Do you want to improve your accounting knowledge? Are you in charge of your business’s finances?
In Financial Intelligence, Karen Berman and Joe Knight explain how to calculate important numbers that reflect your business’s profitability, efficiency, and potential to attract investors. They also discuss how to manage your working capital to increase how much cash your business keeps on hand.
Read more to learn how to understand accounting better so your business’s finances can soar.
How to Understand Accounting
Berman and Knight’s main idea is that financial knowledge isn’t just for accountants. Rather, they argue that improving financial intelligence throughout an organization can significantly boost its performance. When employees at all levels understand their business’s financial aspects, they make better decisions, react more quickly to changes, and contribute more effectively to the company’s success. However, creating a financially intelligent company requires more than just a book or a one-time training session. Instead, teaching employees how to understand accounting better should be an ongoing process that’s part of the company’s culture. Training should be customized to your company’s specific needs and include a basic foundation for all employees.
The authors also argue that, in today’s business world, where job security can’t be taken for granted, employees have a legitimate interest in understanding their company’s financial health. Berman and Knight advocate for a policy of financial transparency in which financial information is shared widely and explained. They believe this approach can lead to increased trust and loyalty among managers and rank-and-file employees. That being said, public companies must be cautious about sharing non-public information, but the authors maintain that most financial training rarely includes information that would help a company’s rivals.
| Financial Intelligence and Transparency While financial intelligence can improve decision-making, to implement it company-wide may require more than training—it also means giving workers the freedom to apply the knowledge they’ve gained. In No Rules Rules, Reed Hastings explains how this was put into practice at Netflix. Hastings installed a culture of transparency by disseminating the company’s financial data, but he also gave workers the autonomy to make their own decisions and accept the consequences. For this to work, Hastings says you need a talented workforce, a focus on innovation, and a flexible organizational structure. The financial training Berman and Knight recommend could be very impactful in such a business setting. In Reinventing Organizations, Frédéric Laloux points out another benefit of transparency—it lets every employee see the organization from the CEO’s point of view, including the financial perspective. Keeping information on a “need to know” basis infantilizes workers by suggesting they can’t be trusted, whereas trusting workers with financial data lets you make use of the whole organization’s intelligence while also demonstrating trust in your employees. When everyone grasps their business’s financial situation and feels responsible for it, it generates a sense of ownership that’s been shown to increase productivity beyond the financial decision-making that Berman and Knight focus on. |
Important Metrics
To understand which numbers to look at and how to determine what they mean, the authors discuss several key financial ratios that managers, investors, and analysts use to evaluate a company’s performance and financial health. Among all the various financial measures, Berman and Knight identify several important financial measures that indicate a company’s profitability, efficiency, and overall financial strength.
Profitability
To measure a company’s profitability, Berman and Knight offer three financial ratios:
- Gross profit margin: Divide the gross profit number on the income statement by the total sales. This tells you how profitable your products and services are in and of themselves.
- Operating profit margin: First, subtract your operating costs from your gross profit, then divide by total sales. This percentage lets you gauge the profitability of your core business operations.
- Net profit margin: Divide the income statement’s net profit amount by your total sales—this lets you assess your overall profitability after all expenses.
Berman and Knight recommend that you track these ratios over time to spot trends in your company’s profitability. These margins show you how effectively your business generates profits at different stages of the money-making process. For instance, if your gross profit is high but your operating profit is low, then you may be paying too much overhead in day-to-day business operations. With these numbers, you can also compare your performance to business competitors and industry benchmarks.
Efficiency
To measure a business’s efficiency using financial statements, Berman and Knight say to turn to your balance sheet, from which you can assess how well your business is using its resources. For instance, you can measure how quickly you sell your inventory by dividing the average value of the inventory you keep in stock by the cost of goods sold on a daily basis. You can compute how fast customers pay their bills by dividing the amount of money your customers owe by your average daily sales, letting you know how efficient you are at collecting payment for the goods you provide. Finally, you can calculate the turnover rate of all your company’s assets by dividing your total revenue by the value of everything your company owns.
The trick lies in recognizing whether your efficiency numbers are good or bad. Berman and Knight explain that this is largely subjective and changes from industry to industry. Nevertheless, you should track your efficiency numbers over time and compare them to industry standards so you can identify areas for improvement in your business operations. You must also recognize that your efficiency numbers rely heavily on your company’s balance sheet and will reflect any assumptions that you or your accountants make in preparing that document.
Investment Potential
While managers view their businesses from a different perspective than Wall Street investors, Berman and Knight say that it’s important to analyze your financial statements the same way that potential investors will. This is especially crucial if your business wants to finance itself by bringing in shareholders rather than by taking on debt. To make your business more attractive to investors, you need to know what they’re looking for and, if needed, find ways to improve your performance in those areas.
First off, investors expect to see a business’s revenue expand over time. The authors note that sustainable growth rates vary by industry and company size, but consistent growth is key. Another measure investors expect to increase is the amount of earnings per share (EPS), which is the net income on the income statement divided by the company’s total number of shares. This is a metric that investors want to see going up even during economic downturns. Also of value to investors are a company’s ability to generate cash beyond its operating needs and how efficiently a company uses its capital to generate returns for its owners. The latter is reflected in the return on investment (ROI), which we’ll cover in more detail next.
Return on Investment
Perhaps the most basic question anyone who invests in a business asks is, “Will this be a good use of my time and money?” In the simplest terms, the ROI answers this by measuring how profitable an investment is compared to its cost. Berman and Knight discuss how ROI calculations involve estimating future business performance, whether an investment will earn back its value, and what the minimum return must be in order for a business or an investment to move forward.
To calculate ROI, you estimate the initial cash outlay for a business project and project its future cash flows. According to Berman and Knight, the hard part is to make realistic estimates of how much cash your business will generate, not just theoretical profits. Since determining a return on investment involves making guesses as to future performance, calculating the ROI requires significant judgment and estimation, making it as much an art as a science. However, ROI calculations are useful beyond measuring the performance of your business as a whole—they can also be applied to any new project or venture you create within the larger organization, such as investing in a new product or service.
When calculating your return on investment, it’s also common to take into account how quickly your investment will pay off. The simplest way to do this is to calculate how long it will take for an investment to recoup its initial costs. While easy to understand, this approach has limitations, since it doesn’t consider how money’s value changes over time or what happens after the payback period. Berman and Knight prefer a calculation method called net present value (NPV), which is more complex but provides a more comprehensive analysis. In short, the NPV takes into account that due to inflation, money in the future is worth less than the same amount of money today.
To determine if your ROI is high enough, Berman and Knight say you have to decide on your required rate of return. This is the bare minimum amount of return that your business or a shareholder expects to earn back from an investment for it to be worthwhile. Companies set this rate based on factors such as how much risk is involved and what the potential returns are from other potential investments. If a business or a project’s projected rate of return exceeds this benchmark, it’s considered financially attractive. The rate may vary for different industries or economic conditions, reflecting investors’ tolerance for risk and what your financial goals are.
Managing Capital
Since many of the financial tools listed in this guide rely on guesses and assumptions, it’s not hard to imagine how a business might paint a rosy picture of itself by tweaking an assumption here or there. However, Berman and Knight describe a way of using financial numbers to help your company improve its actual performance without increasing sales or bringing costs down. You can do this by managing your working capital—the resources that are readily available, not theoretical or tied up in long-term debt—by adjusting the timing of how payments are made and carefully controlling inventory levels.
A business’s working capital consists primarily of cash, inventory, and incoming payments, minus short-term liabilities. By effectively managing how it handles capital, your company can free up cash and improve its financial flexibility. Two key metrics that Berman and Knight say to watch are the time it takes to collect on payments, and how long you take to pay your own bills. In general, you want to collect incoming payments as early as possible, while putting off outgoing payments as long as you can without angering your vendors. Doing so maximizes how much cash you have on hand at any moment, even without increasing your sales or bringing down your operating expenses.
Berman and Knight also stress that inventory management is crucial in freeing up cash. While keeping goods and materials in inventory is necessary for many industries, excess inventory ties up cash that could be used elsewhere. The challenge is to maintain enough inventory to satisfy your customers while minimizing the amount of cash it ties up. Managers throughout your company can impact inventory levels, from salespeople placing orders to engineers requesting raw materials, so everyone in the product chain needs to know how they add to or subtract from working capital.
Berman and Knight conclude that even small improvements in capital and inventory management can result in more cash for your business, so a little financial intelligence can go a long way toward your company’s success.
