PDF Summary:Financial Intelligence, by Karen Berman and Joe Knight

Understanding accounting can be a challenge. Even in the business world, executives and entrepreneurs find it hard to interpret complex financial statements. Nevertheless, in Financial Intelligence, Karen Berman and Joe Knight argue that basic financial knowledge is something you can learn, regardless of your educational background or your aptitude for numbers. Developing financial intelligence lets you analyze your company's performance, spot potential issues, and make stronger cases for your business ideas.

Berman and Knight are both prominent figures in business education and financial literacy. In this guide, we’ll outline their main tenets of financial literacy, such as how to read basic financial statements, how to analyze data using ratios and calculations, and what the numbers mean within the broader context of your business. We’ll also discuss how to apply the authors’ concepts, provide counterpoints and different interpretations, and show how modern digital tools can help shoulder the burden of financial analysis.

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(Shortform note: One tactic to adjust the income and balance sheets that’s become prevalent in Hollywood is to cancel nearly completed films and take the loss as a write-off. Berman and Knight discuss write-offs as a necessary hardship when a business project fails, but movie studios such as Warner Brothers have canceled several much-anticipated films to boost their financial position. If a completed project is taken off the books, then its expenses no longer show on the income statement, increasing overall estimated profit, nor will the film’s projected marketing budget appear as a liability on the balance sheet. The downside, of course, is that moviegoers will never see Coyote vs. Acme, despite the film’s acclaim from early screenings.)

The Cash Flow Statement

While the income statement and the balance sheet give an overview of a business’s financial position, taking into account past and future revenue and expenses, the cash flow statement fleshes out the full picture of where a business stands in the present—and whether it can afford to pay its bills. We’ll explain how the cash flow statement organizes revenue and expenses, what it can tell you that other statements don’t, and why it’s important to everyone in the business.

The cash flow statement shows how much money is coming in and going out in three different areas of the business:

• Operating cash flow shows how much cash the company spends and generates while performing its core business operations.
• Investing cash flow reveals how much the company is spending on itself in terms of capital assets and investments for the future.
• Financing cash flow shows how much of the business is funded through loans versus shareholder investments.

By examining these three areas, managers can gain insight into the company's strategy, its ability to fund its own growth, and its reliance on outside capital.

Personal Cash Flow

The three types of cash flow that Berman and Knight illustrate are loosely analogous to the forms of income generation and expenses you may have in your personal life. In Rich Dad’s Cashflow Quadrant, Robert T. Kiyosaki details four types of income streams you can develop both in your career and outside it. Though Kiyosaki focuses on earning cash through different channels, each of his methods has associated expenses that you must also take into account, just as a business does on its cash flow statement.

Kiyosaki’s first avenue for cash is the simplest—if you’re an employee, you’re paid for your work. This income, plus its associated expenses, such as work clothes and transportation, constitute your personal operating cash flow. This income stream has the advantage of predictability, but steady employment lacks the sense of security that it provided in generations past. Like a business that coasts on standard operations, this cash flow stream leaves you vulnerable to changes in your market or field.

The next option Kiyosaki presents is to be a business owner, in which you invest the time, labor, and costs to form a working enterprise and reap the benefits yourself. This is the personal equivalent of the investing cash flow Berman and Knight describe—just as a business invests in its growth, you can invest in yourself as a business. This cash stream has the disadvantage of being high-risk and high-cost, but it also has a higher potential for reward.

Lastly, you have your financing cash flow. On a personal level, this would include the interest paid on the loans, mortgages, and credit cards you use to fund your day-to-day life. However, from Kiyosaki’s point of view, it would also include any wealth you generate as an investor in passive income streams. These include stocks and bonds, as well as income earned from investment properties and other avenues that don’t require your day-to-day attention. If you wished, you could conceivably create a personal cash flow statement similar to that which Berman and Knight illustrate for business use.

Berman and Knight list several reasons why the cash flow statement provides a clearer picture than profit figures alone, because profit does not equal cash on hand. A company can be profitable on paper but still run out of cash if it can’t collect its debts or if it has large expenses to be paid before its revenue comes in. Also, cash figures aren’t as dependent on potentially faulty accounting estimates as profit figures are. Lastly, knowing how much cash you have helps you decide when to take advantage of business opportunities and tells you how much to hold in reserve so you can weather downturns without relying too heavily on external financing.

(Shortform note: Berman and Knight don’t specify how much cash your business should keep on hand. However, in Great by Choice, Jim Collins and Morten T. Hansen suggest that to survive unexpected fiscal shocks, you should carry three to 10 times the ratio of cash to assets that other companies in your industry maintain. It may seem that having so much idle cash isn’t a good use of a company’s resources, but disruptive economic events are inevitable, and having cash on hand serves as a shock absorber, increasing your company’s chances of survival.)

Berman and Knight emphasize that all managers impact cash flow, not just those in finance roles. Sales managers influence how quickly customers pay, bringing cash into the business. Operations managers affect inventory spending, which impacts cash flowing out. Therefore, by understanding the cash flow statement, managers can make more informed decisions that improve the company's financial health and can speak more knowledgeably with executives about the cash implications of various projects and initiatives.

(Shortform note: Making all managers money-conscious, as Berman and Knight suggest, is one way to keep them in alignment with your business’s overall goals. In The Essential Drucker, management expert Peter F. Drucker says that people who make management decisions now comprise more than a third of the workforce, and every one of these people is responsible for whether their businesses’ efforts produce their desired effects. In your business, therefore, you should make sure that you and your fellow managers keep their monetary goals in mind, and not just the goals of their departments, teams, or projects.)

Making Sense of the Numbers

Now that we’ve covered the specific information accountants include on business financial statements, we’ll discuss how to interpret and use that information. We’ll begin with how to calculate important numbers that reflect your business’s profitability, efficiency, and potential to attract investors, with extra focus given to the importance of determining your business’s return on investment. After that, we’ll discuss how to manage your working capital to increase how much cash your business keeps on hand.

Remember, 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, financial training 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.

What Profit Margins Tell You

As you track your company’s profit margins to measure the factors Berman and Knight describe, investors will likely be doing the same. For instance, financial analysts often use your gross profit margin to compare your business to industry competitors. A gross profit margin that doesn’t change much points to effective management and stable product performance, while swings up and down may indicate underlying issues that need attention. A low margin compared to your industry peers signals a need to reassess pricing strategies or find ways to cut production costs.

Your operating profit margin speaks to how well you're controlling variable costs that are largely under management's discretion, such as employee wages and how much you spend on rental agreements. Unlike gross or net profit margins, your operating profit focuses on your core business operations, but a low operating profit margin doesn't always signal poor performance, especially for growing businesses that reinvest heavily in expansion. Likewise, mature businesses in stable industries are expected to have higher operating margins. Context, therefore, is very important in judging the significance of operating profit.

Of the three types of profit Berman and Knight list, your net profit margin provides the most comprehensive view of your financial condition. It shows how much of your business’s total revenue remains as profit after accounting for all expenses. A higher net profit margin indicates that you're effectively managing costs and generating sales, but this metric alone doesn't tell the whole story. It can be influenced by one-time events like shocks to the market or a merger with another business, so you shouldn’t rely solely on net profit to determine the strength of your business.

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.

(Shortform note: Another way to look at resource use in addition to Berman and Knight’s numbers-based approach is to view it in terms of customer satisfaction. In The Personal MBA, Josh Kaufman argues that the more efficient your operations, the better position you’ll be in to provide high-quality products and services that outdo your competitors. Therefore, on top of your balance sheet analysis, Kaufman says to come up with a list of both minor and major improvements you can make and prioritize those that will make the biggest difference to your efficiency and profits, in terms of their impact and consequences for your business.)

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.

(Shortform note: Depending on your industry, there are a plethora of standards to grade yourself by that Berman and Knight don’t specifically go into, many of which are set by the International Organization for Standardization (ISO). To determine which efficiency standards are appropriate for your company, you can start with quality management standards like ISO 9001, which can improve your processes and customer satisfaction. Environmental standards such as ISO 14001 demonstrate your commitment to sustainability, whereas health and safety management standards like ISO 45001 maximize your workplace’s safety. By assessing your company's needs in these and other areas, you can prioritize which standards are most vital to improving your business processes and ultimately increasing your profitability.)

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.

(Shortform note: Especially for startups, attracting investors will almost surely be necessary at some point—a process depicted on the reality TV show Shark Tank. Investors on the show use several methods to value entrepreneurs' companies. They start by examining revenue, manufacturing expenses, and other overheads to calculate prospective companies’ profit margins. To put these numbers in context, they often compare the startup's metrics to those of their direct competitors. Finally, the investors also weigh intangible factors like brand recognition. If you, as an owner, analyze these factors first as Berman and Knight recommend, you’ll have done much of your potential investors’ work for them.)

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.

(Shortform note: The revenue and earnings growth that Berman and Knight show how to calculate are certainly important to investors, but not every kind of growth is good for business. Sometimes, a runaway success can actually be dangerous, especially for startups. Rapid growth leads to financial strain by increasing a business’s operating costs and the size of the workforce it needs, both of which can trigger a cash flow crisis and skew the numbers on your balance sheet and cash flow statement. Additionally, unsustainable growth can cause employee burnout and lower levels of customer satisfaction, undermining your company's reputation.)

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.

(Shortform note: Though the process of estimating income is still tricky, AI tools can significantly enhance predictions of future revenue by applying machine learning to historical information, market changes, and customer profiles. By spotting patterns in sales transactions, AI tools can give a comprehensive view of your performance in the market and more accurate forecasts of your future cash flow. Since AI’s real-time processing can adjust your revenue projections on the fly, you can update your ROI calculations as market conditions change, rather than relying on old information. Nevertheless, Berman and Knight might suggest you try to understand the numbers for yourself so that you can filter an AI’s predictions through your personal judgment.)

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.

The Trouble With ROI

Because, as Berman and Knight reiterate, there are so many guesses in making revenue predictions, ROI calculations are often inaccurate due to estimation errors. One study suggests that even small mistakes in predicting costs and revenue can lead to substantial errors in the final ROI figure. The study found that in many IT system projects, cost estimation errors typically fell between 30% and 50%. The level of these mistakes can result in highly inaccurate ROI calculations, followed by misguided investment decisions. The study’s author recommends always including an assessment of ROI accuracy alongside your ROI figures themselves to provide a more complete picture for decision-makers.

Though Berman and Knight prefer using NPV to calculate ROI, even that approach has disadvantages. First, it requires you to estimate future inflation—what financial experts call the discount rate—which NPV analysis assumes will remain constant. However, inflation rates vary widely as economic conditions change. NPV also doesn't account for the cost of the investments you might miss at a later date by choosing one now based on NPV analysis. As with nearly all financial decisions, investment potential relies as much on judgment and experience as it does on running the numbers.

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.

(Shortform note: For a business owner, the rate of return that Berman and Knight describe will let you decide whether a project or expansion is worth your company’s time and money. For investors looking to buy into your business, the rate of return will manifest as growing stock prices and increasing dividends. In The Intelligent Investor, Benjamin Graham divides these prospective investors into defensive and aggressive. Defensive investors are mostly content to keep up with regular stock market growth, but aggressive investors—those looking to get the best returns on their money—usually expect gains of 5% or more in addition to the stock market’s regular growth. Whether such expectations are realistic is a subject for debate.)

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.

(Shortform note: Berman and Knight’s recommendation to “collect early and pay late” is age-old business advice, but there are some advantages to the opposite approach. For instance, Some vendors offer better terms, priority service, discounts for early payment, which can result in cost savings over time. Likewise, offering longer payment terms can attract customers, retain their business, and set you apart from competitors. Your optimal approach will depend on your specific circumstances, industry norms, and your relationships with customers and suppliers.)

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.

(Shortform note: In a mid-size to large business, Berman and Knight’s advice not to tie up too much cash in inventory applies, but for small businesses, there’s sometimes a risk of being low on inventory just when you need it. In 12 Months to $1 Million, Ryan Daniel Moran says that running out of your product can be disastrous for a startup. It cuts off your revenue, destroys your sales momentum, and loses customer engagement. If your product becomes suddenly popular and your sales go up, you might run out of stock and be unable to fulfill all your orders.)

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.

(Shortform note: The smaller your business, the more important it is to manage your capital well. In Innovation and Entrepreneurship, Peter F. Drucker writes that a lack of robust financial controls can doom even the most promising startups, particularly those that grow too rapidly and can find themselves starved of much-needed funds. Drucker also says that as your business expands, it will outgrow its initial funding method, possibly making you bring in new partners or offer stock to the public. The capital management skills that Berman and Knight suggest you develop can help you estimate your business’s future needs and set them in motion today.)