The easiest way to express this concept is to emphasize that the IRR is the rate at which the NPV is zero— meaning it calculates the hurdle rate required for the project to break even, allowing for the time value of money. So if a project’s IRR is 6 percent and a company’s actual hurdle rate is 9 percent, we have a problem. Why? Well, what the calculation is showing us is that the project breaks even only if the organization’s hurdle rate is 6 percent. This is because, in our example, if the hurdle rate is 9 percent, the project would be a foolish investment—we’d be destroying economic value. We’d fall below the hurdle, and we’d be destroying shareholder value.

Conversely, of course, if the IRR is 12 percent and our hurdle rate is 9 percent,

we have some wiggle room—our hurdle rate could increase to 12 percent and we’d still break even. Or another way of looking at it is that the income from the project could fall or the expenses for the project could increase and we’d still break even, as there’s a margin for error between 12 percent and 9 percent.

Albert Einstein once said, during his frustrations with ants at Caltech in Pasadena, California, “The trouble with most ants is they know the cost of everything but the value of very little.” There are some things you can’t measure. There are some capital investments an organization has to make regardless of which method of appraisal the ants choose to use.

Here’s an example: During my tenure as a regional finance director for Hilton International Hotels, I was sitting in one of our properties, looking at a tatty and tired lobby carpet of a four-star establishment in central England. The general manager was trying to convince me it needed to be replaced. I had my super spreadsheet, able to handle any of the four methods we’ve covered in this chapter, ready to go. I asked the general manager to tell me how much he thought the hotel could increase the room rates by or perhaps increase the prices of teas and coffees in the lounge by or how much more the hotel could charge for the health club hip purely because we’d changed out the lobby carpet. I’ll never forget the eloquent and intelligent words this general manager said to me: “Close your laptop, son—we just need to replace the carpet.”

So, I guess Albert was right—some things can’t be measured. But for those items that can be, one or more of the four capital-investment appraisal methods we discussed may be useful.

, the purpose of this book isn’t to turn you into an ant but rather to help you understand the finance folks use that are often misunderstood by everyone else.

The Six Benefits of a High Stock Price

When a company is publicly traded, it’s common to hear employees rejoicing in the corporate corridors or staff cafés when the stock price increases. But if you were to stop some of these folks in their tracks and ask, “Why is this a good thing?” you’d find that most employees wouldn’t know why.

, we’re trying to tap into the intrapreneurial spirit (you know, the mindset and skillset of thinking and acting like a business owner), so it’s useful to understand why a high stock price is a good thing.

In no particular order, here are the six reasons why a high stock price is something worth celebrating for an employee who thinks and acts like a business owner:

1. The treasury stock is worth more.

The stock that the company owns itself is called treasury stock. When the stock price increases, the treasury stock is therefore worth more. In effect, the company can make money on its own stock because it can sell it at a price that’s higher than what it first purchased the stock for back when some shareholders were willing to sell it back to them.

2. Secondary offerings bring more cash. When a company first becomes publicly traded, its initial stock offering is called an IPO (initial public offering). Second and subsequent issues of stock are collectively called secondary offerings. We don’t say “the 412th issue of stock.” Because the treasury stock is worth more (see reason number one), any subsequent offering of stock will generate more cash because the offering will likely come from the treasury stock.

3. Higher stock prices mean the company can buy debt cheaper. , there are only two sources of funding for all organizations—debt and equity. If the stock price is increasing, a company is likely to be able to buy debt cheaper. Specifically, the company may be able to buy convertible debt (, this has the option of converting into equity) at a lower interest rate because the lender is excited about the direction of the stock. More generally, a company can buy debt cheaper when its stock price is increasing—due to the larger amounts of cash now flowing through the business because of the sale of treasury stock and due to the generally improved business performance. Debt investors are then attracted to the company due to this improvement in operations (e.g., increased sales, reduced expenses, or improved cash flow), which drives the stock price increase.

4. Higher stock prices mean the company has more acquisition power. When one company acquires another, the purchase is normally completed by a combination of transfers of stock and cash from the buyer to the seller. Companies like to protect cash as much as possible—because cash is the oxygen supply and the lifeblood of a business. Generally, companies prefer not to give up too much cash, so if a company has a high stock price, it doesn’t have to give much of it up to acquire another company—it can make the deal pretty sweet for

the existing shareholders of the company being acquired due to the acquiring company’s own high stock price.

5. Higher stock prices mean the company can better attract and retain talented employees. Innately, we all want to be winners. A high stock price can serve as a talent magnet because people like to work for organizations that are doing well. A high stock price calls out that the company is winning over its competitor set and performing well in the stock market overall. In addition, companies sometimes use stock options as a way of attracting and retaining talented employees—the higher the stock price, the bigger the win for the employee (when the stock option is exercised).

6. Higher stock prices mean the company will be more expensive in a buyout. This reason is number four in reverse. A high stock price is a defense against a hostile takeover bid. The higher the stock price, the higher the barrier to entry is, as it would mean the acquirer would have to either give up a high proportion of its stock or a whole bunch of cash (or both) to take a nibble at the company it wants to buy. Giving up a high proportion of stock or exhausting cash reserves can make the predator very nervous and may back them away from making a move.

So if you’re an employee of a publicly traded company and you hear the news of an increasing stock price, feel free to share with others the six reasons why this is a good thing. You’ll be the awe of the staff café—and may even get the last donut.

The Seven Components of Business Financial Intelligence

Over the years, I’ve wrestled with how best to measure organizational performance. I’ve observed how some businesses are all about the profit-andloss . Others focus on a strong balance sheet. Then there are those that take great pride in winning awards. Many organizations appreciate the accolades they receive for their altruistic efforts to give back to communities and causes they believe in. Some focus more on internal metrics to monitor the minuscule aspects of every level of productivity, as if the enterprise were one big soulless machine.

There are seven components of business financial intelligence. They’re interdependent and can provide the most balanced, healthy, sustainable scorecard for measuring an organization’s success.

Customers Cash flow Profit Productivity Growth Teams Community

1. Customers In my experience, business financial intelligence has to start with the customer. It’s almost as if the customer is the trunk of the tree and the other six components are just the fruits that fall from the tree when we serve our customers well. Of course, organizations sometimes call their customers clients, students, or even colleagues (because organizations not only have external customers but also internal ones). There are three levels of service we provide to our customers: satisfying, exceeding, and anticipating. At best, we anticipate our customers’ needs.

2. Cash Flow We know there are three types of cash flows—operating, investing, and financing (OIF). We also know that cash flows both ways and that we need positive cash flows—we must have more coming in than going out. But , an outflow of cash under investing activities isn’t a bad move, as we may sell that investment in the future at a price much higher than what we paid for it. Likewise, an outflow of cash under financing activities isn’t a bad move, because we may have paid down debt or completed a stock buyback (or both).

3. Profit We know there are three levels of profit if we’re a manufacturing or retail business: gross, operating, and net profit. Service businesses don’t calculate

gross profit, because they don’t have a cost of goods sold. Whereas manufacturing businesses create products to sell, retailers sell those products, which they call inventory. And , a service business sells time, not a product. Of course, organizations can be manufacturers and retailers and service businesses. Apple is a great example. It manufactures products, has retail stores, and offers service contracts to small local businesses to and maintain their technology.

4. Productivity Productivity is also an internal measure that your customers care about only when it impacts them—for example, how quickly the customer receives your product or service from the moment the customer places the order. Different organizations measure productivity in different ways, but there’s always a numerator and a denominator. The business is measuring the ratio of inputs to outputs.

5. Growth Organizations commonly measure growth as top line (i.e., revenue growth), bottom line (i.e., net-profit growth), and earnings-per-share growth. Earningsper-share growth is most common for publicly traded companies, but , privately held companies can have a notional calculation of earnings per share. If we’re not growing in today’s highly competitive and global marketplace, we’re going backward in real due to inflation. Our customers want us to grow. Our investors expect us to grow. And our employees are more engaged when we grow.

6. Teams We’ve all heard the phrase, “Money makes the world go ’round,” but I believe

it’s teams that make the world of business go ’round.

It’s teams of people, working effectively and efficiently together, who serve the customers (and each other as internal customers). It’s teams of people who help make the cash flow positive and the enterprise profitable. People are often the numerator within productivity measurements, and people are crucial to ensuring that the organization is growing.

There are various ways to measure how engaged your people are within the organization. Low turnover isn’t necessarily one of them. Our company has consulted with organizations where low labor turnover was suffocating them because there was no innovation. People were simply punching the clock, and they stayed only because the benefits packages were generous. If you haven’t yet conducted one, consider doing an employee engagement survey, which can be an effective way of taking the pulse of how your people are feeling about the work they do and about how the organization is being run. Here’s a tip: If you survey people, make sure you tell them the results and what you intend to do about any suboptimal aspects the survey reveals. And then act on those plans.

7. Community Community has many definitions, but at its core, it’s the concept of giving back. Organizations that do well over time give back to others over time. My word of caution here is to choose causes that are acceptable to the organization as a whole and avoid the risk of getting behind a political or social cause that may mean a lot to some but not to others. The worst type of community engagement I’ve seen is organizations dictating service projects for their employees to without any consultation with those employees to seek their opinions on the selected charity, cause, or social mission. This approach can backfire if your political or social cause isn’t every employee’s political or social cause.

In Summary I’ve found that these seven components can provide a much more balanced scoreboard for measuring an organization’s success than just the bottom line of net profit. I’ve seen how these seven components can sustain success over time. Four of them are primarily internal measurements (cash flow, profit, productivity, and growth), two are primarily external (customers and community), and ultimately, it’s teams of people who make this all happen.

I hope this provides a framework for you to look more holistically at your organization and consider how you can monitor and reward performance in ways you’ve perhaps never imagined before.

So, What’s Next?

As we all know, the problem when learning something new is that, to retain the knowledge, you have to apply it. If I had a dollar for every time someone asked me some version of this question, my kids would have had an overflowing college fund: “So, what can I do now to further develop my knowledge?”

Here are my top five suggestions to help apply and therefore retain this knowledge:

If your company is publicly traded, make a point of listening to the quarterly earnings call—you’ll find it encouraging to see how much you now understand after reading this little book.

The best way to learn something is to teach it. See if you can find a colleague or a friend outside of work who will take you up on an offer to teach them through this book based on what you’ve learned.

Stay informed on what’s happening in the news regarding business. You know more now than you did before, so you’ll find the articles much more engaging now that you better understand the . I subscribe to Investor’s Business Daily and have found it to be a clear, concise, and engaging publication that helps sharpen and apply my business acumen. Investor’s Business Daily is also available as a podcast, and I also highly recommend the podcasts Problem Solvers and World Business Report.

If your company is publicly traded, how about investing a few hours each quarter reviewing the primary financial statements?

Consider how your work connects to the money-making model of your organization. What could you do to improve income and reduce expenses—and therefore push up profits? What would you do or not do if you owned the business?I hope this book has been and continues to be useful to you. , you can make only so much contribution based on your technical area of expertise alone. Over and above that, you need to be good at managing yourself and influencing others.

I hope you’re encouraged to see that business financial intelligence can not only help you become invaluable to your employer but also take you to the top of any organization. Hey, you may even be motivated to start your own business with the enhanced knowledge you now have!

, business financial intelligence is a mindset and skillset few people have and all organizations need.

Feel free to me if I can ever be of help to you.

All the best!

Contents

About the Author ABOUT Why I Wrote This Book Endorsements Disclaimer Dedication Contents CHAPTER 1: MVP: Margin × Velocity × People CHAPTER 2: The Three Levels of Profit CHAPTER 3: The Three Rs CHAPTER 4: The Working-Capital High-or-Low Game CHAPTER 5: Current Assets, Current Liabilities, Fixed Assets, & Long-Term Liabilities CHAPTER 6: Debits, Credits, and Normal Balances CHAPTER 7: The Primary Financial Statements CHAPTER 8: The Differences and Similarities between Management ing and Financial ing CHAPTER 9: Accruals and Prepayments CHAPTER 10: Depreciation and Amortization

CHAPTER 11: Capital-Investment Appraisal CHAPTER 12: The Six Benefits of a High Stock Price CHAPTER 13: The Seven Components of Business Financial Intelligence So, What’s Next?

Landmarks

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