Financial intelligence for entrepreneurs berman, karen;knight, joe

Financial Intelligence for Entrepreneurs What You Really Need to Know About the Numbers Karen Berman Joe Knight Copyright 2008 Business Literacy Institute, Inc All rights reserved Printed in the United States of America 12 11 10 09 08 No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior permission of the publisher Requests for permission should be directed to permissions@hbsp.harvard.edu, or mailed to Permissions, Harvard Business School Publishing, 60 Harvard Way, Boston, Massachusetts 02163 Library of Congress Cataloging-in-Publication Data Berman, Karen, 1962 – Financial intelligence for entrepreneurs : what you really need to know about the numbers / Karen Berman, Joe Knight; with John Case p cm Includes bibliographical references and index 9781422131824 Financial statements Cash management Business enterprises—Finance Corporations— Finance I Knight, Joe, 1963 – II Case, John, 1944 – III Berman, Karen, 1962 – Financial intelligence IV Title HG4028.B2B422 2008 658.15’11—dc22 2008012635 The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Publications and Documents in Libraries and Archives Z39.48-1992 Karen dedicates this book to her husband, Young Riddle, and their daughter, Marie Joe dedicates this book to his wife, Donielle, and to the seven Js— Jacob, Jordan, Jewel, Jessica, James, Jonah, and Joseph Christian (JC) Table of Contents Title Page Copyright Page Dedication PREFACE Part One - The Art of Finance (and Why It Matters) - What Is Financial Intelligence? - A Primer on the Art of Finance Part One - TOOLBOX Part Two - The (Many) Peculiarities of the Income Statement - Profit Is an Estimate - Cracking the Code of the Income Statement - Revenue - Costs and Expenses - The Many Forms of Profit Part Two - TOOLBOX Part Three - The Balance Sheet Reveals the Most - Understanding Balance Sheet Basics - Assets 10 - On the Other Side 11 - Why the Balance Sheet Balances 12 - The Income Statement Affects the Balance Sheet Part Three - TOOLBOX Part Four - Cash Is King 13 - Cash Is a Reality Check 14 - Profit ≠ Cash (and You Need Both) 15 - The Language of Cash Flow 16 - How Cash Connects with Everything Else 17 - Why Cash Matters Part Four - TOOLBOX Part Five - Ratios: Learning What the Numbers Are Really Telling You 18 - The Power of Ratios 19 - Profitability Ratios 20 - Leverage Ratios 21 - Liquidity Ratios 22 - Efficiency Ratios Part Five - TOOLBOX Part Six - How to Calculate (and Really Understand) Return on Investment 23 - The Building Blocks of ROI 24 - Figuring ROI Part Six - TOOLBOX Part Seven - Applied Financial Intelligence: Working Capital Management 25 - The Magic of Managing the Balance Sheet 26 - Your Balance Sheet Levers 27 - Homing In on Cash Conversion Part Seven - TOOLBOX Part Eight - Creating a Financially Intelligent Company 28 - Financial Literacy, Transparency, and Your Business’s Performance 29 - Financial Literacy Strategies 30 - Putting Financial Intelligence to Work Part Eight - TOOLBOX APPENDIX A - Sample Financials APPENDIX B - Exercises to Build Your Financial Intelligence APPENDIX C - Under Armour and eBay Financial Statements NOTES ACKNOWLEDGMENTS INDEX ABOUT THE AUTHORS PREFACE scoreboards and visual aids strategies for weekly “numbers” meetings financial literacy training financially intelligent companies financial literacy and (see financial literacy) growing businesses (see business growth) open-book management Sarbanes-Oxley Act of 2002, toolbox financial projections financial ratios See ratios financial statements audited footnotes to as foundation of financial intelligence of privately held companies of publicly traded companies financial statements (samples) balance sheet cash flow statement income statement financing activities “Fine Cigar Shops” example finished-goods inventory fiscal year fixed assets See property, plant, and equipment fixed costs footnotes to financial statements Ford Motor Company forecasts Form 10-K format of balance sheet formulas and calculations cash conversion cycle cost of capital current ratio days in inventory (DII) days payable outstanding (DPO) days sales outstanding (DSO) debt-to-equity ratio discounting equation free cash flow gross profit margin percentage interest coverage ratio inventory turns ratio net present value operating profit margin percentage payback method percent of/percent change PPE turnover ratio quick (acid-test) ratio return on assets (ROA) return on equity (ROE) sustainable growth rate total asset turnover working capital Fortune magazine franchisors frauds and scandals capital expenditures vs operating expenses Cendant Enron Corporation most common sources of revenue recognition Sarbanes-Oxley Act of 2002 and Sunbeam (see Sunbeam) Tyco International Waste Management Inc WorldCom Xerox free cash flow fundamental accounting equation future cash flows for capital expenditures discounted value of, NPV based on future value future value calculator GAAP See generally accepted accounting principles general and administrative expenses (G&A) General Electric generally accepted accounting principles (GAAP) General Motors goodwill Google Great Game of Business, The (Stack & Burlingham) gross margin See gross profit margin percentage gross profit gross profit margin percentage Hewlett-Packard hurdle rate in calculating IRR in calculating NPV cost of capital and IBM IMAX Corporation income See also profit measured in accrual accounting net income (see net profit) operating income pressures for manipulation of income statement “actual” vs “pro forma,” cash flow statement and comparative consolidated costs and expenses shown in definition divisional system for effects on balance sheet estimates and assumptions in financial intelligence exercise footnotes to gross profit shown in label of operating expenses shown in percent of and percent change percent of sales shown in purpose of reading and understanding revenue samples of toolbox understanding language of variance shown in individual financial worth industry averages industry standards industry variations information sharing initial public offerings (IPOs) intangible assets goodwill patents and copyrights R&D expenses rules for amortization of valuation of intellectual property interest coverage ratio internal controls internal rate of return (IRR) method of analyzing capital expenditures comparison with other methods inventory as asset days in inventory (DII) finished-goods inventory improving cash position and just-in-time inventory management managing, working capital and not included in quick ratio raw-materials inventory reducing working capital and work-in-process (WIP) inventory days inventory period inventory turns inventory valuation investors “angel” investors bullish or bearish interest in balance sheet interest in operating profit preferred shares issued to ROE as key ratio for use of ratios venture capitalists IPOs (initial public offerings) IRR (internal rate of return) method Johnson, H Thomas Johnson & Johnson Joie de Vivre Hospitality just-in-time inventory management Kant, Immanuel Kaplan, Robert S key performance indicators (KPIs) Kmart Knight, Joe KPIs See key performance indicators label of income statement land, valuation of laws Sarbanes-Oxley Act of 2002, Securities Exchange Act of 1934, layoffs lean enterprise principles lean manufacturing learning See also training financial intelligence as learned skill set involvement in reinforcement of leases leverage leverage ratios debt-to-equity ratio interest coverage ratio liabilities accounts payable accrued expenses current portion of long-term debt long-term liabilities other short-term liabilities short-term loans liquid assets liquidity ratios current ratio quick ratio loans as long-term liabilities personal, forbidden by SOX raising cash through borrowing relationship with banker and shown in balance sheet long-term assets long-term liabilities Macromedia managing balance sheet market cap market value of company matching principle accrued liabilities and definition illustrated mergers See acquisitions Merrill, Dave Microsoft Corporation Money Maps Nathan’s Famous, Inc net margin See net profit margin percentage net present value (NPV) method of analyzing capital expenditures comparison with other methods net profit definition effect on equity fixes for low profitability reconciling to cash net profit margin percentage noncash charges noncash expenses nonprofit organizations NPV (net present value) method office politics one-time charges open-book management Open-Book Management (Case) open communication operating expenses capital expenditures contrasted with cutting definition operating income See operating profit operating leases operating leverage operating margin See operating profit margin percentage operating profit operating profit margin percentage operating statement See income statement opportunity cost overhead See operating expenses overleveraged companies owner earnings owner financing owners’ equity additional paid-in capital common shares preferred shares retained earnings Packard, David Paine Webber Parmalat par value of stock patents payback method analyzing capital expenditures with comparison with other methods payroll See also employee compensation as accrued expense recording payroll services firms percent change, calculating percent of, calculating percent of sales ratio personal finances as collateral for loan individual financial worth investment in business separate from company finances time value of money in Peter, Laurence J Peter Principle, The (Peter) Pfeffer, Jeffrey physical capital P&L statement See income statement point in time, of balance sheet PPE See property, plant, and equipment preferred shares prepaid assets prepaid rent present value pretax charge price-to-earnings ratio privately held companies distribution of dividends financial statements of market vs book value of stock buybacks valuation of production costs production cycle profit See also earnings; income cash contrasted with cash without definition effect on equity as estimate forms of gross profit measured in accrual accounting net profit (see net profit) operating profit reconciling to cash reinvested in business without cash profitability cash contrasted with cash flow and definition low, fixes for skewed picture of profitability ratios derived from income statement gross profit margin percentage net profit margin percentage operating profit margin percentage return on assets return on equity profit and loss statement See income statement pro forma income statement project-based companies property, plant, and equipment (PPE) adjustments for depreciation PPE turnover reducing purchase of proposals, written Public Company Accounting Oversight Board publicly traded companies cash flow statements of distribution of dividends footnoted financial statements free cash flow disclosure not required market vs book value of price-to-earnings ratio of restructuring charges by valued by stock market purchase price for PPE QuickBooks accounting software quick (acid-test) ratio ratios accounting tricks with analyzing asset turnover ratio calculating (see formulas and calculations) current ratio days in inventory (DII) days payable outstanding (DPO) days sales outstanding (DSO) (see days sales outstanding) debt-to-equity ratio efficiency ratios financial intelligence exercises gross profit margin percentage interest coverage ratio inventory turns leverage ratios liquidity ratios net profit margin percentage operating profit margin percentage percent of sales power of profitability ratios property, plant, and equipment turnover quick (acid-test) ratio return on assets (ROA) return on equity (ROE) return on investment (ROI) (see return on investment) sustainable growth rate toolbox total asset turnover raw materials raw-materials inventory reasonable-and-consistent test receivable days See days sales outstanding reconciliation recording revenue See revenue recognition relationships with vendors Relevance Lost (Johnson & Kaplan) replication strategy reputation for slow payments required rate of return See hurdle rate research and development (R&D) restaurant chains restaurants restructuring charges retail chains retailers retained earnings return on assets (ROA) return on equity (ROE) return on investment (ROI) See also capital expenditures analyzing capital expenditures building blocks of comparison of methods definition future value in hurdle rate in internal rate of return method net present value method payback method present value in toolbox return on sales (ROS) revenue See also sales as basis of profit expenses matched to measured in accrual accounting recorded at sale shown in income statement revenue recognition effect on gross profit guidelines for income statement and issue of when sales are recorded manipulation of risk(s) in capital expenditures of debt financing entrepreneur’s willingness to take of growing business hurdle rate and leverage and smaller customers as time value of money and Rite-Aid ROA (return on assets) roadblocks to financial intelligence Rocky Mountain Chocolate Factory ROE (return on equity) ROI See return on investment roll-ups ROS (return on sales) Saginaw, Paul salaries sales See also revenue definition increasing measured in accrual accounting revenue recorded at time of shown in income statement sales, general, and administrative expenses (SG&A) sales managers salespeople Sarbanes-Oxley Act of 2002, scale, issue of, IRR and scoreboards Securities Exchange Act of 1934, selling expenses sensitivity analysis Setpoint shareholders’ equity See owners’ equity Shore, Andrew short-term liabilities short-term loans Small Giants (Burlingham) “smoothing” earnings solvency sources of capital SOX See Sarbanes-Oxley Act of 2002 Stack, Jack Starbucks start-up companies statement of earnings See income statement statement of operations See income statement stock buybacks common stock (see common stock) dividends on preferred stock (see preferred shares) stockholders’ equity See owners’ equity stock market stockout straight-line depreciation Sullivan, Scott Sunbeam bill-and-hold scam downsizing of sustainable growth rate “Sweet Dreams Bakery” example “taking the big bath,” Target Stores taxes time period covered by income statement time value of money toolboxes art of finance balance sheet building financial staff cash accounting employees as asset expenses vs capital expenditures financially intelligent companies financing a business free cash flow income statement open-book management percent of and percent change percent of sales power of ratios ratios return on investment (ROI) Sarbanes-Oxley Act of 2002, sustainable growth rate variance working capital total asset turnover Toyota training See also learning financial literacy training training businesses in understanding business transparency treasurer trend lines Tyco International Ultralife Batteries Under Armour balance sheet exercise cash flow statement exercise income statement exercise ratios exercise sample financial statements unfavorable variance unit costs unusual items in balance sheet U.S Marine Corps Useem, Jerry useful life of assets valuation of companies variable costs variances VCs See venture capitalists vendors venture capitalists (VCs) visual aids voting rights Wall Street earnings “smoothing” and focus on free cash flow impressed by Sunbeam stock price interest in operating profit pressures for income manipulation Wall Street Journal Wal-Mart Stores Warfighting (U.S Marine Corps) Waste Management Inc (WMI) Web tools weekly “numbers” meetings Weinzweig, Ari WIP (work-in-process) inventory WMI See Waste Management Inc working capital balance sheet levers balance sheet management cash conversion cycle days sales outstanding and elements of inventory management and production cycle illustrated relationship with banker work-in-process inventory (WIP) WorldCom write-downs write-offs Xerox year-to-year trends Zimmer, Ed Zingerman’s ABOUT THE AUTHORS Karen Berman, PhD, is founder, president, and co-owner of the Business Literacy Institute, a consulting firm offering customized training programs, Money Maps, keynotes, and other products and services designed to ensure that people in organizations understand how financial success is measured and how they make an impact Karen has worked with dozens of companies, helping them create financial literacy programs that transform employees, managers, and leaders into business partners Joe Knight is co-owner of the Business Literacy Institute and co-owner of Setpoint Systems He works as chief financial officer of Setpoint and as a facilitator and keynote speaker for the Business Literacy Institute, traveling to clients all over the world to teach them about finance Joe, who holds a master’s of business administration from the University of California at Berkeley, is a true believer in financial transparency and lives it every day at Setpoint ... Cataloging-in-Publication Data Berman, Karen, 1962 – Financial intelligence for entrepreneurs : what you really need to know about the numbers / Karen Berman, Joe Knight; with John Case p cm... Eight - Creating a Financially Intelligent Company 28 - Financial Literacy, Transparency, and Your Business’s Performance 29 - Financial Literacy Strategies 30 - Putting Financial Intelligence to... just because he was able to read the financial reports—the foundation of financial intelligence Some entrepreneurs think they don’t need to bother with formal financial reports They run the business