Note: While reading a book whenever I come across something interesting, I highlight it on my Kindle. Later I turn those highlights into a blogpost. It is not a complete summary of the book. These are my notes which I intend to go back to later. I know the formatting of this post is a bit messed up. It was too much effort to edit it. So please bear for once. Let’s start!

Revenue or sales refers to the value of what a company sold to its customers during a given period. You’d think that would be an easy matter to determine. But the question is, When should revenue be recorded (or “recognized,” as accountants like to say)? Here are some possibilities: • When a contract is signed • When the product or service is delivered • When the invoice is sent out • When the bill is paid

If you said, “When the product or service is delivered,” you’re correct

The income statement shows revenues, expenses, and profit for a period of time, such as a month, quarter, or year. It’s also called a profit and loss statement, P&L, statement of earnings, or statement of operations. Sometimes the word consolidated is thrown in front of those phrases, but it’s still just an income statement. The bottom line of the income statement is net profit, also known as net income or net earnings

Imagine, for instance, that a company sells a customer a copying machine, complete with a maintenance contract, all wrapped up in one financial package. Suppose the machine is delivered in October, but the maintenance contract is good for the following twelve months. Now: how much of the initial purchase price should be recorded on the books for October? After all, the company hasn’t yet delivered all the services that it is responsible for during the year. Accountants can make estimates of the value of those services, of course, and adjust the revenue accordingly. But this requires a big judgment call

Operating expenses are the costs that are required to keep the business going day to day. They include salaries, benefits, and insurance costs, among a host of other items. Operating expenses are listed on the income statement and are subtracted from revenue to determine profit

One example of an artful work of finance that played a huge role in recent financial scandals—is determining whether a given cost is a capital expenditure or an operating expense. An operating expense reduces the bottom line immediately, and a capital expenditure spreads the hit out over several accounting periods. You can see the temptation here. Wait. You mean if we take all those office supply purchases and call them “capital expenditures,” we can increase our profit accordingly? This is the kind of thinking that got the company WorldCom into trouble

A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement


An accrual is the portion of a given revenue or expense item that is recorded in a particular time span. Product development costs, for instance, are likely to be spread out over several accounting periods, and so a portion of the total cost will be accrued each month. The purpose of accruals is to match revenues to costs in a given time period as accurately as possible.

Allocations Allocations are apportionments of costs to different departments or activities within a company. For instance, overhead costs such as the CEO’s salary are often allocated to the company’s operating units

Determining accruals and allocations nearly always entails making assumptions and estimates. Take your salary as an example. Say that you worked in June on a new product line and that the new line was introduced in July. Now the accountant determining the allocations has to estimate how much of your salary should be matched to the product cost (because you spent much of your time on those initial products), and how much should be charged to development costs (because you also worked on the original development of the product). She must also decide how to accrue for June versus July. Depending on how she answers these questions, she can dramatically change the appearance of the income statement. Product cost goes into cost of goods sold. If product costs go up, gross profit goes down— and gross profit is a key measure for assessing product profitability. Development costs, however, go into research and development, which are included in the operating expense section of the income statement and don’t affect gross profit at all. So let’s say the accountant determined that all of your salary should go into the development cost in June, rather than the product cost in July. Her assumption is that your work wasn’t directly related to the manufacturing of the product and therefore shouldn’t be categorized as product cost. But there’s a twofold bias that results:

First, development costs are larger than they otherwise would be. An executive who analyzes those costs later on may decide that product development is too expensive and that the company shouldn’t take that risk again. If that’s what happens, the company might do less product development, thereby jeopardizing its future. Second, the product cost is smaller than it otherwise would be. That, in turn, will affect key decisions such as pricing and hiring. Maybe the product will be priced too low. Maybe more people will be hired to put out what looks like a profitable product— even though the profit reflects some dubious assumptions.

Of course, any individual’s salary won’t make much of a difference in most companies. But the assumptions that govern one person are likely to be applied across the board

Ask some simple but critical questions:

What were the assumptions in this number? Are there any estimates in the numbers? What is the bias those assumptions and estimates lead to? What are the implications?

At any rate, this case is simple enough that you can easily see the answers to the questions we posed earlier. The assumptions in the numbers? Your time was spent in development and didn’t really have much to do with the production of the product that was sold in July. The estimates? How your salary should be split, if at all, between development and product cost. The bias? Higher development costs and lower product costs. And the implications? Concern about the high cost of development; product pricing that may be too low

Depreciation Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of products and services as shown on the income statement. It is based on the same idea as accruals: we want to match as closely as possible the costs of our products and services with what was sold. Most capital expenditures are depreciated (land is an example of one that isn’t). Accountants attempt to spread the cost of the expenditure over the useful life of the item

The notion of depreciation isn’t complicated. Say a company buys some expensive machinery or vehicles that it expects to use for several years. Accountants think about such an event like this: rather than subtract the entire cost from one month’s revenues—perhaps plunging the company or business unit into the red for that month—we should spread the cost out over the equipment’s useful life. If we think a machine will last three years, for instance, we can record (“depreciate”) one-third of the cost per year, or one-thirty-sixth per month, using a simple method of depreciation. That’s a better way of estimating the company’s true costs in any given month or year than if we recorded it all at once. Furthermore, it better matches the expenses of the equipment to the revenue that it is used to generate

practice, however, accountants have a good deal of discretion as to exactly how a piece of equipment is depreciated. And that discretion can have a considerable impact. Take the airline industry. Some years back, airlines realized that their planes were lasting longer than anticipated. So the industry’s accountants changed their depreciation schedules to reflect that longer life. As a result, they subtracted less depreciation from revenue each month. And guess what? The industry’s profits rose significantly, reflecting the fact that the airlines wouldn’t have to be buying planes as soon as they had thought. But note that the accountants had to assume that they could predict how long a plane would be useful. On that judgment—and a judgment it is—hung the resulting upward bias in the profit numbers. On that judgment, too, hung all the implications: investors deciding to buy more stock, airline executives figuring they could afford to give out better raises, and so on

art here lies in choosing the valuation method. Different methods produce different results—which, of course, injects a bias into the numbers.

Suppose, for example, your company proposes to acquire a closely held manufacturer of industrial valves. It’s a good fit with your business—it’s a “strategic” acquisition—but how much should you pay? Well, you could look at the valve company’s earnings (another word for profits), then go to the public markets and see how the market values similar companies in relation to their earnings. (This is known as the price-to-earnings ratio method.) Or you could look at how much cash the valve company generates each year, and figure that you are, in effect, buying that stream of cash. Then you would use some interest rate to determine what that stream of future cash is worth today. (This is the discounted cash flow method.) Alternatively, you could simply look at the company’s assets—its plant, equipment, inventory, and so on, along with intangibles such as its reputation and customer list—and make estimates about what those assets are worth (the asset valuation method).

Needless to say, each method entails a whole passel of assumptions and estimates. The price-to-earnings method, for example, assumes that the stock market is somehow rational and that the prices it sets are therefore accurate. But of course the market isn’t wholly rational; if the market is high, the value of your target company will be higher than at times when the market is low. And besides, that “earnings” number is itself an estimate.

So maybe, you might think, we should use the discounted cash flow method. The question with this method is, What is the right interest or “discount” rate to use when we’re calculating the value of that stream of cash? Depending on how we set it, the price could vary enormously. And of course, the asset valuation method itself is merely a collection of guesses as to what each asset might be worth

Goodwill Goodwill comes into play when one company acquires another company. It is the difference between the net assets acquired (that is, the fair market value of the assets less the assumed liabilities) and the amount of money the acquiring company pays for them. For example, if a company’s net assets are valued at $1 million and the acquirer pays $3 million, then goodwill of $2 million goes onto the acquirer’s balance sheet. That $2 million reflects all the value that is not reflected in the acquiree’s tangible assets—for example, its name, reputation, customer lists, and so on

Balance Sheet The balance sheet reflects the assets, liabilities, and owners’ equity at a point in time. In other words, it shows, on a specific day, what the company owned, what it owed, and how much it was worth. The balance sheet is called such because it balances—assets always must equal liabilities plus owners’ equity

Profit is based on revenue. Revenue, remember, is recognized when a product or service is delivered, not when the bill is paid. So the top line of the income statement, the line from which we subtract expenses to determine profit, is often no more than a promise. Customers have not paid yet, so the revenue number does not reflect real money and neither does the profit line at the bottom. If everything goes well, the company will eventually collect its receivables and will have cash corresponding to that profit. In the meantime, it doesn’t

Cash Cash as presented on the balance sheet means the money a company has in the bank, plus anything else (like stocks and bonds) that can readily be turned into cash

Chief financial officer (CFO). The CFO is involved in the management and strategy of the organization from a financial perspective. He or she oversees all financial functions; the company controller and treasurer report to the CFO. The CFO is usually part of the executive committee and often sits on the board of directors. For financial matters, the buck stops here. Treasurer. The treasurer focuses outside the company as well as inside. He or she is responsible for building and maintaining banking relationships, managing cash flow, forecasting, and making equity and capital-structure decisions. The treasurer is also responsible for investor relations and stock-based equity decisions. Some would say that the ideal treasurer is a finance professional with a personality. Controller. The focus of the controller—sometimes spelled comptroller—is purely internal. His or her job is providing reliable and accurate financial reports. The controller is responsible for general accounting, financial reporting, business analysis, financial planning, asset management, and internal controls. He or she ensures that day-to-day transactions are recorded accurately and correctly. Without good, consistent data from the controller, the CFO and the treasurer can’t do their jobs

Peter Drucker said profit is the sovereign criterion of the enterprise. The use of the word sovereign is right on the money. A profitable company charts its own course. Its managers can run it the way they wish to. When a company stops being profitable, other people begin to poke their noses into the business. Profitability is also how you as a manager are likely to be judged. Are you contributing to the company’s profitability or detracting from it? Are you figuring out ways to increase profitability every day, or are you just doing your job and hoping everything will work out?

The income statement is supposed to show a company’s profit for a given period—usually a month, a quarter, or a year. It’s only a short leap of imagination to conclude that the income statement shows how much cash the company took in during that period, how much it spent, and how much was left over. That “left over” amount would then be the company’s profit, right?

Alas, no. Except for some very small businesses that do their accounting this way—it’s called cash-based accounting—that notion of an income statement and profit is based on a fundamental misconception. In fact, an income statement measures something quite different from cash in the door, cash out the door, and cash left over. It measures sales or revenues, costs or expenses, and profit or income.

Any income statement begins with sales. When a business delivers a product or a service to a customer, accountants say it has made a sale. Never mind if the customer hasn’t paid for the product or service yet—the business may count the amount of the sale on the top line of its income statement for the period in question. No money at all may have changed hands. Of course, for cash-based businesses such as retailers and restaurants, sales and cash coming in are pretty much the same. But most businesses have to wait thirty days or more to collect on their sales, and manufacturers of big products such as airplanes may have to wait many months

The costs and expenses a company reports are not necessarily the ones it wrote checks for during that period. The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period. Accountants call this the matching principle—the appropriate costs should be matched to all the sales for the period represented in the income statement—and it’s the key to understanding how profit is determined

The Matching Principle The matching principle is a fundamental accounting rule for preparing an income statement. It simply states, “Match the sale with its associated costs to determine profits in a given period of time—usually a month, quarter, or year.” In other words, one of the accountants’ primary jobs is to figure out and properly record all the costs incurred in generating sales

The matching principle is the little bit of accounting you need to learn. For example:

If an ink-and-toner company buys a truckload of cartridges in June to resell to customers over the next several months, it does not record the cost of all those cartridges in June. Rather, it records the cost of each cartridge when the cartridge is sold. The reason is the matching principle. And if a delivery company buys a truck in January that it plans to use over the next three years, the cost of the truck doesn’t show up on the income statement for January. Rather, the truck is depreciated over the whole three years, with one-thirty-sixth of the truck’s cost appearing as an expense on the income statement each month (assuming a simple straight-line method of depreciation). Why? The matching principle. The truck is one of the many costs associated with that month’s work—the work that shows up in January’s sales. The matching principle even extends to items like taxes. A company may pay its tax bill once a quarter—but every month the accountants will tuck into the income statement a figure reflecting the taxes owed on that month’s profits. The matching principle applies to service companies as well as product companies. A consulting firm, for example, sells billable hours, meaning the time each consultant is working with a client. Accountants still need to match all the expenses associated with the time—marketing costs, materials costs, research costs, and so on—to the associated revenue

You can see how far we are from cash in and cash out. Tracking the flow of cash in and out the door is the job of another financial document, namely the cash flow statement. You can also see how far we are from simple objective reality. Accountants can’t just tote up the flow of dollars; they have to decide which costs are associated with the sales. They have to make assumptions and come up with estimates. In the process, they may introduce bias into the numbers

In principle, the income statement tries to measure whether the products or services that a company provides are profitable when everything is added up. It’s the accountants’ best effort to show the sales the company generated during a given time period, the costs incurred in making those sales (including the costs of operating the business for that span of time), and the profit, if any, that is left over. Possible bias aside, this is a critically important endeavor for nearly every manager in a business. A sales manager needs to know what kind of profits she and her team are generating so that she can make decisions about discounts, terms, which customers to pursue, and so on. A marketing manager needs to know which products are most profitable so that those can be emphasized in any marketing campaigns. A human resources manager should know the profitability of products so that he knows where the company’s strategic priorities are likely to lie when he is recruiting new people

Over time, the income statement and the cash flow statement in a well-run company will track one another. Profit will be turned into cash. However, just because a company is making a profit in any given time period doesn’t mean it will have the cash to pay its bills. Profit is always an estimate—and you can’t spend estimates

Before you even start contemplating the numbers, you need some context for understanding the document. The Label Does it say “income statement” at the top? It may not. It may instead say “profit and loss statement” or “P&L statement,” “operating statement” or “statement of operations,” “statement of earnings” or “earnings statement.” Often the word consolidated is in front of these phrases. We will always use the term income statement. Incidentally, if you see “balance sheet” or “statement of cash flows” at the top, you have the wrong document. The label pretty much has to include one of those phrases we just mentioned

What It’s Measuring Is this income statement for an entire company? Is it for a division or business unit? Is it for a region? Larger companies typically produce income statements for various parts of the business as well as for the whole organization

Creating income statements for smaller business units has provided managers in large corporations with enormous insights into their financial performance.

Once you have identified the relevant entity, you need to check the time period. An income statement, like a report card in school, is always for a span of time: a month, quarter, or year, or maybe year-to-date

“Actual” Versus “Pro Forma” Most income statements are “actual,” and if there’s no other label, you can assume that is what you’re looking at. They show what “actually” happened to revenues, costs, and profits during that time period according to the rules of accounting. (We put “actually” in quotes to remind you that any income statement has those built-in estimates, assumptions, and biases, which we will discuss in more detail later in this part of the book.)

Then there are what’s known as pro forma income statements. Sometimes pro forma means that the income statement is a projection. If you are drawing up a plan for a new business, for instance, you might write down a projected income statement for the first year or two—in other words, what you hope and expect will happen in terms of sales and costs. That projection is called a pro forma. But pro forma can also mean an income statement that excludes any unusual or one-time charges. Say a company has to take a big write-off in a particular year, resulting in a loss on the bottom line. (More on write-offs later in this part.) Along with its actual income statement, it might prepare one that shows what would have happened without the write-off

The Big Numbers No matter whose income statement you’re looking at, there will be three main categories. One is sales, which may be called revenue (it’s the same thing). Sales or revenue is always at the top. When people refer to “top-line growth,” that’s what they mean: sales growth. Costs and expenses are in the middle, and profit is at the bottom

You can usually tell what’s important to a company by looking at the biggest numbers relative to sales. For example, the sales line is usually followed by “cost of goods sold,” or COGS. In a service business the line is often “cost of services,” or COS. If that line is a large fraction of sales, you can bet that management in that company watches COGS or COS very closely

Comparative Data The consolidated income statements presented in annual reports typically have three columns of figures, reflecting what happened during the past three years. Internal income statements may have many more columns. You may see something like this, for example:

Actual % of sales      Budget % of sales       Variance % Or like this: Actual previous period       $ Change (+/-)       % Change

Tables of numbers like these can be intimidating. But they don’t need to be. In the first case, “% of sales” is simply a way of showing the magnitude of an expense number relative to revenue. The revenue line is taken as a given—a fixed point—and everything else is compared with it. Many companies set percent-of-sales targets for given line items, and then take action if they miss the target by a significant amount. For instance, maybe senior executives have decided that selling expenses shouldn’t be more than 12 percent of sales. If the number creeps up much above 12 percent, the sales organization had better watch out. It’s the same with the budget and variance numbers. (“Variance” just means difference.) If the actual number is way off budget—that is, if the variance is high—you can be sure that somebody will want to know why. Financially savvy managers always identify variances to budget and find out why they occurred.

In the second case, the statement simply shows how the company is doing compared with last quarter or last year. Sometimes the point of comparison will be “same quarter last year.” Again, if a number has moved in the wrong direction by a sizable amount, someone will want to know why.

In short, the point of these comparative income statements is to highlight what is changing, which numbers are where they are supposed to be, and which ones are not

Remember that many numbers on the income statement reflect estimates and assumptions. Accountants have decided to include some transactions here and not there. They have decided to estimate one way and not another. That is the art of finance. If you remember this one point, we assure you that your financial intelligence already exceeds that of many managers


Sales or revenue is the dollar value of all the products or services a company provided to its customers during a given period of time

The guideline that accountants use for recording or recognizing a sale is that the revenue must have been earned. A products company must have shipped the product. A service company must have performed the work. Fair enough—but what would you do about these situations?

Your company does systems integration for large customers. A typical project requires about six months to design and gain approval from the customer, then another twelve months to implement. The customer gets no real value from the project until the whole thing is complete. So when have you earned the revenue that the project generates? Your company sells to retailers. Using a practice known as bill-and-hold, you allow your customers to buy product (say, a popular Christmas item) well in advance of the time they will actually need it. You warehouse it for them and ship it out later. When have you earned the revenue? You work for an architectural firm. The firm provides clients with plans for buildings, deals with the local building authorities, and supervises the construction or reconstruction. All these services are included in the firm’s fee, which is generally figured as a percentage of construction costs. How do you figure out when the firm has earned its revenue?

We can’t provide exact answers to these questions, because accounting practices differ from one company to another. But that’s precisely the point: there are no hard-and-fast answers. Project-based companies typically have rules allowing partial revenue recognition when a project reaches certain milestones. But the rules can vary. The “sales” figure on a company’s top line always reflects the accountants’ judgments about when they should recognize revenue. And where there is judgment, there is room for dispute—not to say manipulation

Earnings per Share

Earnings per share (EPS) is a company’s net profit divided by the number of shares outstanding. It’s one of the numbers that Wall Street watches most closely. Wall Street has “expectations” for many companies’ EPS, and if the expectations aren’t met, the share price is likely to drop

of accounting fraud has been and probably always will be in that top line: sales. Sunbeam, Cendant, Xerox, and Rite Aid all played with revenue recognition in questionable ways. The issue is particularly acute in the software industry. Many software companies sell their products to resellers, who then sell the products to end users. Manufacturers, often under pressure from Wall Street to make their numbers, are frequently tempted to ship unordered software to these distributors at the end of a quarter. (The practice is known as channel stuffing.) One company that took the high road in regard to this practice is Macromedia, creators of the Internet Flash player and other products. When channel stuffing was becoming a serious problem in the industry, Macromedia voluntarily reported estimates of inventory held by its distributors, thereby showing that the channels for its products were not artificially loaded up. The message was clear to shareholders and employees alike: Macromedia was not going to be dragged into this practice

Expenses on the income statement fall into two basic categories. The first is cost of goods sold, or COGS. As usual, there are a couple of different names for this category—in a service company, for instance, it may be called cost of services (COS). We’ve also frequently seen cost of revenue and cost of sales. For simplicity’s sake, we’ll use the acronyms COGS or COS

Services (COS) Cost of goods sold or cost of services is one category of expenses. It includes all the costs directly involved in producing a product or delivering a service. materials. The labor

In a manufacturing company, for instance, the following costs are definitely in:

The wages of the people on the manufacturing line The cost of the materials that are used to make the product

And plenty of costs are definitely out, such as:

The cost of supplies used by the accounting department (paper, etc.) The salary of the human resources manager in the corporate office

Ah, but then there’s the gray area—and it’s enormous. For example:

What about the salary of the person who manages the plant where the product is manufactured? What about the wages of the plant supervisors? What about sales commissions?

Are all of these directly related to the manufacturing of the product? Or are they operating expenses, like the cost of the HR manager? There’s the same ambiguity in a service environment. COS in a service company typically includes the labor associated with delivering the service. But what about the group supervisor? You could argue that his salary is part of general operations and therefore shouldn’t be included in the COS line. You could also argue that he is supporting direct-service employees, so he should be included with them in that line. These are all judgment calls. There are no hard-and-fast rules

As to why a manager should care what’s in and what’s out, consider the following scenarios:

You run the engineering analysis department at an architectural firm, and in the past your staff’s salaries have been included in COS. Now the finance folks are moving all those costs out of COS. It’s perfectly reasonable—even though your department has a lot to do with completing an architectural design, a case can be made that it isn’t directly related to any particular job. So does the change matter? You bet. You and your staff are no longer part of what’s often called “above the line.” That means you’re going to show up differently on the corporate radar screen. If your company focuses on gross profit, for instance, management will be monitoring COS carefully, and making sure that departments that affect COS have everything they need to hit their targets. Once you’re outside of COS—“below the line”—the level of attention may be significantly less

You’re a plant manager, charged with making a gross profit of $1 million per month. This month you’re $20,000 short. Then you realize that $25,000 of your COGS is in a line item labeled “contract administration on plant orders.” Does that really belong in COGS? You petition the controller to move those costs to operating expenses. Your controller agrees; the change is done. You hit your target and everyone is happy. An outsider might even look at what’s happening and believe that gross margins are improving—all from a change you made because you were trying to hit a target

GAAP stands for “generally accepted accounting principles.” GAAP defines the standard for creating financial reports in the United States. It helps to ensure the statements’ validity and reliability, and allows for easy comparison between companies and across industries. But GAAP doesn’t spell out everything; it allows for plenty of discretion and judgment calls

Above the Line, Below the Line The “line” generally refers to gross profit. Above that line on the income statement, typically, are sales and COGS or COS. Below the line are operating expenses, interest, and taxes. What’s the difference? Items listed above the line tend to vary more (in the short term) than many of those below the line, and so tend to get more managerial attention

Operating expenses are the other major category of expenses. The category includes costs that are not directly related to making the product or delivering a service.

You can even take an expense out of COGS one month and petition to put it back in next month. All you need is a reason good enough to convince the controller (and the auditor if the changes are material to the company’s financials). Of course, changing the rules constantly from one period to the next would be bad form. One thing we all need from our accountants is consistency

And where do costs go when they are taken out of COGS? Where is “below the line?” That’s the other basic category of costs, namely operating expenses. Some companies refer to operating expenses as sales, general, and administrative expenses (SG&A, or just G&A), while others treat G&A as one subcategory and give sales and marketing its own line. Often a company will make this distinction based on the relative size of each. Microsoft chooses to show sales and marketing on a separate line because sales and marketing are a significant portion of the company’s expenses. By contrast, the biotech firm Genentech includes sales and marketing with G&A, the more typical approach. Both companies separate out research-and-development costs because of their relative importance. So pay attention to how your company organizes these expenses.

Operating expenses are often thought of and referred to as “overhead.” The category includes items such as rent, utilities, telephone, research, and marketing. It also includes management and staff salaries—HR, accounting, IT, and so forth—plus everything else that the accountants have decided does not belong in COGS

You can think of operating expenses as the cholesterol in a business. Good cholesterol makes you healthy, while bad cholesterol clogs your arteries. Good operating expenses make your business strong, and bad operating expenses drag down your bottom line and prevent you from taking advantage of business opportunities

One more thing about COGS and operating expenses. You might think that COGS is the same as “variable costs”—costs that vary with the volume of production—and that operating expenses are fixed costs. Materials, for example, are a variable cost: the more you produce, the more material you have to buy. And materials are included in COGS. The salaries of the people in the HR department are fixed costs, and they’re included in operating expenses. Unfortunately, things aren’t so simple here, either. For example, if the supervisors’ salaries are included in COGS, then that line item is fixed in the short run, whether you turn out one hundred thousand widgets or one hundred fifty thousand. Or take selling expenses, which are typically part of SG&A. If you have a commissioned sales force, sales expenses are to some extent variable, but they are included in operating expenses, rather than COGS

often buried in that SG&A line is depreciation and amortization. How this expense is treated can greatly affect the profit on an income statement.

We described an example of depreciation earlier in this part— buying a delivery truck and then spreading the cost over the three-year period that we assume the truck will be used for. As we said, that’s an example of the matching principle. In general, depreciation is the “expensing” of a physical asset, such as a truck or a machine, over its estimated useful life. All this means is that the accountants figure out how long the asset is likely to be in use, take the appropriate fraction of its total cost, and count that amount as an expense on the income statement.

In those few dry sentences, however, lurks a powerful tool that financial artists can put to work. It’s worth going into some detail, because you’ll see exactly how assumptions about depreciation can affect any company’s bottom line.

To keep things simple, let’s assume we start a delivery company and line up a few customers. In the first full month of operation we do $10,000 worth of business. At the start of that month, our company bought one of those $36,000 trucks to make the deliveries. Since we’re expecting the truck to last three years, we depreciate it at $1,000 a month (using the simple straight-line depreciation approach). So a greatly simplified income statement might look like this:

Revenues          $10,000

Cost of goods sold              5,000

Gross profit              5,000

Expenses              3,000

Depreciation              1,000

Net profit           $ 1,000

But our accountants don’t have a crystal ball. They don’t know that the truck will last exactly three years. That’s an assumption they’re making. Consider some alternative assumptions:

They might assume the truck will last only one year, in which case they have to depreciate it at $3,000 a month. That takes $2,000 off the bottom line and moves the company from a net profit of $1,000 to a loss of $1,000. Alternatively, they could assume that it will last six years (seventy-two months). In that case, depreciation is only $500 a month, and net profit jumps to $1,500.

Hmm. In the former case, we’re suddenly operating in the red. In the latter, we have increased net profit 50 percent—just by changing one assumption about depreciation. Accountants have to follow GAAP, of course, but GAAP allows plenty of flexibility. No matter what set of rules the accountants follow, estimating will be required whenever an asset lasts longer than a single accounting period. The job for the financially intelligent manager is to understand those estimates and to know how they affect the financials

consider the sorry example of Waste Management Inc. (WMI). WMI was one of the great corporate success stories of the 1970s and 1980s. So it came as a shock to everybody when the company announced in 1998 that it would take a pretax charge—a one-time write-off—of $3.54 billion against its earnings. Sometimes one-time charges are taken in advance of a restructuring, as we’ll discuss later in this chapter. But this was different. In effect, WMI was admitting that it had been cooking its books on a previously unimaginable scale. It had actually earned $3.54 billion less in the previous several years than it had reported during that time.

What was going on? WMI had been a darling of Wall Street since the 1980s, when it began to grow rapidly by buying up other garbage companies. When the supply of garbage companies to buy began to dwindle, around 1992, it bought companies in other industries. But while it was pretty good at hauling trash, it didn’t know how to run those other companies effectively. WMI’s profit margins declined. Its share price plummeted. Desperate to prop up the stock, executives began looking for ways to increase earnings.

Their gaze fell first on their fleet of twenty thousand garbage trucks, for which they’d paid an average of$150,000 apiece. Up to that point, they had been depreciating the trucks over eight to ten years, which was the standard practice in the industry. That period wasn’t long enough, the executives decided. A good truck could last twelve, thirteen, even fourteen years. When you add four years to your truck depreciation schedule, you can do wonderful things to your bottom line; it’s like the preceding little example multiplied thousands of times over. But the executives didn’t stop there. They realized that they had other assets they could do the same tricks with—about 1.5 million Dumpsters, for example. You could extend each Dumpster’s depreciation period from the standard twelve years to, say, fifteen, eighteen, or twenty years, and you’d pick up another chunk of earnings per year. By fiddling with the depreciation numbers on the trucks and the Dumpsters, Waste Management’s executives were able to pump up pretax earnings by a whopping $716 million. And this was just one of many tricks they used to make profits look larger than they were, which is why the end total was so huge.

Of course, the whole tangled web eventually came unraveled, as fraudulent schemes usually do. By then, however, it was too late to save the company. It was sold to a competitor, which kept the name but changed just about everything else. As for the perpetrators of the fraud, no criminal charges were ever filed against them, although some civil penalties were assessed

Depreciation is a prime example of what accountants call a noncash expense. Right here, of course, is where they often lose the rest of us. How can an expense be other than cash? The key to that puzzling term is to remember that the cash has probably already been paid. The company already bought the truck. But the expense wasn’t recorded that month, so it has to be recorded over the truck’s life, a little at a time. No more money is going out the door; rather, it’s just the accountant’s way of figuring that this month’s revenues depend on using that truck, so the income statement better have something in it that reflects the truck’s cost. Incidentally, you should know that there are many methods to determine how to depreciate an asset. You don’t need to know what they are; you can leave that to the accountants. All you need to know is whether the use of the asset is matched appropriately to the revenue it is bringing in.

Amortization is the same basic idea as depreciation, but it applies to intangible assets. These days, intangible assets are often a big part of companies’ balance sheets. Items such as patents, copyrights, and goodwill are all assets—they cost money to acquire, and they have value—but they aren’t physical assets like real estate and equipment. Still, they must be accounted for in a similar way. Take a patent. Your company had to buy the patent, or it had to do the research and development that lies behind it and then apply for it. Now the patent is helping to bring in revenue. So the company must match the expense of the patent with the revenue it helps to bring in, a little bit at a time. When an asset is intangible, though, accountants call that process amortization rather than depreciation. We’re not sure why— but whatever the reason, it’s a source of confusion

A noncash expense is one that is charged to a period on the income statement but is not actually paid out in cash. An example is depreciation: accountants deduct a certain amount each month for depreciation of equipment, but the company isn’t obliged to pay out that amount, because the equipment was acquired in a previous period

Every income statement has a big group of expenses that do not fall into COGS and are not operating expenses or overhead either. Every statement is different, but typically you’ll see lines for “other income/expense” (usually this is gain or loss from selling assets, or from transactions unrelated to the actual operating of the business) and of course “taxes.” Most of these you don’t need to worry about. But there is one line that often turns up after COGS and operating expenses (though it is sometimes included under operating expenses)—a line you should definitely understand because it is often critical to profitability. The most common label for this line is “one-time charge.”

One-time charges include extraordinary items, write-offs, write-downs, or restructuring charges. Sometimes write-offs occur, as in Waste Management’s case, when a company has been doing something wrong and wants to correct its books. More often, onetime charges occur when a new CEO takes over a company and wants to restructure, reorganize, close plants, and maybe lay off people. It’s the CEO’s attempt, right or wrong, to improve the company based on his assessment of what the company needs. Normally, such a restructuring entails a lot of costs—paying off leases, offering severance packages, disposing of facilities, selling off equipment, and so on

Accountants always want to be conservative. In fact, they’re required to be. GAAP recommends that accountants record expenses as soon as it is known that expenses will be incurred, even if they have to estimate exactly what the final figure will be. So when a restructuring occurs, accountants need to estimate those charges and record them

Here is a real yellow flag—a truly terrific place for bias in the numbers to show up. After all, how do you really estimate the cost of restructuring? Accountants have a lot of discretion, and they’re liable to be off the mark in one direction or another. If their estimate is too high—that is, if the actual costs are lower than expected—then part of that one-time charge has to be “reversed.” A reversed charge actually adds to profit in the new time period, so profits in that period wind up higher than they would otherwise have been—and all because an accounting estimate in a previous period was inaccurate!

Profit is the amount left over after expenses are subtracted from revenue. There are three basic types of profit: gross profit, operating profit, and net profit. Each one is determined by subtracting certain categories of expenses from revenue

Gross profit is sales minus cost of goods sold or cost of services. It is what is left over after a company has paid the direct costs incurred in making the product or delivering the service. Gross profit must be sufficient to cover a business’s operating expenses, taxes, financing costs, and net profit. It tells you the basic profitability of your product or service. If that part of your business is not profitable, your company is probably not going to survive long

Gross profit can be greatly affected by decisions about when to recognize revenue and by decisions about what to include in COGS

Operating Profit, or EBIT Operating profit is gross profit minus operating expenses, which include depreciation and amortization. In other words, it shows the profit made from running the business

EBIT stands for earnings before interest and taxes. (Remember, earnings is just another name for profit). What has not yet been subtracted from revenue is interest and taxes. Why not? Because operating profit is the profit a business earns from the business it is in—from operations. Taxes don’t really have anything to do with how well you are running your company. And interest expenses depend on whether the company is financed with debt or equity. But the financial structure of the company doesn’t say anything about how well it is run from an operational perspective

EBIT is a good gauge of how well a company is being managed. It’s watched closely by all stakeholders, because it measures both overall demand for the company’s products or services (sales) and the company’s efficiency in delivering those products or services (costs). Bankers and investors look at operating profit to see whether the company will be able to pay its debts and earn money for its shareholders. Vendors look at it to see if the company will be able to pay its bills. Large customers examine operating profit to ascertain whether the company is doing an efficient job and is likely to be around for a while. Even savvy employees check out the operating profit figures. A healthy and growing operating profit suggests that the employees are going to be able to keep their jobs and may have opportunities for advancement.

However, remember that potential biases in the numbers can impact operating profit as well. Are there any one-time charges? What is the depreciation line? As we have seen, depreciation can be altered to affect profits one way or another. For a while, Wall Street analysts were watching companies’ operating profit, or EBIT, closely. But some of the companies that were later revealed to have committed fraud turned out to be playing games with depreciation (remember Waste Management), so their EBIT numbers were suspect. Before long, Wall Street began focusing on another number—EBITDA (pronounced EE-bid-dah), or earnings before interest, taxes, depreciation, and amortization. Some people feel EBITDA is a better measure of a company’s operating efficiency, because it ignores noncash charges such as depreciation altogether

Net profit is the bottom line of the income statement: what’s left after all costs and expenses are subtracted from revenue. It’s operating profit minus interest expenses, taxes, one-time charges, and any other costs not included in operating profit

When someone asks, “What’s the bottom line?” he or she is almost always referring to net profit. Some of the key numbers used to measure a company, such as earnings per share and price/earnings ratio, are based on net profit. Yes, it is strange that they don’t just call it profit per share and price/ profit ratio. But they don’t

Adelphia, the big cable TV operator wound up in bankruptcy a couple of years ago. Adelphia bought large numbers of cable boxes that it installed in customers’ homes. The boxes cost $500 apiece. At one point, somebody in Adelphia came up with a bright idea: charge the cable-box supplier a marketing fee for using its boxes, then let the supplier raise its price just enough to cover the fee. So Adelphia began charging the supplier $26 per box, and the supplier raised its price accordingly. There wasn’t even any need for cash to change hands: when the supplier’s bill arrived, at $526 per box, Adelphia would simply knock $26 off the price to cover the so-called marketing fee, and then pay the balance. Meanwhile, the supposed costs of the marketing campaign—there weren’t any, really, as Adelphia later admitted—were amortized over several years.

So the whole transaction existed only on paper. But just like that, Adelphia was able to book millions of dollars in additional revenue without having to do anything to earn it. Because the alleged costs were amortized over time, most of the $26 per box went straight to Adelphia’s bottom line. The effect was to inflate the company’s earnings by $37 million in 2000 and by $54 million in 2001

Give a company’s financials to an experienced manager in the business, and the first thing he will turn to is the income statement. Most managers have—or aspire to have—“P&L responsibility.” They’re accountable for making the various forms of profit turn out right. They know that the income statement is where their performance is ultimately recorded. So that’s what they look at first.

Now try giving the same set of financials to a banker, an experienced Wall Street investor, or maybe a veteran board member. The first statement this person will turn to is invariably the balance sheet. In fact, she’s likely to pore over it for some time. Then she’ll start flipping the pages, checking out the income statement and the cash flow statement—but always going back to the balance sheet.

Why don’t managers do what the pros do? Why do they limit their attention to the income statement? We chalk it up to three factors:

The balance sheet is a little harder to get your mind around than the income statement. Income statements, after all, are pretty intuitive. The balance sheet isn’t—at least not until you understand the basics. Most companies’ budgeting processes focus on revenue and expenses. In other words, the budget categories more or less align with the income statement. You can’t be a manager without knowing something about budgeting—which automatically means that you’re familiar with many of the lines on the income statement. Balance sheet data, by contrast, rarely figures in an operating manager’s budgeting process (although the finance department certainly budgets the balance sheet accounts). Managing the balance sheet requires a deeper understanding of finance than managing an income statement. You not only have to know what the various categories refer to, you have to know how they fit together. You also have to understand how changes in the balance sheet impact the other financial statements, and vice versa

So what is the balance sheet? It’s no more, and no less, than a statement of what a business owns and what it owes at a particular point in time. The difference between what a company owns and what it owes represents equity. Just as one of a company’s goals is to increase profitability, another is to increase equity. And as it happens, the two are intimately related

Equity is the shareholders’ “stake” in the company as measured by accounting rules. It’s also called the company’s book value. In accounting terms, equity is always assets minus liabilities; it is also the sum of all capital paid in by shareholders plus any profits earned by the company since its inception minus dividends paid out to shareholders. That’s the accounting formula, anyway; remember that what a company’s shares are actually worth is whatever a willing buyer will pay for them

Profitability is sort of like the grade you receive for a course in college. You spend a semester writing papers and taking exams. At the end of the semester, the instructor tallies your performance and gives you an A- or a C+ or whatever. Equity is more like your overall grade point average (GPA). Your GPA always reflects your cumulative performance, but at only one point in time. Any one grade affects it, but doesn’t determine it. The income statement affects the balance sheet much the way an individual grade affects your GPA. Make a profit in any given period, and the equity on your balance sheet will show an increase. Lose money, and it will show a decrease. Over time, the equity section of the balance sheet shows the accumulation of profits or losses left in the business; the line is called retained earnings (losses) or sometimes accumulated earnings (deficit)

Start by considering an individual’s financial situation, or financial worth, again at a given point in time. You add up what the person owns, subtract what she owes, and come up with her net worth: owns - owes = net worth Another way to state the same thing is this: owns = owes + net worth

What the company owns is called its assets. What it owes is called its liabilities. What it’s worth is called owners’ equity or shareholders’ equity.

And the basic equation now looks like this: assets - liabilities = owners’ equity or this: assets = liabilities + owners’ equity

Unlike income statements, balance sheets are almost always for an entire organization. Sometimes a large corporation creates subsidiary balance sheets for its operating divisions, but it rarely does so for a single facility. As we’ll see, accounting professionals have to do some estimating on the balance sheet, just the way they do with the income statement. Remember the delivery business? The way we depreciate the truck affects not only the income statement but also the value of assets shown on the balance sheet. It turns out that the assumptions and biases in the income statement flow into the balance sheet one way or another

A fiscal year is any twelve-month period that a company uses for accounting purposes. Many companies use the calendar year, but some use other periods (October 1 to September 30, for example). Some retailers use a specific weekend, such as the last Sunday of the year, to mark the end of their fiscal year. You must know the company’s fiscal year to ascertain how recent the information you are looking at is

Balance sheets come in two typical formats. The traditional model shows assets on the left-hand side of the page and liabilities and owners’ equity on the right side, with liabilities at the top. The less traditional format puts assets on top, liabilities in the middle, and owners’ equity on the bottom. Whatever the format, the “balance” remains the same: assets must equal liabilities plus owners’ equity

Assets are what the company owns: cash and securities, machinery and equipment, buildings and land, whatever. Current assets, which usually come first on the balance sheet, include anything that can be turned into cash in less than a year. Long-term assets are those that have a useful life of more than a year


Cash and Cash Equivalents This is the hard stuff. Money in the bank. Money in money-market accounts. Also publicly traded stocks and bonds—the kind you can turn into cash in a day or less if you need to. Another name for this category is liquid assets. This is one of the few line items that are not subject to accountants’ discretion. When Microsoft says it has $56 billion in cash and short-term investments, or whatever the latest number is, it means it really has that much in banks, money funds, and publicly traded securities

Accounts Receivable, or A/R This is the amount customers owe the company. Remember, revenue is a promise to pay, so accounts receivable includes all the promises that haven’t yet been collected. Why is this an asset? Because all or most of these commitments will convert to cash and soon will belong to the company. It’s like a loan from the company to its customers—and the company owns the customers’ obligations. Accounts receivable is one line item that managers need to watch closely, particularly since investors, analysts, and creditors are likely to be watching it as well

Sometimes a balance sheet includes an item labeled “allowance for bad debt” that is subtracted from accounts receivable. This is the accountants’ estimate—usually based on past experience—of the dollars owed by customers who don’t pay their bills. In many companies, subtracting a bad-debt allowance provides a more accurate reflection of the value of those accounts receivable. But note well: estimates are already creeping in. In fact, many companies use the bad-debt reserve as a tool to “smooth” their earnings. When you increase the bad-debt reserve on the balance sheet, you have to record an expense against profit on the income statement. That lowers your reported earnings. When you decrease a reserve for bad debt, similarly, the adjustment increases profit on the income statement. Since the bad-debt reserve is always an estimate, there is room here for subjectivity

You might think that Wall Street would like a big spike in a company’s profits—more money for shareholders, right? But if the spike is unforeseen and unexplained—and especially if it catches Wall Street by surprise—investors are likely to react negatively, taking it as a sign that management isn’t in control of the business. So companies like to “smooth” their earnings, maintaining steady and predictable growth

Inventory Service companies typically don’t have much in the way of inventory, but nearly every other company—manufacturers, wholesalers, retailers—does. One part of the inventory figure is the value of the products that are ready to be sold. That’s called finished goods inventory. A second part, usually relevant only to manufacturers, is the value of products that are under construction. Accountants dub that work-in-process inventory, or just WIP (pronounced “whip”). Then, of course, there’s the inventory of raw materials that will be used to make products. That’s called—stand back—raw materials inventory

What you do need to remember as a manager, however, is that all inventory costs money. It is created at the expense of cash. (Maybe you’ve heard the expression “All our cash is tied up in inventory,” though we hope you don’t hear it too often.) In fact, this is one way companies can improve their cash position. Decrease your inventory, other things being equal, and you raise your company’s cash level. A company always wants to carry as little inventory as possible, provided that it still has materials ready for its manufacturing processes and products ready when customers come calling

Property, Plant, and Equipment (PPE) This line on the balance sheet includes buildings, machinery, trucks, computers, and every other physical asset a company owns. The PPE figure is the total number of dollars it cost to buy all the facilities and equipment the company uses to operate the business. Note that the relevant cost here is the purchase price. Without constant appraisals, nobody really knows how much a company’s real estate or equipment might be worth on the open market. So accountants, governed by the principle of conservatism, say in effect, “Let’s use what we do know, which is the cost of acquiring those assets.”

Another reason for using purchase price is to avoid more opportunities to bias the numbers. Suppose an asset—land, for example— has actually increased in value. If we wanted to “mark it up” on the balance sheet to its current value, we would have to record a profit on the income statement. But that profit would be based simply on someone’s opinion as to what the land was worth today. This is not a good idea. Some companies—think Enron—go so far as to set up corporate shells, often owned by a company executive or other insider, and then sell assets to those shells. That allows them to record a profit, just the way they would if they were selling off assets. But it is not the kind of profit investors or the Securities and Exchange Commission likes to see.

The fact that companies must rely on purchase price to value their assets, of course, can create some striking anomalies. Maybe you work for an entertainment company that bought land around Los Angeles for $500,000 thirty years ago. The land could be worth $5 million today—but it will still be valued at $500,000 on the balance sheet. Sophisticated investors like to nose around in companies’ balance sheets in hopes of finding such “undervalued assets

Less: Accumulated Depreciation Land doesn’t wear out, so accountants don’t record any depreciation each year. But buildings and equipment do. The point of accounting depreciation, however, isn’t to estimate what the buildings and equipment are worth right now; the point is to allocate the investment in the asset over the time it is used to generate revenue and profits

The depreciation charge is a way of ensuring that the income statement accurately reflects the true cost of producing goods or delivering services. To calculate accumulated depreciation, accountants simply add up all the charges for depreciation they have taken since the day an asset was bought

A company can “magically” go from unprofitable to profitable just by changing the way it depreciates its assets. That art-of-finance magic extends to the balance sheet as well. If a company decides its trucks can last six years rather than three, it will record a 50 percent smaller charge on its income statement year after year. That means less accumulated depreciation on the balance sheet, a higher figure for net PPE, and thus more assets. More assets, by the fundamental accounting equation, translates into more owners’ equity

A company’s intangible assets include anything that has value but that you can’t touch or spend: employees, customer lists, proprietary knowledge, patents, brand names, reputation, strategic strengths, and so on. Most of these assets are not found on the balance sheet unless an acquiring company pays for them and records them as goodwill. The exception is intellectual property, such as patents and copyrights. This can be shown on the balance sheet and amortized over its useful life.

Goodwill is found on the balance sheets of companies that have acquired other companies. It’s the difference between the price paid for the acquired company and the net assets the acquirer actually gets. (Net assets, again, refers to the fair market value of the acquiree’s assets minus the liabilities assumed by the acquirer.)

The idea isn’t as complex as it sounds. Say you’re the CEO of a company that is out shopping, and you spot a nice little warehousing business called MJQ Storage that fits your needs perfectly. You agree to buy MJQ for $5 million. By the rules of accounting, if you pay cash, the asset called cash on your balance sheet will decrease by $5 million. That means other assets have to rise by $5 million. After all, the balance sheet still has to balance. And you haven’t done anything so far that would change liabilities or owners’ equity. Since you are buying a collection of physical assets (among other things), you will appraise those assets the way any buyer would. Maybe you decide that MJQ’s buildings, shelving, forklifts, and computers are worth $2 million, after deducting whatever liabilities you are assuming. That doesn’t mean you made a bad deal. You are buying a going concern with a name, a customer list, talented and knowledgeable employees, and so on, and these so-called intangibles can in some cases be much more valuable than the tangible assets. (How much would you pay for the brand name Coca-Cola? Or for Dell Computer’s customer list?) In our example, you’re buying $3 million worth of intangibles. Accountants call that $3 million “goodwill.” The $3 million of goodwill and the $2 million of net physical assets add up to the $5 million you paid and the corresponding $5 million increase in assets on the balance sheet

In years past, goodwill was amortized. (Remember, amortization is the same idea as depreciation, except that it applies to intangible assets.) Other assets were typically depreciated over two to five years, but goodwill could be amortized over a maximum of forty years, or the estimated useful life of the acquired business.

Then the rule changed. The people who write those generally accepted accounting principles—the Financial Accounting Standards Board, or FASB—decided that if goodwill consists of the reputation, the customer base, and so on of the company you are buying, then all those assets don’t lose value over time. They actually may become more valuable over time. In short, goodwill is more like land than it is like equipment. So not amortizing it helps accountants portray that accurate reflection of reality that they are always seeking

When you bought MJQ Storage, you wound up with $3 million worth of goodwill on your balance sheet, and let’s say you estimated MJQ’s useful life at thirty years. Before the rule change, you would have amortized the goodwill over thirty years at $100,000 per year. In other words, you would have deducted $100,000 a year from revenues, thereby reducing the profitability of your company by the same amount. Meanwhile, you’re depreciating MJQ’s physical assets over, say, a four-year period at $500,000 per year. Again, that $500,000 would be subtracted from revenue to determine profit.

So what happens? Before the rule change, other things being equal, you wanted to have more goodwill and less in physical assets, simply because goodwill is amortized over a longer period of time, so the amount subtracted from revenue to determine profit is less (keeping profits higher). You had an incentive to shop for companies where most of what you’d be buying was goodwill, and you had an incentive to undervalue the physical assets of the company you were buying. (Remember, it is your own people who are doing the appraisal of those assets!)

With the new rule, goodwill sits on the books and isn’t amortized. Nothing at all is subtracted from revenue, and profitability is correspondingly higher. You now have even more of an incentive to look for companies without much in the way of physical assets, and even more of an incentive to undervalue those assets. Tyco was one company that was accused of taking advantage of this rule. In the go-go years of 2000 and 2001, Tyco was buying companies at breakneck speed—more than six hundred in those two years alone. Many analysts felt that Tyco regularly undervalued the assets of these numerous companies. Doing so would increase the goodwill included in all those acquisitions and lower the depreciation Tyco had to take each year. That, in turn, would make profit higher and would drive up Tyco’s share price.

But eventually, analysts and investors noticed that Tyco had so much goodwill on its books and so little (relatively speaking) in the way of physical assets, that if you took goodwill out of the balance sheet equation, the company’s liabilities were actually higher than its assets. This was not a situation investors liked to see

How do you account for the cost of creating a new software program that you expect to generate revenue for years? What about the cost of developing a new wonder drug, which is protected by a twenty-year patent (from the date of application)? Obviously, it makes no sense to record the whole cost as an expense on the income statement in any given period, any more than you would record the whole cost of buying a truck. Like a truck, the software and the patent will help generate revenue in future accounting periods. So these investments are considered intangible assets and should be amortized over the life of the revenue stream they generate. By the same token, however, research-and-development expenses that do not result in an asset likely to generate revenue should be recorded as an expense on the income statement.

You can see the potential for subjectivity here. GAAP says that R&D can be amortized if the product under development is technologically feasible. But who determines technological feasibility? Again, we are back in the realm of art. If a company decides that its R&D projects are technologically feasible, it can amortize those sums over time and make its profits look higher. Otherwise, it must expense R&D costs as they are incurred—a more conservative approach. Computer Associates is one company that got itself into trouble for amortizing R&D on products that had a questionable future. Like depreciation, amortization decisions can often have a sizable effect on profitability and owners’ equity.

Accruals and Prepaid Assets: To explain this line item, let’s look at a hypothetical example. Say you start a bicycle manufacturing company, and you rent manufacturing space for the entire year for $60,000. Since your company is a lousy credit risk—nobody likes to do business with a start-up for just this reason—the landlord insists on payment up front.

Now, we know from the matching principle that it doesn’t make sense to “book” the entire $60,000 in January as an expense on the income statement. It’s rent for the whole year. It has to be spread out over the year, so that the cost of the rent is matched to the revenue that it helped to bring in. So in January you put $5,000 on the income statement for rent. But where does the other $55,000 go? You have to keep track of it somewhere. Well, prepaid rent is one example of a prepaid asset. You have bought something—you own the rights to that space for a year—so it is an asset. And you keep track of assets on the balance sheet.

Every month, of course, you’ll have to move $5,000 out of the prepaid-asset line on the balance sheet and put it in the income statement as an expense for rent. That’s called an accrual, and the “account” on the balance sheet that records what has not yet been expensed is called an accrued asset account. Though the terms are confusing, note that the practice is still conservative: we’re keeping track of all our known expenses, and we’re also tracking what we paid for in advance.

But the art of finance can creep in here as well, because there is room for judgment on what to accrue and what to charge in any given period. Say, for example, your company is developing a major advertising campaign. The work is all done in January, and it comes to $1 million. The accountants might decide that this campaign will benefit the company for two years, so they would book the $1 million as a prepaid asset and charge one-twenty-fourth of the cost each month on the income statement. A company facing a tough month is likely to decide that this is the best course—after all, it’s better to deduct one-twenty-fourth of a million dollars from profits than the whole million. But what if January is a great month? Then the company might decide to “expense” the entire campaign—charge it all against January’s revenue—because, well, they aren’t sure that it will help generate revenue during the next two years. Now they have an advertising campaign that’s all paid for, and profits in the months to come will be correspondingly higher. In a perfect world, our accounting friends would have a crystal ball to tell them exactly how long that advertising campaign will generate revenue. Since they don’t yet have such a device, they must rely on estimates.

So that’s it for assets. Add them all up, along with whatever extraneous items you might find, and you get the “total assets” line at the bottom of the left side. Now it’s time to move on to the other side— liabilities and owners’ equity

Liabilities are what a company owes, and equity is its net worth

Liabilities are always divided into two main categories. Current liabilities are those that have to be paid off in less than a year. Long-term liabilities are those that come due over a longer time frame. Liabilities are usually listed on the balance sheet from shortest-term to longest-term, so the very layout tells you something about what’s due when

If your company owes $100,000 to a bank on a long-term loan, maybe $10,000 of it is due this year. So that’s the amount that shows up in the current-liabilities section of the balance sheet. The line will be labeled “current portion of long-term debt” or something like that. The other $90,000 shows up under long-term liabilities

These are lines of credit and short-term revolving loans. These short-term credit lines are usually secured by current assets such as accounts receivable and inventory. The entire balance outstanding is shown here

Accounts payable shows the amount the company owes its vendors. The company receives goods and services from suppliers every day and typically doesn’t pay the bill for at least thirty days. The vendors, in effect, have loaned the company money. Accounts payable shows how much was owed on the date of the balance sheet. Any balance on a company’s credit cards is usually included in accounts payable

Accrued Expenses and Other Short-Term Liabilities: This catch-all category includes everything else the company owes. One example is payroll. Let’s assume that you get paid on October 1. Does it make sense to charge your pay as an expense on the income statement in October? Probably not—your October paycheck is for work performed in September. So the accountants would figure out or estimate how much the company owes you on October 1 for work completed in September and then charge those expenses to September. This is an accrued liability. It’s like an internal bill in September for a payment to be made in October. Accrued liabilities are part of the matching principle—we have matched expenses with the revenue they help to bring in every month

Long-Term Liabilities Most long-term liabilities are loans. But there are also other liabilities that you might see listed here. Examples include deferred bonuses or compensation, deferred taxes, and pension liabilities. If these other liabilities are substantial, this section of the balance sheet needs to be watched closely.

OWNERS’ EQUITY Finally! Remember the equation? Owners’ equity is what’s left after we subtract liabilities from assets. Equity includes the capital provided by investors and the profits retained by the company over time. Owners’ equity goes by many names, including shareholders’ equity and stockholders’ equity. The owners’ equity line items listed in some companies’ balance sheets can be quite detailed and confusing. They typically include the following categories.

Capital The word means a number of things in business. Physical capital is plant, equipment, vehicles, and the like. Financial capital from an investor’s point of view is the stocks and bonds he holds; from a company’s point of view it is the shareholders’ equity investment plus whatever funds the company has borrowed. “Sources of capital” in an annual report shows where the company got its money. “Uses of capital” shows how the company used its money.

Preferred Shares

Preferred shares—also known as preference stock or shares—are a specific type of stock. People who hold preferred shares receive dividends on their investment before the holders of common stock get a nickel. But preferred shares typically carry a fixed dividend, so their price doesn’t fluctuate as much as the price of common shares. Investors who hold preferred shares may not receive the full benefit of a company’s growth in value. When the company issues preferred shares, it sells them to investors at a certain initial price. The value shown on the balance sheet reflects that price.

Most preferred shares do not carry voting rights. In a way, they’re more like bonds than like common stock. The difference? With a bond, the owner gets a fixed coupon or interest payment, and with preferred shares the owner gets a fixed dividend. Companies use preferred stock to raise money because it does not carry the same legal implications as debt. If a company cannot pay a coupon on a bond, bondholders can force it into bankruptcy. Holders of preferred shares normally can’t.

Common Shares or Common Stock Unlike most preferred shares, common shares usually carry voting rights. People who hold them can vote for members of the board of directors (usually one share, one vote) and on any other matter that may be put before the shareholders. Common shares may or may not pay dividends. The value shown on the balance sheet is typically shown at “par value,” which is the nominal dollar amount assigned to the stock by the issuer. Par value is usually a very small amount and has no relationship to the stock’s market price. Our balance sheet shows the common stock with a par value of $1.

Additional Paid-in Capital This is the amount over the par value that investors initially paid for the stock. For example, if the stock is initially sold at $5 per share, and if the par value is $1 per share, the additional paid in capital is $4 per share. It is summed up over time—so, for example, if a company issues additional shares, the additional paid-in capital is added to the existing amount.


Dividends are funds distributed to shareholders taken from a company’s equity. In public companies, dividends are typically distributed at the end of a quarter or year.

Retained Earnings Retained earnings or accumulated earnings are the profits that have been reinvested in the business instead of being paid out in dividends. The number represents the total after-tax income that has been reinvested or retained over the life of the business. Sometimes a company that holds a lot of retained earnings in the form of cash— Microsoft is an example—comes under pressure to pay out some of the money to shareholders, in the form of dividends. After all, what shareholder wants to see his money just sitting there in the company’s coffers, rather than being reinvested in productive assets? Of course, you may see an accumulated deficit—a negative number— which indicates that the company has lost money over time.

So owners’ equity is what the shareholders would receive if the company were sold, right? Of course not! Remember all those rules, estimates, and assumptions that affect the balance sheet. Assets are recorded at their acquisition price less accumulated depreciation. Goodwill is piled up with every acquisition the company makes, and it is never amortized. And of course the company has intangible assets of its own, such as its brand name and customer list, which don’t show up on the balance sheet at all. Moral: the market value of a company almost never matches its equity or book value on the balance sheet. The actual market value of a company is what a willing buyer would pay for it. In the case of a public company, that value is estimated by calculating the company’s market cap, or the number of shares outstanding times the share price on any given day. In the case of private companies, the market value can be estimated by one of the valuation methods

It’s called the balance sheet because it balances. Assets always equal liabilities plus owners’ equity. But even if you dutifully wrote down that answer on the exam, you may be less than 100 percent crystal-clear on why the balance sheet balances. So here are three ways of understanding it.

REASONS FOR BALANCE First, let’s go back to an individual. You can look at a company’s balance sheet just the same way you’d look at a person’s net worth. Net worth has to equal what he owns minus what he owes, because that’s the way we define the term. The first formulation of the “individual” equation is owns – owes = net worth. It’s the same for a business. Owners’ equity is defined as assets minus liabilities.

Second, look at what the balance sheet shows. On one side are the assets, which is what the company owns. On the other side are the liabilities and equity, which show how the company obtained what it owns. Since you can’t get something for nothing, the “owns” side and the “how we obtained it” side will always be in balance. They have to be.

Third, consider what happens to the balance sheet over time. This approach should help you see why it always stays in balance.

Imagine a company that is just starting out. Its owner has invested $50,000 in the business, so he has $50,000 in cash on the assets side of the balance sheet. He has no liabilities yet, so he has $50,000 in owners’ equity. The balance sheet balances.

Now, the company buys a truck for $36,000 in cash. If nothing else changes—and if you constructed a balance sheet right after the truck transaction—the assets side of the balance sheet would look like this:


Cash        $14,000

Property, plant, and equipment        36,000

It still adds up to $50,000—and on the other side of the balance sheet, he still has $50,000 worth of owners’ equity. The balance sheet still balances.

Next, imagine that the owner decides he needs more cash. So he goes to the bank and borrows $10,000, raising his total cash to $24,000. Now the balance sheet looks like this:


Cash        $24,000

Property, plant, and equipment        36,000

Wow! It adds up to $60,000. He has increased his assets. But of course, he has increased his liabilities as well. So the other side of the balance sheet looks like this:

Liabilities and Owners’ Equity

Bank loan        $10,000

Owners’ equity        $50,000

That, too, adds up to $60,000.

Note that owners’ equity remains unchanged throughout all these transactions. Owners’ equity is affected only when a company takes in funds from its owners, pays out money to its owners, or records a profit or loss.

In the meantime, every transaction that affects one side of the balance sheet affects the other as well. For example:

A company uses $100,000 cash to pay off a loan. The cash line on the assets side decreases by $100,000, and the liabilities line on the other side decreases by the same amount. So the balance sheet stays in balance. A company buys a $100,000 machine, paying $50,000 down and owing the rest. Now the cash line is $50,000 less than it used to be—but the new machine shows up on the assets side at $100,000. So total assets increase by $50,000. Meanwhile, the $50,000 owed on the machine shows up on the liabilities side. Again, we’re still in balance.

Remember that transactions affect both sides of the balance sheet, you’ll be OK. That’s why the balance sheet balances. Understanding this point is a basic building block of financial intelligence. Remember, if assets don’t equal liabilities and equity, you do not have a balance sheet

A change in one statement nearly always has an impact on the other statements. So when you’re managing the income statement, you’re also having an effect on the balance sheet.

THE EFFECT OF PROFIT ON EQUITY To see the relationship between profit, from the income statement, and equity, which appears on the balance sheet, we’ll look at a couple of examples. Here’s a highly simplified balance sheet for a brand-new (and very small!) company:


Cash $25

Accounts receivable     0

Total assets $25  

Liabilities and Owners’ Equity

Accounts payable $0

Owners’ equity $25

Say we operate this company for a month. We buy $50 worth of parts and materials, which we use to produce and sell $100 worth of finished product. We also incur $25 in other expenses. The income statement for the month looks like this:

Sales                            $100

Cost of goods sold                               50

Gross profit                               50

All expenses                               25

Net profit                            $ 25                              

Now: what has changed on the balance sheet?

First, we have spent all our cash to cover expenses. Second, we have $100 in receivables from our customers. Third, we have incurred $50 in obligations to our suppliers. Thus the balance sheet at the end of the month looks like this:


Cash $   0

Accounts receivable   100

Total assets $100

Liabilities and Owners’ Equity

Accounts payable $ 50

Owners’ equity $ 50

Liabilities and owners’ equity $100

As you can see, that $25 of net profit becomes $25 of owners’ equity. On a more detailed balance sheet, it would appear under owners’ equity as retained earnings. That’s true in any business: net profit adds to equity unless it is paid out in dividends. By the same token, a net loss decreases equity. If a business loses money every month, liabilities will eventually exceed assets, creating negative equity. Then it is a candidate for bankruptcy court.

Note something else about this simple example: the company wound up that month with no cash! It was making money, and equity was growing, but it had nothing in the bank. So a good manager needs to be aware of how both cash and profit interact on the balance sheet

The relationship between profit and equity isn’t the only link between changes in the income statement and changes on the balance sheet. Far from it. Every sale recorded on the income statement generates an increase either in cash (if it’s a cash sale) or in receivables. Every payroll dollar recorded under COGS or under operating expenses represents a dollar less on the cash line or a dollar more on the accrued expenses line of the balance sheet. A purchase of materials adds to accounts payable, and so on. And of course, all these changes have an effect on total assets or liabilities.

Overall, if a manager’s job is to boost profitability, he or she can have a positive effect on the balance sheet, just because profits increase equity. But it isn’t quite so simple, because it matters how those profits are achieved, and it matters what happens to the other assets and liabilities on the balance sheet itself. For example:

A plant manager hears of a good deal on an important raw material and asks purchasing to buy a lot of it. Makes sense, right? Not necessarily. The inventory line on the balance sheet increases. The accounts payable line increases a corresponding amount. Eventually, the company will have to draw down its cash to cover the accounts payable—possibly long before the material is used to generate revenue. Meanwhile, the company has to pay for warehousing the inventory, and it may need to borrow money to cover the decrease in cash. Figuring out whether to take advantage of the deal requires detailed analysis; be sure to consider all of the financial issues when making these kinds of decisions. A sales manager is looking to boost revenue and profit, and decides to target smaller businesses as customers. Is it a good idea? Maybe not. Smaller customers may not be as good credit risks as larger ones. Accounts receivable may rise disproportionately because the customers are slower to pay. The accountants may need to increase that “bad debt” allowance, which reduces profit, assets, and thus equity. The financially intelligent sales manager will need to investigate pricing possibilities: can he increase gross margin to compensate for the increased risk on sales to smaller customers? An IT manager makes a decision to buy a new computer system, believing that the new system will boost productivity and therefore contribute to profitability. But how is the new equipment going to be paid for? If a company is overleveraged—that is, if it has a heavy debt load compared with its equity—borrowing the money to pay for the system may not be a good idea. Perhaps it will need to issue new stock and therefore increase its equity investment. Making decisions about how to get the capital required to run a business is the job of the chief financial officer and the treasurer, not the IT manager. But an understanding of the company’s cash and debt situation should inform the manager’s decision about when to buy the new equipment.

Any manager, in short, may want to step back now and then and look at the big picture. Consider not just the one line item on the income statement that you are focusing on, but the balance sheet as well (and the cash flow statement, which we’ll get to shortly). When you do, your thinking, your work, and your decisions will be “deeper”—that is, they will consider more factors, and you’ll be able to talk about the impact at a deeper level

The balance sheet answers a lot of questions—questions like the following:

Is the company solvent? That is, do its assets outweigh its liabilities, so that owners’ equity is a positive number? Can the company pay its bills? Here the important numbers are current assets, particularly cash, compared with current liabilities. More on this in part 5, on ratios. Has owners’ equity been growing over time? A comparison of balance sheets for a period of time will show whether the company has been moving in the right direction.

These are simple, basic questions, of course. But investors can learn much more from detailed examination of the balance sheet and its footnotes, and from comparisons between the balance sheet and other statements. How important is goodwill to the company’s “total assets” line? What assumptions have been used to determine depreciation, and how important is that? (Remember Waste Management.) Is the “cash” line increasing over time—usually a good sign—or is it decreasing? If owners’ equity is rising, is that because the company has required an infusion of capital, or is it because the company has been making money?

The balance sheet, in short, helps to show whether a company is financially healthy. All the statements help you make that judgment, but the balance sheet—a company’s cumulative GPA—may be the most important of all

Owner Earnings Owner earnings is a measure of the company’s ability to generate cash over a period of time. We like to say it is the money an owner could take out of his business and spend, say, at the grocery store for his own benefit. Owner earnings is an important measure because it allows for the continuing capital expenditures that will be necessary to maintain a healthy business. Profit and even operating cash flow measures do not. More about owner earnings in the toolbox at the end of this part.

Why target cash flow as a key measure of business performance? Why not just profit, as found on the income statement? Why not just a company’s assets or owners’ equity, as revealed by the balance sheet? We suspect Warren Buffett knows that the income statement and balance sheet, however useful, have all sorts of potential biases, a result of all the assumptions and estimates that are built into them. Cash is different. Look at a company’s cash flow statement, and you are indirectly peering into its bank account. Today, after the dot-com bust and the financial-fraud revelations of the late 1990s and early 2000s, cash flow is once again the darling of Wall Street. It has become a prominent measure by which analysts evaluate companies. But Warren Buffett has been looking at cash all along because he knows that it’s the number least affected by the art of finance.

So why don’t managers pay attention to cash? There are any number of reasons. In the past, nobody asked them to (though this is beginning to change). Some senior executives themselves may not worry about cash—at least, not until it’s too late—so their direct reports don’t think much about it, either. Folks in the finance organization often believe that cash is their concern and nobody else’s. But often, the reason is simply a lack of financial intelligence. Managers don’t understand the accounting rules that determine profit, so they assume that profit is pretty much the same as net cash coming in. Some don’t believe that their actions affect their company’s cash situation; others may believe it, but they don’t understand how.

There’s another reason, too, which is that the language in the cash flow statement is a little arcane. A simple antidote to financial fraud: a “detailed, easily readable cash-flow report” required to be given to the board, to employees, and to investors. Unfortunately, no one, to our knowledge, has taken up the suggestion. So we are left with conventional cash flow statements. Most of these, however detailed, are hard for a non-financial person to read, let alone understand.

But talk about an investment that pays off: if you take the time to understand cash, you can cut right through a lot of the smoke and mirrors created by your company’s financial artists. You can see how good a job your company is doing at turning profit into cash. You can spot early warning signs of trouble, and you will know how to manage so that cash flow is healthy. Cash is a reality check.

bvious: cash may be coming in from loans or from investors, and that cash isn’t going to show up on the income statement at all. Operating cash flow is not at all the same as net profit. There are three essential reasons:

Revenue is booked at sale. One reason is the fundamental fact that we explained in our discussion of the income statement. A sale is recorded whenever a company delivers a product or service. Ace Printing Company delivers $1,000 worth of brochures to a customer; Ace Printing Company records revenue of $1,000, and theoretically it could record a profit based on subtracting its costs and expenses from that revenue. But no cash has changed hands, because Ace’s customer typically has thirty days or more to pay. Since profit starts with revenue, it always reflects customers’ promises to pay. Cash flow, by contrast, always reflects cash transactions.

Expenses are matched to revenue. The purpose of the income statement is to tote up all the costs and expenses associated with generating revenue during a given time period. Those expenses may not be the ones that were actually paid during that time period. Some may have been paid for earlier (as with the start-up we mentioned that had to pay for a year’s rent in advance). Most will be paid for later, when vendors’ bills come due. So the expenses on the income statement do not reflect cash going out. The cash flow statement, however, always measures cash in and out the door during a particular time period. Capital expenditures don’t count against profit. A capital expenditure doesn’t appear on the income statement when it occurs; only the depreciation is charged against revenue. So a company can buy trucks, machinery, computer systems, and so on, and the expense will appear on the income statement only gradually, over the useful life of each item. Cash, of course, is another story: all those items often are paid for long before they have been fully depreciated, and the cash used to pay for them will be reflected in the cash flow statement.

You may be thinking that in the long run cash flow will pretty much track net profit. Accounts receivable will be collected, so sales will turn into cash. Accounts payable will be paid, so expenses will more or less even out from one time period to the next. And capital expenditures will be depreciated, so that over time the charges against revenue from depreciation will more or less equal the cash being spent on new assets. All this is true, to a degree, at least for a mature, well-managed company. But the difference between profit and cash can create all sorts of mischief in the meantime

Sweet Dreams Bakery is a new cookies-and-cakes manufacturer that supplies specialty grocery stores. The founder has lined up orders based on her unique home-style recipes, and she’s ready to launch on January 1. We’ll assume she has $10,000 cash in the bank, and we’ll also assume that in the first three months her sales are $20,000, $30,000, and $45,000. Cost of goods are 60 percent of sales, and her monthly operating expenses are $10,000.

Just by eyeballing those numbers, you can see she’ll soon be making a profit. In fact, the simplified income statements for the first three months look like this:

January February March

Sales $20,000 $30,000 $45,000

COGS   12,000   18,000   27,000

Gross profit     8,000   12,000   18,000

Expenses   10,000   10,000   10,000

Net profit $  (2,000)     $  2,000     $  8,000    

A simplified cash flow statement, however, would tell a different story. Sweet Dreams Bakery has an agreement with its vendors to pay for the ingredients and other supplies it buys in thirty days. But those specialty groceries that the company sells to? They’re kind of precarious, and they take sixty days to pay their bills. So here’s what happens to Sweet Dreams’s cash situation:

In January, Sweet Dreams collects nothing from its customers. At the end of the month, all it has is $20,000 in receivables from its sales. Luckily, it does not have to pay anything out for the ingredients it uses, since its vendors expect to be paid in thirty days. (We’ll assume that the COGS figure is all for ingredients, because the owner herself does all the baking.) But the company does have to pay expenses—rent, utilities, and so on. So all of the initial $10,000 in cash goes out the door to pay expenses, and Sweet Dreams is left with no cash in the bank. In February, Sweet Dreams still hasn’t collected anything. (Remember, the customers pay in sixty days.) At the end of the month, it has $50,000 in receivables—January’s $20,000 plus February’s $30,000—but still no cash. Meanwhile, Sweet Dreams now has to pay for the ingredients and supplies for January ($12,000), and it has another month’s worth of expenses ($10,000). So it’s now in the hole by $22,000.

Can the owner turn this around? Surely, in March those rising profits will improve the cash picture! Alas, no.

In March, Sweet Dreams finally collects on its January sales, so it has $20,000 in cash coming in the door, leaving it only $2,000 short against its end-of-February cash position. But now it has to pay for February’s COGS of $18,000 plus March’s expenses of $10,000. So at the end of March, it ends up $30,000 in the hole— a worse position than at the end of February.

What’s going on here? The answer is that Sweet Dreams is growing. Its sales increase every month, meaning that it must pay more each month for its ingredients. Eventually, its operating expenses will increase as well, as the owner has to hire more people. The other problem is the disparity between the fact that Sweet Dreams must pay its vendors in thirty days while waiting sixty days for receipts from its customers. In effect, it has to front the cash for thirty days— and as long as sales are increasing, it will never be able to catch up unless it finds additional sources of cash. As fictional and oversimplified as Sweet Dreams may be, this is precisely how profitable companies go out of business. It is one reason why so many small companies fail in their first year. They simply run out of cash

But now let’s look at another sort of profit/cash disparity. Fine Cigar Shops is another start-up. It sells very expensive cigars, and it’s located in a part of town frequented by businessmen and well-to-do tourists. Its sales for the first three months are $50,000, $75,000, and $95,000—again, a healthy growth trend. Its cost of goods is 70 percent of sales, and its monthly operating expenses are $30,000 (high rent!). For the sake of comparison, we’ll say it too begins the period with $10,000 in the bank.

So Fine Cigar’s income statement for these months looks like this:

January February March

Sales $50,000 $75,000 $95,000

COGS   35,000   52,500   66,500

Gross profit   15,000   22,500   28,500

Expenses   30,000   30,000   30,000

Net profit $(15,000)     $ (7,500)     $ (1,500)    

It hasn’t yet turned the corner on profitability, though it is losing less money each month. Meanwhile, what does its cash picture look like? As a retailer, of course, it collects the money on each sale immediately. And we’ll assume that Fine Cigar was able to negotiate good terms with its vendors, paying them in sixty days.

In January, it begins with $10,000 and adds $50,000 in cash sales. It doesn’t have to pay for any cost of goods sold yet, so the only cash out the door is that $30,000 in expenses. End-of-the-month bank balance: $30,000. In February, it adds $75,000 in cash sales and still doesn’t pay anything for cost of goods sold. So the month’s net cash after the $30,000 in expenses is $45,000. Now the bank balance is $75,000! In March, it adds $95,000 in cash sales, pays for January’s supplies ($35,000) and March’s expenses ($30,000). Net cash in for the month is $30,000, and the bank balance is now $105,000.

Cash-based businesses—retailers, restaurants, and so on—can thus get an equally skewed picture of their situation. In this case Fine Cigar’s bank balance is climbing every month even though the company is unprofitable. That’s fine for a while, and it will continue to be fine so long as the company holds down expenses so that it can turn the corner on profitability. But the owner has to be careful: if he’s lulled into thinking that his business is doing great and he can increase those expenses, he’s liable to continue on the unprofitable path. If he fails to attain profitability, eventually he will run out of cash. Fine Cigar, too, has its real-world parallels. Every cash-based business, from tiny Main Street shops to giants such as and Dell, has the luxury of taking the customer’s money before it must pay for its costs and expenses. It enjoys the “float”—and if it is growing, that float will grow ever larger. But ultimately, the company must be profitable by the standards of the income statement; cash flow in the long run is no protection against unprofitability In the cigar-store example, the losses on the books will eventually lead to negative cash flow; just as profits eventually lead to cash, losses eventually use up cash. It’s the timing of those cash flows that we are trying to understand here.

Understanding the difference between profit and cash is a key to increasing your financial intelligence. It is a foundational concept, one that many managers haven’t had an opportunity to learn. And it opens a whole new window of opportunity to ask questions and make smart decisions. For example:

Finding the right kind of expertise. The two situations we described in this chapter require different skills. If a company is profitable but short on cash, then it needs financial expertise— someone capable of lining up additional financing. If a company has cash but is unprofitable, it needs operational expertise, meaning someone capable of bringing down costs or generating additional revenue without adding costs. So not only do financial statements tell you what is going on in the company, they also can tell you what kind of expertise you need to hire. Making good decisions about timing. Informed decisions on when to take an action can increase a company’s effectiveness. Take Set-point as an example. When Joe isn’t out training people in business literacy, he is CFO of Set-point, a company that builds roller-coaster equipment and factory-automation systems. Managers at the company know that the first quarter of the year, when many orders for automation systems come in, is the most profitable for the business. But cash is always tight because Set-point must pay out cash to buy components and pay contractors. The next quarter, Set-point’s cash flow typically improves because receivables from the prior quarter are collected, but profits slow down. Set-point managers have learned that it’s better to buy capital equipment for the business in the second quarter rather than the first, even though the second quarter is traditionally less profitable, just because there’s more cash available to pay for it.

The ultimate lesson here is that companies need both profit and cash. They are different, and a healthy business requires both.

The cash flow statement shows the cash moving into a business, called the inflows, and the cash moving out of a business, called the outflows. These are divided into three main categories.

Cash From or Used in Operating Activities At times you’ll see slight variations to this language, such as “cash provided by or used for operating activities.” Whatever the specifics, all of this is more accountantspeak: too many accountants can’t say, “operations,” they have to say, “operating activities.” But whatever the exact language, this category includes all the cash flow, in and out, that is related to the actual operations of the business. It includes the cash customers send in when they pay their bills. It includes the cash the company pays out in salaries, to vendors, and to the landlord, along with all the other cash it must spend to keep the doors open and the business operating.

Cash From or Used in Investing Activities Note that investing activities here refers to investments made by the company, not by its owners. The biggest subcategory here is cash spent on capital investments—that is, the purchase of assets. If the company buys a truck or a machine, the cash it pays out shows up on this part of the statement. Conversely, if the company sells a truck or a machine (or any other asset), the cash it receives shows up here.

Cash From or Used in Financing Activities Financing refers to borrowing and paying back loans, on the one hand, and transactions between a company and its shareholders on the other. So if a company receives a loan, the proceeds show up in this category. If a company gets an equity investment from a shareholder, that too shows up here. Should the company pay off the principal on a loan, buy back its own stock, or pay a dividend to its shareholders, those expenditures of cash also would appear in this category.

You can see right away that there is a lot of useful information in the cash flow statement. The first category shows operating cash flow, which in many ways is the single most important number indicating the health of a business. A company with a consistently healthy operating cash flow is probably profitable, and it is probably doing a good job of turning its profits into cash. A healthy operating cash flow, moreover, means that it can finance more of its growth internally, without either borrowing or selling more stock.

The second category shows how much cash the company is spending on investments in its future. If the number is low, relative to the size of the company, it may not be investing much at all; management may be treating the business as a “cash cow,” milking it for the cash it can generate while not investing in future growth. If the number is high, relatively, it may suggest that management has high hopes for the future of the company. Of course, what counts as high or low will depend on the type of company it is. A service company, for instance, typically invests less in assets than a manufacturing company. So your analysis has to reflect the big picture of the company you’re assessing.

The third category shows to what extent the company is dependent on outside financing. Look at this category over time, and you can see whether the company is a net borrower (borrowing more than it is paying off). You can also see whether it has been selling new shares to outside investors or buying back its own stock.

Finally, the cash flow statement allows you to calculate Warren Buffett’s famous “owner earnings” metric

Wall Street in recent years has been focusing more and more on the cash flow statement. As Warren Buffett knows, there is much less room for manipulation of the numbers on this statement than on the others. To be sure, “less room” doesn’t mean “no room.” For example, if a company is trying to show good cash flow in a particular quarter, it may delay paying vendors or employee bonuses until the next quarter. Unless a company delays payments over and over, however—and eventually, vendors who don’t get paid will stop providing goods and services—the effects are significant only in the short term

Financing a Company How a company is financed refers to how it gets the cash it needs to start up or expand. Ordinarily, a company is financed through debt, equity, or both. Debt means borrowing money from banks, family members, or other creditors. Equity means getting people to buy stock in the company.

Buying Back Stock

If a company has extra cash and believes that its stock is trading at a price that is lower than it ought to be, it may buy back some of its shares. The effect is to decrease the number of shares outstanding, so that each shareholder owns a larger piece of the company

You can calculate a cash flow statement just by looking at the income statement and two balance sheets

You can see the connections in common transactions. For example, remember that a credit sale worth $100 shows up both as an increase of $100 in accounts receivable on the balance sheet and as an increase in sales of $100 on the income statement. When the customer pays the bill, accounts receivable decreases by $100 and cash increases by $100 on the balance sheet. And because cash is involved, it affects the cash flow statement as well.

Remember, too, that when the company buys $100 worth of inventory, the balance sheet records two changes: accounts payable rises by $100 and inventory rises by $100. When the company pays the bill, accounts payable decreases by $100 and cash decreases by $100—again, both on the balance sheet. When that inventory is sold (either intact, as by a retailer, or incorporated into a product by a manufacturer), $100 worth of cost of goods sold will be recorded on the income statement. Again, the cash part of the transaction will show up on the cash flow statement.

So all these transactions ultimately have an effect on the income statement, the balance sheet, and the cash flow statement. In fact, most transactions eventually find their way onto all three

Reconciliation In a financial context, reconciliation means getting the cash line on a company’s balance sheet to match the actual cash the company has in the bank—sort of like balancing your checkbook, but on a larger scale.

First, knowing your company’s cash situation will help you understand what is going on now, where the business is headed, and what senior management’s priorities are likely to be. You need to know not just whether the overall cash position is healthy but specifically where the cash is coming from. Is it from operations? That’s a good thing—it means the business is generating cash. Is investing cash flow a sizable negative number? If it isn’t, it may mean that the company isn’t investing in its future. And what about financing cash flow? If investment money is coming in, that may be an optimistic sign for the future, or it may mean that the company is desperately selling stock to stay afloat. Looking at the cash flow statement may generate a lot of questions, but they are the right ones to be asking. Are we paying off loans? Why or why not? Are we buying equipment? The answers to those questions will reveal a lot about senior management’s plans for the company.

Second, you affect cash. As we’ve said before, most managers focus on profit, when they should be focusing on both profit and cash. Of course, their impact is usually limited to operating cash flow—but that’s one of the most important measures there is. For instance:

Accounts receivable. If you’re in sales, are you selling to customers who pay their bills on time? Do you have a close enough relationship with your customers to talk with them about payment terms? If you’re in customer service, do you offer customers the kind of service that will encourage them to pay their bills on time? Is the product free of defects? Are the invoices accurate? Does the mail room send invoices on a timely basis? Is the receptionist helpful? All these factors help determine how customers feel about your company, and indirectly influence how fast they are likely to pay their bills. Disgruntled customers are not known for prompt payments—they like to wait until any dispute is resolved. Inventory. If you’re in engineering, do you request special products all the time? If you do, you may be creating an inventory nightmare. If you’re in operations and you like to have lots in stock, just in case, you may be creating a situation in which cash is just sitting on the shelves, when it could be used for something else. Manufacturing and warehouse managers can often reduce inventory hugely by studying and applying the principles of “lean” enterprise, pioneered at Toyota. Expenses. Do you defer expenses when you can? Do you consider the timing of cash flow when making purchases? Obviously, we’re not saying it’s always wise to defer expenses; it’s just wise to understand what the cash impact will be when you do decide to spend money, and to take that into account. Giving credit. Do you give credit to potential customers too easily? Alternatively, do you withhold credit when you should give it? Both decisions affect the company’s cash flow and sales, which is why the credit department always has to strike a careful balance.

The list goes on. Maybe you’re a plant manager, and you are always recommending buying more equipment, just in case the orders come in. Perhaps you’re in IT, and you feel that the company always needs the latest upgrades to its computer systems. All these decisions affect cash flow, and senior management usually understands that very well. If you want to make an effective request, you need to familiarize yourself with the numbers that they’re looking at.

Third, managers who understand cash flow tend to be given more responsibilities, and thus tend to advance more quickly, than those who focus purely on the income statement. In the following part, for instance, you’ll learn to calculate ratios such as days sales outstanding (DSO), which is a key measure of the company’s efficiency in collecting receivables. The faster receivables are collected, the better a company’s cash position. You could go to someone in finance and say, “Say, I notice our DSO has been heading in the wrong direction over the last few months—how can I help turn that around?” Alternatively, you might learn the precepts of lean enterprise, which focuses on (among other things) keeping inventories to a minimum. A manager who leads a company in converting to lean thereby frees up huge quantities of cash.

But our general point here is that cash flow is a key indicator of a company’s financial health, along with profitability and shareholders’ equity. It’s the final link in the triad, and you need all three to assess a company’s financial health. It’s also the final link in the first level of financial intelligence.

How to calculate free cash flow? First, get the company’s cash flow statement. Next, take net cash from operations and subtract the amount invested in capital equipment. That’s all there is to it—free cash flow is simply the cash generated by operating the business minus the money invested to keep it running. Once you think about it, it makes perfect sense as a performance measure. If you’re trying to evaluate the cash generated by the company, what you really want to know is the cash from the business itself minus the cash required to keep it healthy over the longer term.

Publicly traded companies are not required to disclose free cash flow, but many do report it, especially with the new Wall Street focus on cash. It might have helped us all back in the dot-com craze, when so many new companies had negative operating cash and huge capital investments. Their free cash flow was a big negative number, and their cash needs were covered only because investors were throwing lots of dollars into the pot. Buffett, who was nearly alone back then in relying on free cash flow, never invested in any of those companies. What a surprise!

At any rate, if your company’s free cash flow is healthy and increasing, you know at least the following:

Your company has options. It can use free cash flow to pay down debt, buy a competitor, or pay dividends to owners. You and your colleagues can focus on the business, not on making payroll or on raising additional funds. Wall Street is likely to look favorably on the company’s stock.

Ratios indicate the relationship of one number to another. People use them every day. A baseball player’s batting average of .333 shows the relationship between hits and official at bats—one hit for every three at bats. The odds of winning a lottery jackpot, say one in 6 million, show the relationship between winning tickets sold (1) and total tickets sold (6 million). Ratios don’t require any complex calculations. To figure a ratio, usually, you just divide one number by another and then express the result as a decimal or as a percentage.

All kinds of people use all kinds of financial ratios in assessing a business. For example:

Bankers and other lenders examine ratios such as debt-to-equity, which gives them an idea of whether a company will be able to pay back a loan. Senior managers watch ratios such as gross margin, which helps them be aware of rising costs or inappropriate discounting. Credit managers assess potential customers’ financial health by inspecting the quick ratio, which gives them an indication of the customer’s supply of ready cash compared with its current liabilities.

Potential and current shareholders look at ratios such as price-to-earnings, which helps them decide whether a company is valued high or low by comparison with other stocks (and with its own value in previous years)

There are four categories of ratios that managers and other stakeholders in a business typically use to analyze the company’s performance: profitability, leverage, liquidity, and efficiency

Profitability ratios help you evaluate a company’s ability to generate profits

Gross profit is revenue minus cost of goods sold. Gross profit margin percentage, often called gross margin, is simply gross profit divided by revenue, with the result expressed as a percentage

Gross margin shows the basic profitability of the product or service itself, before expenses or overhead are added in. It tells you how much of every sales dollar you get to use in the business and (indirectly) how much you must pay out in direct costs (COGS or COS), just to get the product produced or the service delivered. (COGS or COS) is. It’s thus a key measure of a company’s financial health. After all, if you can’t deliver your products or services at a price that is sufficiently above cost to support the rest of your company, you don’t have a chance of earning a net profit

Trend lines in gross margin are equally important, because they indicate potential problems. IBM not long ago announced great sales numbers in one quarter—better than expected—but the stock actually dropped. Why? Analysts noted that gross margin percentage was heading downward, and assumed that IBM must have been doing considerable discounting to record the sales it did. In general, a negative trend in gross margin indicates one of two things (sometimes both). Either the company is under severe price pressure and salespeople are being forced to discount, or else materials and labor costs are rising, driving up COGS or COS. Gross margin thus can be a kind of early-warning light, indicating favorable or unfavorable trends in the marketplace

Operating profit margin percentage, or operating margin, is a more comprehensive measure of a company’s ability to generate profit. Operating profit or EBIT, remember, is gross profit minus operating expenses, so the level of operating profit indicates how well a company is running its entire business from an operational standpoint. Operating margin is just operating profit divided by revenue, with the result expressed as a percentage

Operating margin can be a key metric for managers to watch, and not just because many companies tie bonus payments to operating-margin targets. The reason is that nonfinancial managers don’t have much control over the other items—interest and taxes—that are ultimately subtracted to get net profit margin. So operating margin is a good indicator of how well managers as a group are doing their jobs. A downward trend line in operating margin should be a flashing yellow light. It shows that costs and expenses are rising faster than sales, which is rarely a healthy sign. As with gross margin, it’s easier to see the trends in operating results when you’re looking at percentages rather than raw numbers. A percentage change shows not only the direction of the change but how great a change it is

Net profit margin percentage, or net margin, tells a company how much out of every sales dollar it gets to keep after everything else has been paid for—people, vendors, lenders, the government, and so on. It is also known as return on sales, or ROS. Again, it’s just net profit divided by revenue, expressed as a percentage

Net profit is the proverbial bottom line, so net margin is a bottom-line ratio. But it’s highly variable from one industry to another. Net margin is low in most kinds of retailing, for example. In some kinds of manufacturing it can be relatively high. The best point of comparison for net margin is a company’s performance in previous time periods and its performance relative to similar companies in the same industry

Return on assets, or ROA, tells you what percentage of every dollar invested in the business was returned to you as profit. This measure isn’t quite as intuitive as the ones we already mentioned, but the fundamental idea isn’t complex. Every business puts assets to work: cash, facilities, machinery, equipment, vehicles, inventory, whatever. A manufacturing company may have a lot of capital tied up in plant and equipment. A service business may have expensive computer and telecommunications systems. Retailers need a lot of inventory. All these assets show up on the balance sheet. The total assets figure shows how many dollars, in whatever form, are being utilized in the business to generate profit. ROA simply shows how effective the company is at using those assets to generate profit. It’s a measure that can be used in any given industry to compare the performance of companies of different size.

The formula is simply net profit/ total assets

ROA has another idiosyncrasy by comparison with the income statement ratios mentioned earlier. It’s hard for gross margin or net margin to be too high; you generally want to see them as high as possible. But ROA can be too high. An ROA that is considerably above the industry norm may suggest that the company isn’t renewing its asset base for the future—that is, it isn’t investing in new machinery and equipment. If that’s true, its long-term prospects will be compromised, however good its ROA may look at the moment. (In assessing ROA, however, remember that norms vary widely from one industry to another. Service and retail businesses require less in terms of assets than manufacturing companies; then again, they usually generate lower margins.)

Another possibility if ROA is very high is that executives are playing fast and loose with the balance sheet, using various accounting tricks to reduce the asset base and therefore making the ROA look better. Enron, for instance, set up a host of partnerships partially owned by CFO Andrew Fastow and other executives, then “sold” assets to the partnerships. The company’s share of the partnerships’ profits appeared on its income statement, but the assets were nowhere to be found on its balance sheet. Enron’s ROA was great, but Enron wasn’t a healthy company

Return on equity, or ROE, is a little different: it tells us what percentage of profit we make for every dollar of equity invested in the company. Remember the difference between assets and equity: assets refers to what the company owns, and equity refers to its net worth as determined by accounting rules.

As with the other profitability ratios, ROE can be used to compare a company with its competitors (and, indeed, with companies in other industries). Still, the comparison isn’t always simple. For instance, Company A may have a higher ROE than Company B because it has borrowed more money—that is, it has greater liabilities and proportionately less equity invested in the company. Is this good or bad? The answer depends on whether Company A is taking on too much risk, or whether, by contrast, it is using borrowed money judiciously to enhance its return. That gets us into ratios such as debt-to-equity

Formula for ROE: Net profit/shareholder’s equity

From an investor’s perspective, ROE is a key ratio. Depending on interest rates, an investor can probably earn 3 percent or 4 percent on a treasury bond, which is essentially a risk-free investment. So if someone is going to put money into a company, he’ll want a substantially higher return on his equity. ROE doesn’t specify how much cash he’ll ultimately get out of the company, since that depends on the company’s decision about dividend payments and on how much the stock price appreciates until he sells. But it’s a good indication of whether the company is even capable of generating a return that is worth whatever risk the investment may entail.

Again, note one thing about all these ratios: the numerator is some form of profit, which is always an estimate. The denominators, too, are based on assumptions and estimates. The ratios are useful, particularly when they are tracked over time to establish trend lines. But we shouldn’t be lulled into thinking that they are impervious to artistic effort

Leverage ratios let you peer into how—and how extensively—a company uses debt. Debt is a loaded word for many people: it conjures up images of credit cards, interest payments, an enterprise in hock to the bank. But consider the analogy with home ownership. As long as a family takes on a mortgage it can afford, debt allows them to live in a house that they might otherwise never be able to own. What’s more, homeowners can deduct the interest paid on the debt from their taxable income, making it even cheaper to own that house. So it is with a business: debt allows a company to grow beyond what its invested capital alone would allow, and indeed to earn profits that expand its equity base. A business can also deduct interest payments on debt from its taxable income. The financial analyst’s word for debt is leverage. The implication of this term is that a business can use a modest amount of capital to build up a larger amount of assets through debt to run the business, just the way a person using a lever can move a larger weight than she otherwise could.

The term leverage is actually defined in two ways in business— operating leverage and financial leverage. The ideas are related but different. Operating leverage is the ratio between fixed costs and variable costs; increasing your operating leverage means adding to fixed costs with the objective of reducing variable costs. A retailer that occupies a bigger, more efficient store and a manufacturer that builds a bigger, more productive factory are both increasing their fixed costs. But they hope to reduce their variable costs, because the new collection of assets is more efficient than the old. These are examples of operating leverage. Financial leverage, by contrast, simply means the extent to which a company’s asset base is financed by debt.

Leverage of either kind makes it possible for a company to make more money, but it also increases risk. The airline industry is an example of a business with high operating leverage—all those airplanes!—and high financial leverage, since most of the planes are financed through debt. The combination creates enormous risk, because if revenue drops off for any reason, the companies are not easily able to cut those fixed costs. That’s pretty much what happened after September 11,2001. The airlines were forced to shut down for a couple of weeks, and the industry lost billions of dollars in just that short time. (Most of them haven’t done too well since then, either.)

Let’s focus only on financial leverage for now and look at just two ratios: debt-to-equity and interest coverage

The debt-to-equity ratio is simple and straightforward: it tells how much debt the company has for every dollar of shareholders’ equity. The formula look like this: Total liabilities/ Shareholders’ equity

(Note that this ratio isn’t usually expressed in percentage terms.) Both these numbers come from the balance sheet.

What’s a good debt-to-equity ratio? As with most ratios, the answer depends on the industry. But many, many companies have a debt-to-equity ratio considerably larger than 1—that is, they have more debt than equity. Since the interest on debt is deductible from a company’s taxable income, plenty of companies use debt to finance at least a part of their business. In fact, companies with particularly low debt-to-equity ratios may be targets for a leveraged buyout, in which management or other investors use debt to buy up the stock.

Bankers love the debt-to-equity ratio. They use it to determine whether or not to offer a company a loan. They know from experience what a reasonable debt-to-equity ratio is for a company of a given size in a particular industry (and, of course, they check out profitability, cash flow, and other measures as well). For a manager, knowing the debt-to-equity ratio and how it compares with those of competitors is a handy gauge of how senior management is likely to feel about taking on more debt. If the ratio is high, raising more cash through borrowing could be difficult. So expansion could require more equity investment

Interest coverage is a measure of the company’s “interest exposure”—how much interest it has to pay every year—relative to how much it’s making. The formula look like this: Operating profile/ Annual interest charges

In other words, the ratio shows how easy it will be for the company to pay its interest. A ratio that gets too close to 1 is obviously a bad sign: most of a company’s profit is going to pay off interest!

A high ratio is generally a sign that the company can afford to take on more debt—or at least that it can make the payments.

What happens when either of these ratios heads too far in the wrong direction—that is, too high for debt-to-equity and too low for interest coverage? We’d like to think that senior management’s response is always to focus on paying off debt, so as to get both ratios back into a reasonable range. But financial artists often have different ideas. There’s a wonderful little invention called an operating lease, for instance, which is widely used in the airline industry and others. Rather than buying equipment such as an airplane outright, a company leases it from an investor. The lease payments count as an expense on the income statement, but there is no asset and no debt related to that asset on a company’s books. Some companies that are already overleveraged are willing to pay a premium to lease equipment just to keep these two ratios in the area that bankers and investors like to see. If you want to get a complete sense of your company’s indebtedness, by all means calculate the ratios—but ask someone in finance if the company uses any debt-like instruments such as operating leases as well.

Liquidity ratios tell you about a company’s ability to meet all its financial obligations—not just debt but payroll, payments to vendors, taxes, and so on. These ratios are particularly important to small businesses—the ones that are often in danger of running out of cash—but they become important whenever a larger company encounters financial trouble as well. Not to harp on the airlines too much, but again they are a case in point. You can bet that in the years since 2001, professional investors and bondholders have been carefully watching the liquidity ratios of some of the larger airlines.

The current ratio measures a company’s current assets against its current liabilities. Current in accountantese generally means a period of less than a year. So current assets are those that can be converted into cash in less than a year; the figure normally includes accounts receivable and inventory as well as cash. Current liabilities are those that will have to be paid off in less than a year, mostly accounts payable and short-term loans.

The formula: Current assets/ Current liabilities

This is another ratio that can be both too low and too high. In most industries, a current ratio is too low when it is getting close to 1. At that point, you are just barely able to cover the liabilities that will come due with the cash you’ll have coming in. Most bankers aren’t going to lend money to a company with a current ratio anywhere near 1. Less than 1, of course, is way too low, regardless of how much cash you have in the bank. With a current ratio of less than 1, you know you’re going to run short of cash sometime during the next year unless you can find a way of generating more cash or attracting more from investors.

A current ratio is too high when it suggests to shareholders that the company is sitting on its cash. Microsoft, for example, had amassed a cash horde of nearly $60 billion (yes, billion), until in 2004 it announced a one-time dividend of $32 billion to its shareholders.

The quick ratio is also known as the acid test, which gives you an idea of its importance. Here are the formula: Current assets - Inventory/ Current liabilities

Notice that the quick ratio is the current ratio with inventory removed from the calculation. What’s the significance of subtracting inventory? Nearly everything else in the current assets category is cash or is easily transformed into cash. Most receivables, for example, will be paid in a month or two, so they’re almost as good as cash. The quick ratio shows how easy it would be for a company to pay off its short-term debt without waiting to sell off inventory or convert it into product. Any business that has a lot of cash tied up in inventory has to know that lenders and vendors will be looking at its quick ratio— and that they will be expecting it (in most cases) to be above 1.

Eifficiency ratios help you evaluate how efficiently you manage certain key balance sheet assets and liabilities.

The phrase managing the balance sheet may have a peculiar ring, especially since most managers are accustomed to focusing only on the income statement. But think about it: the balance sheet lists assets and liabilities, and these assets and liabilities are always in flux. If you can reduce inventory or speed up collection of receivables, you will have a direct and immediate impact on your company’s cash position. The efficiency ratios let you know how you’re doing on just such measures of performance

Inventory flows through a company, and it can flow at a greater or lesser speed. Moreover, how fast it flows matters a lot. If you look at inventory as “frozen cash,” then the faster you can get it out the door and collect the actual cash, the better off you will be.

Days in inventory, or DII. (It’s also called inventory days) measures the number of days inventory stays in the system. The numerator is average inventory, which is just beginning inventory plus ending inventory (found on the balance sheet for each date) divided by 2. (Some companies use just the ending inventory number.) The denominator is cost of goods sold (COGS) per day, which is a measure of how much inventory is actually used in each day. The formula: Average inventory/ (COGS/day)

Whether that’s good or bad, of course, depends on the product, the industry, the competition, and so on.

Inventory turns, the other inventory measure, is a measure of how many times inventory turns over in a year. If every item of inventory was processed at exactly the same rate, inventory turns would be the number of times per year you sold out your stock and had to replenish it. The formula is simple: 360/ DII

What are we actually measuring here? Both ratios are a measure of how efficiently a company uses its inventory. The higher the number of inventory turns—or the lower the inventory days—the tighter your management of inventory and the better your cash position. So long as you have enough inventory on hand to meet customer demands, the more efficient you can be, the better. In 2002 Target Stores had inventory turns of 6.5—a pretty good number for a big retailer. But Wal-Mart’s turns were 8.1, even better. In the retail business, a difference in the inventory turnover ratio can spell the difference between success and failure; both Target and Wal-Mart are successful, though Wal-Mart is certainly in the lead. If your responsibilities are anywhere near inventory management, you need to be tracking this ratio carefully (And even if they aren’t, there’s nothing to stop you from raising the issue: “Hey, Sally, how come there’s been an uptick in our DII recently?”) These two ratios are key levers that can be used by financially intelligent managers to create a more efficient organization

Days sales outstanding or DSO is also known as average collection period and receivable days. It’s a measure of the average time it takes to collect the cash from sales—in other words, how fast customers pay their bills. The numerator of this ratio is ending accounts receivable, taken from the balance sheet at the end of the period you’re looking at. The denominator is revenue per day—just the annual sales figure divided by 360

DSO: Ending AR / (revenue/day)

In other words, it takes this company’s customers an average of about DSO days to pay their bills. Right there, of course, is an avenue for rapid improvement in a company’s cash position. Why is it taking so long? Are customers unhappy because of product defects or poor service? Are salespeople too lax in negotiating terms? Are the receivables clerks demoralized or inefficient? Is everybody laboring with outdated financial management software? DSO does tend to vary a good deal by industry, region, economy, and seasonality, but still: if this company could get the ratio down to forty-five or even forty days, it would improve its cash position considerably. This is a prime example of a significant phenomenon, namely that careful management can improve a business’s financial picture even with no change in its revenue or costs.

DSO is also a key ratio for the folks who are doing due diligence on a potential acquisition. A high DSO may be a red flag, in that it suggests that customers aren’t paying their bills in a timely fashion. Maybe the customers themselves are in financial trouble. Maybe the target company’s operations and financial management are poor. Maybe, as at Sunbeam, there is some fast-and-loose financial artistry going on. We’ll come back to DSO in part 7 on the management of working capital; for the moment, note only that it is by definition a weighted average. So it’s important that the due diligence folks look at the aging of receivables—that is, how old specific invoices are and how many there are. It may be that a couple of unusually large, unusually late invoices are skewing the DSO number

The days payable outstanding (DPO) ratio shows the average number of days it takes a company to pay its own outstanding invoices. It’s sort of the flip side of DSO. The formula is similar: take ending accounts payable and divide by COGS per day: DPO: Ending AP / (COGS/day)

In other words, this company’s suppliers are waiting a longtime to get paid—about as long as the company is taking to collect its receivables. So what? Isn’t that the vendors’ problem to worry about, rather than this company’s managers? Well, yes and no. The higher the DPO, the better a company’s cash position, but the less happy its vendors are likely to be. A company with a reputation for slow pay may find that top-of-the-line vendors don’t compete for its business quite so aggressively as they otherwise might. Prices might be a little higher, terms a little stiffer. A company with a reputation for prompt thirty-day payment will find the exact opposite. Watching DPO is a way of ensuring that the company is sticking to whatever balance it wants to strike between preserving its cash and keeping vendors happy.

PPE turnover ratio tells you how many dollars of sales your company gets for each dollar invested in property, plant, and equipment (PPE invested in property, plant, and equipment (PPE). It’s a measure of how efficient you are at generating revenue from fixed assets such as buildings, vehicles, and machinery. The calculation is simply total revenue (from the income statement) divided by ending PPE (from the balance sheet)

By itself, X of sales for every dollar of PPE doesn’t mean much. But it may mean a lot when compared with past performance and with competitors’ performance. A company that generates a lower PPE turnover, other things being equal, isn’t using its assets as efficiently as a company with a higher one. So check the trend lines and the industry averages to see how your company stacks up.

But please note that sneaky little qualifier, “other things being equal.” The fact is, this is one ratio where the art of finance can affect the numbers dramatically. If a company leases much of its equipment rather than owning it, for instance, the leased assets may not show up on its balance sheet. Its apparent asset base will be that much lower and PPE turnover that much higher. Some companies pay bonuses pegged to this ratio, which gives managers an incentive to lease equipment rather than buy it. Leasing may or may not make strategic sense for any individual enterprise. What doesn’t make sense is to have the decision made on the basis of a bonus payment. Incidentally, a lease must meet specific requirements to qualify as an operating lease (which may not show up on the balance sheet) as opposed to a capital lease (which does). Check with your finance department before entering into any kind of lease.

Total assets turnover is the same idea as the previous ratio, but it compares revenue with total assets, not just fixed assets. (Total assets, remember, includes cash, receivables, and inventory as well as PPE and other long-term assets.) The formula: Revenue/ Total assets

Total asset turnover gauges not just efficiency in the use of fixed assets, but efficiency in the use of all assets. If you can reduce inventory, total asset turnover rises. If you can cut average receivables, total asset turnover rises. If you can increase sales while holding assets constant (or increasing at a slower rate), total asset turnover rises. Any of these managing-the-balancesheet moves improves efficiency. Watching the trends in total asset turnover shows you how you’re doing.

There are many more ratios than these, of course. Financial professionals of all sorts use a lot of them. Investment analysts do, too. (A familiar one to investors is the price-to-earnings ratio, which shows the relationship between a company’s stock price and its earnings or profits.) Your own organization is likely to have specific ratios that are appropriate for the company, the industry, or both. You’ll want to learn how to calculate them, how to use them, and how you affect them. But the ones we have outlined here are the most common for most working managers. Although understanding the financial statements is important, it is just a start on the journey to financial intelligence. Ratios take you to the next level; they give you a way to read between (or maybe underneath) the lines, so you can really see what is going on. They are a useful tool for analyzing your company and for telling its financial story.

Certain ratios are generally seen as critical in certain industries. Retailers, for instance, watch inventory turnover closely. The faster they can turn their stock, the more efficient use they are making of their other assets, such as the store itself. But individual companies typically like to create their own key ratios, depending on their circumstances and competitive situation. For example, Joe’s company, Set-point, is a small, project-based business that must keep a careful eye on both operating expenses and cash. So which ratios do Set-point’s managers watch most closely? One is homegrown: gross profit divided by operating expenses. Keeping an eye on that ratio ensures that operating expenses don’t get out of line by comparison with the gross profit dollars the company is generating. The other is the current ratio, which compares current assets with current liabilities. The current ratio is usually a good indication of whether a company has enough cash to meet its obligations.

You may already know your company’s key ratios. If not, try asking the CFO or someone on her staff what they are. We bet they’ll be able to answer the question pretty easily.

You’ll often see one kind of ratio built right into a company’s income statement: each line item will be expressed not only in dollars but as a percent of sales. For instance, COGS might be 68 percent of sales, operating expenses 20 percent, and so on. The percent-of-sales figure itself will be tracked over time to establish trend lines. Companies can pursue this analysis in some detail—for example, tracking what percent of sales each product line accounts for, or what percent of sales each store or region in a retail chain accounts for. The power here is that percent-of-sales calculations give a manager much more information than the raw numbers alone. Percent of sales allows a manager to track his expenses in relationship to sales. Otherwise, it’s tough for the manager to know if he is in line or not as sales increase and decrease.

If your company doesn’t break out percent of sales, try this exercise: locate the last three income statements and calculate percent of sales for each major line item. Then track the results over time. If you see certain items creep up while others creep down, ask yourself why that happened—and if you don’t know, try to find someone who does. The exercise can teach you a lot about the competitive (or other) pressures your company has been under.

Like the financial statements themselves, ratios fit together mathematically. One relationship among ratios is worth spelling out because it shows so clearly what we have been saying, namely that managers can affect a business’s performance in a variety of ways.

Start with the fact that one of a business’s key profitability objectives is return on assets, or ROA. That’s a critical metric because investment capital is a business’s fuel, and if a company can’t deliver a satisfactory ROA, its flow of capital will dry up. We know from this part that ROA is equal to net income divided by total assets.

But another way to express ROA is through two different factors that, multiplied together, equal net income divided by total assets. Here they are: (Net income/Revenue)* (Revenue/ Assets) = Net income/ Assets

The first term, net income divided by revenue, is of course net profit margin percentage, or return on sales (ROS). The second term, revenue divided by assets, is asset turnover. So net profit margin times asset turnover equals ROA.

The equation shows explicitly that there are two moves to the hoop, where the “hoop” is higher ROA. One is to increase net profit margin, either by raising prices or by delivering goods or services more efficiently. That can be tough if the marketplace you operate in is highly competitive. A second is to increase the asset turnover ratio. That opens up another set of possible actions: reducing average inventory, reducing days sales outstanding, and reducing the purchase of property, plant, and equipment. If you can’t improve your net profit margin, working on those ratios—that is, managing the balance sheet—may be your best path to beating the competition and improving your ROA.

Principle of the time value of money says this: a dollar in your hand today is worth more than a dollar you expect to collect tomorrow—and it’s worth a whole lot more than a dollar you hope to collect ten years from now. The reasons are obvious. You know you have today’s dollar, whereas a dollar you expect to get tomorrow (let alone in ten years) is a little iffy. There’s risk involved. What’s more, you can buy something today with the dollar you have. If you want to spend the dollar you hope to have, you have to wait until you have it. Given the time value of money, anyone who lends money to somebody else expects to be paid interest, and anybody who borrows money expects to pay interest. The longer the time period and the higher the risk, the larger the interest charges are likely to be

While the time value of money is the basic principle, the three key concepts used in analyzing capital expenditures are future value, present value, and required rate of return

Future value is what a given amount of cash will be worth in the future if it is loaned out or invested. In personal finance, it’s a concept often used in retirement planning. Perhaps you have $50,000 in the bank at age thirty-five, and you want to know what that $50,000 will be worth at age sixty-five. That’s the future value of the $50,000. In business, an investment analyst might project the value of a company’s stock in two years if earnings grow at some given percent a year. That future-value calculation can help her advise clients as to whether the company is a good investment

Every calculation of future value involves a series of assumptions about what will happen between now and the time that you’re looking at. Change the assumptions, and you get a different future value. The variance in return rates is a form of financial risk. The longer the investment outlook, the more estimating is required, hence the higher the risk

Present Value is the concept used most often in capital expenditure analysis. It’s the reverse of future value. Say you believe that a particular investment will generate $100,000 in cash flow per year over the next three years. If you want to know whether the investment is worth spending money on, you need to know what that $300,000 would be worth right now. Just as you use a particular interest rate to figure future value, you also use an interest rate to “discount” a future value and bring it back to present value. To take a simple example, the present value of $106,000 one year from now at 6 percent interest is $100,000. We are back to the notion that a dollar today is worth more than a dollar tomorrow. In this example, $106,000 next year is worth $100,000 today.

Present-value concepts are widely used to evaluate investments in equipment, real estate, business opportunities, even mergers and acquisitions. But you can see the art of finance clearly here as well. To figure present value, you have to make assumptions both about the cash the investment will generate in the future and about what kind of an interest rate can reasonably be used to discount that future value

When you’re figuring what interest rate to use in calculating present value, remember that you’re working backward. You are assuming your investment will pay off a certain amount in the future, and you want to know how much is worth investing now in order to get that amount at a future date. So your decision about the interest or discount rate is essentially a decision about what interest rate you need in order to make the investment at all. You might not invest $100,000 now to get $102,000 in a year—a 2 percent rate—but you might very well invest $100,000 now to get $120,000 in a year—a 20 percent rate. Different companies set the bar, or “hurdle,” at different points, and they typically set it higher for riskier projects than for less risky ones. The rate that they require before they will make an investment is called the required rate of return, or the “hurdle rate.”

There is always some judgment involved in establishing a hurdle rate, but the judgment isn’t wholly arbitrary. One factor is the opportunity cost involved. The company has only so much cash, and it has to make judgments about how best to use its funds. That 2 percent return is unattractive because the company could do better just by buying a treasury bill, which might pay 4 percent or 5 percent with almost no risk. The 20 percent return may well be attractive—it’s hard to make 20 percent on most investments—but it obviously depends on how risky the venture is. A second factor is the company’s own cost of capital. If it borrows money, it has to pay interest. If it uses shareholders’ capital, the shareholders expect a return. The proposed investment has to add enough value to the company that debtholders can be repaid and shareholders kept happy. An investment that returns less than the company’s cost of capital won’t meet these two objectives—so the required rate of return should always be higher than the cost of capital

Opportunity Cost denotes what you had to give up to follow a certain course of action. If you spend all your money on a fancy vacation, the opportunity cost is that you can’t buy a car. In business, opportunity cost often means the potential benefit forgone from not following the financially optimal course of action

Cost of Capital: Financial analysts figure a company’s cost of capital by (1) figuring the cost of its debt (the interest rate), (2) estimating the return expected by shareholders, and (3) taking a weighted average of the two. Say a company can borrow at 4 percent (after taking into account the fact it can deduct interest payments from its taxes), and its shareholders expect a 16 percent return. Say it’s financed 25 percent by debt and 75 percent by equity. The cost of capital is simply (25%)(4%) + (75%)(16%) = 13%. If an investment isn’t projected to return more than 13 percent, it isn’t likely to be funded

Capital expenditures are large projects that require a significant investment of cash. Every organization defines significant differently; some draw the line at $1,000, others at $5,000 or more. Capital projects are typically expected to help generate revenue or reduce costs for more than a year. The category is broad. It includes equipment purchases, business expansions, acquisitions, and the development of new products. A new marketing campaign can be considered a capital expenditure. So can the renovation of a building, the upgrade of a computer system, and the purchase of a new company car.

Expenditures like these are treated differently from ordinary purchases of inventory, supplies, utilities, and so on, for at least three reasons. One is simply that they require the company to commit large (and sometimes indeterminate) amounts of cash. A second is that they are typically expected to provide returns for several years, so the time value of money comes into play. A third is that they always entail some degree of risk. A company may not know whether the expenditure will “work”—that is, whether it will deliver the expected results. Even if it does work generally as planned, the company can’t know exactly how much cash the investment will actually help to generate. We will outline the basic steps of analyzing capital expenditures, and then teach you the three methods finance people generally use for calculating whether a given expenditure is worth making.

But please: remember that this, too, is an exercise in the art of finance. It’s actually kind of amazing: financial professionals can and do analyze proposed projects and make recommendations using a host of assumptions and estimates, and the results turn out well. They even enjoy the challenge of taking these unknowns and quantifying them in a way that makes their company more successful. With a little financial intelligence, you can contribute your own specialized knowledge to this process. We know of a company where the CFO makes a point of involving engineers and technicians in the capital budgeting process, precisely because they are likely to know more about what an investment in a steel fabricating plant, say, will actually produce. The CFO likes to say that he’d rather teach those people a little finance than learn metallurgy himself.

So here’s how to go about it:

Step 1 in analyzing a capital expenditure is to determine the initial cash outlay. Even this step involves estimates and assumptions: you must make judgments about what a machine or project is likely to cost before it begins to generate revenue. The costs may include purchasing equipment, installing it, allowing people time to learn to use it, and so on. Typically, most of the costs are incurred during the first year, but some may spill over into year two or even year three. All these calculations should be done in terms of cash-out-the-door, not in terms of decreased profits. Step 2 is to project future cash flows from the investment. (Again, you want to know cash inflows, not profit.) This is a tricky step—definitely an example of the art of finance—both because it is so difficult to predict the future and because there are many factors that need to be taken into account. (See the toolbox at the end of this part.) Managers need to be conservative, even cautious, in projecting future cash flows from an investment. If the investment returns more than projected, everybody will be happy. If it returns significantly less, no one will be happy, and the company may well have wasted its money. Step 3, finally, is to evaluate the future cash flows—to figure the return on investment. Are they substantial enough so that the investment is worth making? On what basis can we make that determination? Finance professionals typically use three different methods—alone or in combination—for deciding whether a given expenditure is worth it: the payback method, the net present value (NPV) method, and the internal rate of return (IRR) method. Each provides different information, and each has its characteristic strengths and weaknesses.

You can see right away that most of the work and intelligence in good capital budgeting involves the estimates of costs and returns. A lot of data must be collected and analyzed—a tough job in and of itself. Then the data has to be translated into projections about the future. Financially savvy managers will understand that both of these are difficult processes, and will ask questions and challenge assumptions

specialized computer, say. It’s expected to last three years. At the end of each of the three years, the cash flow from this piece of equipment is estimated at $1,300. Your company’s required rate of return—the hurdle rate—is 8 percent. Do you buy this computer or not?

The payback method is probably the simplest way to evaluate the future cash flow from a capital expenditure. It measures the time required for the cash flow from the project to return the original investment— in other words, it tells you how long it will take to get your money back. The payback period obviously has to be shorter than the life of the project; otherwise, there’s no reason to make the investment at all. In our example, you just take the initial investment of $3,000 and divide by the cash flow per year to get the payback period

Since we know the machine will last three years, the payback period meets the first test: it is shorter than the life of the project. What we have not yet calculated is how much cash the project will return over its entire life.

Right there you can see both the strengths and the weaknesses of the payback method. On the plus side, it is simple to calculate and explain. It provides a quick and easy reality check. If a project you are considering has a payback period that is obviously longer than the life of the project, you probably need to look no further. If it has a quicker payback period, you’re probably justified in doing some more investigation. This is the method often used in meetings to quickly determine if a project is worth exploring.

On the minus side, the payback method doesn’t tell you much. A company doesn’t just want to break even on an investment, after all; it wants to generate a return. This method doesn’t consider the cash flow beyond breakeven, and doesn’t give you an overall return. Nor does the method consider the time value of money. The method compares the cash outlay today with projected cash flows tomorrow, but it is really comparing apples to oranges, because dollars today have a different value than dollars down the road.

For these reasons, payback should be used only to compare projects (so that you know which will return the initial investment sooner) or to reject projects (those that will never cover their initial investment). But remember, both numbers used in the calculation are estimates. The art in this is pulling the numbers together—how close can you come to quantifying an unknown?

So the payback method is a rough rule of thumb, not strong financial analysis. If payback looks promising, go on to the next method to see if the investment is really worth making.

The net present value method is more complex than payback, but it’s also more powerful; indeed, it’s usually the finance professional’s first choice for analyzing capital expenditures. The reasons? One, it takes into account the time value of money, discounting future cash flows to obtain their value right now. Two, it considers a business’s cost of capital or other hurdle rate. Three, it provides an answer in today’s dollars, thus allowing you to compare the initial cash outlay with the present value of the return.

How to compute present value? As we mentioned, the actual calculation is usually part of a spreadsheet or template developed by your finance department. You can also use a financial calculator, online tools, or the tables found in finance textbooks.

the total expected cash flow of $3,900 is worth only $3,350 in today’s dollars when discounted at 8 percent. Subtract the initial cash outlay of $3,000, and you get a net present value of $350.

How should you interpret this? If the net present value of a project is greater than zero, it should be accepted, because the return is greater than the company’s hurdle rate. Here, the return of $350 shows you that the project has a return greater than 8 percent.

Some companies may expect you to run an NPV calculation using more than one discount rate. If you do, you’ll see the following relationship:

As the interest rate increases, NPV decreases. As the interest rate decreases, NPV increases.

This relationship holds because higher interest rates mean a higher opportunity cost for funds. If a treasurer sets the hurdle rate at 20 percent, it means she’s pretty confident she can get almost that much elsewhere for similar levels of risk. The new investment will have to be pretty darn good to pry loose any funds. By contrast, if she can get only 4 percent elsewhere, many new investments may start to look good. Just as the Federal Reserve stimulates the national economy by lowering interest rates, a company can stimulate internal investment by lowering its hurdle rate. (Of course, it may not be wise policy to do so.)

One drawback of the net present value method is that it can be hard to explain and present to others. Payback is easy to understand, but net present value is a number that’s based on the discounted value of future cash flows—not a phrase that trips easily off the nonfinancial tongue. Still, a manager who wants to make an NPV presentation should persist. Assuming that the hurdle rate is equal to or greater than the company’s cost of capital, any investment that passes the net present value test will increase shareholder value, and any investment that fails would (if carried out anyway) actually hurt the company and its shareholders.

Another potential drawback—the art of finance, again—is simply that NPV calculations are based on so many estimates and assumptions. The cash flow projections can only be estimated. The initial cost of a project may be hard to pin down. And different discount rates, of course, can give you radically different NPV results. Still, the more you understand about the method, the more you can question somebody else’s assumptions—and the easier it will be to prepare your own proposals, using assumptions that you can defend. Your financial intelligence also will be clear to others—your boss, your CEO, whoever— when you present and explain NPV in a meeting to discuss a capital expenditure. Your understanding of the analysis will allow you to confidently explain why, or why not, the investment should be made

Calculating internal rate of return is similar to calculating net present value, but the variable is different. Rather than assuming a particular discount rate and then inspecting the present value of the investment, IRR calculates the actual return provided by the projected cash flows. That rate of return can then be compared with the company’s hurdle rate to see if the investment passes the test.

In our example, the company is proposing to invest $3,000, and it will receive $1,300 in cash flow at the end of each of the following three years. You can’t just use the gross total cash flow of $3,900 to figure the rate of return, because the return is spread out over three years. So we need to do some calculations.

First, here’s another way of looking at IRR: it’s the hurdle rate that makes net present value equal to zero. Remember, we said that as discount rates increase, NPV decreases? If you did NPV calculations using a higher and higher interest rate, you’d find NPV getting smaller and smaller until it finally turned negative, meaning the project no longer passed the hurdle rate. In the preceding example, if you tried 10 percent as the hurdle rate, you’d get an NPV of about $212. If you tried 20 percent, your NPV would be negative, at -$218. So the inflection point, where NPV equals zero, is somewhere between 10 percent and 20 percent. In theory, you could keep narrowing in until you found it. In practice, you can just use a financial calculator or a Web tool, and you will find that the point where NPV equals zero is 14.36 percent. That is the investment’s internal rate of return.

IRR is an easy method to explain and present, because it allows for a quick comparison of the project’s return to the hurdle rate. On the downside, it does not quantify the project’s contribution to the over-all value of the company, as NPV does. It also does not quantify the effects of an important variable, namely how long the company expects to enjoy the given rate of return. When competing projects have different durations, using IRR exclusively can lead you to favor a quick-payback project with a high-percentage return when you should be investing in longer-payback projects with lower-percentage returns. IRR also does not address the issue of scale. For example, an IRR of 20 percent does not tell you anything about the dollar size of the return. It could be 20 percent of one dollar or 20 percent of one million dollars. NPV, by contrast, does tell you the dollar amount. When the stakes are high, in short, it may make sense to use both IRR and NPV.

Different decisions, depending on which one you rely on. The other is that the net present value method is the best choice when the methods conflict. Let’s take another example and see how the differences play out.

Assume again that your company has $3,000 to invest. (Keeping the numbers small makes the calculations easier to follow.) It also has three different possible investments in different types of computer systems, as follows:

Investment A: returns cash flow of $1,000 per year for three years Investment B: returns cash flow of $3,600 at the end of year one Investment C: returns cash flow of $4,600 at the end of year three

The required rate of return—the hurdle rate—in your company is 9 percent, and all three investments carry similar levels of risk. If you could select only one of these investments, which would it be?

The payback method tells us how long it will take to get back the initial investment. Assuming the payback occurs at the end of each year, here is how it turns out: Investment A: three years Investment B: one year Investment C: three years

By this method alone, investment B is the clear winner. But if we run the calculations for net present value, here is how they turn out: Investment A: -$469 (negative!) Investment B: $303 Investment C: $552

Now investment A is out, and investment C looks like the best choice. What does the internal rate of return method say? Investment A: 0 percent Investment B: 20 percent Investment C: 15.3 percent

Interesting. If we went by IRR alone, we would choose investment B. But the NPV calculation favors C—and that would be the correct decision. As NPV shows us, investment C is worth more in today’s dollars than investment B.

The explanation? While B pays a higher return than C, it only pays that return for one year. With C we get a lower return, but we get it for three years. And three years at 15.3 percent is better than one year at 20 percent. Of course, if you assume you could keep on investing the money at 20 percent, then B would be better—but NPV can’t take into account hypothetical future investments. What it does assume is that the company can go on earning 9 percent on its cash. But even so: if we take the $3,600 that investment B gives us at the end of year one and reinvest it at 9 percent, we still end up with less at the end of year three than we would get from investment C.

So it always makes sense to use NPV calculations for your investment decisions, even if you sometimes decide to use one of the other methods for discussion and presentation. But again: the most important step a manager can take when analyzing capital expenditures is to revisit the cash flow estimates themselves. They are where the art of finance really comes into play, and that is where companies make their biggest mistakes. Often it makes sense to do a sensitivity analysis—that is, check the calculations using future cash flows that are 80 percent or 90 percent of the original projections, and see if the investment still makes sense. If it does, you can be more confident that your calculations are leading you to the right decision.

This chapter, we know, has involved a lot of calculating. But sometimes you’d be surprised at how intuitive the whole process can be. Not long ago, Joe was running a financial review meeting at Set-point. A senior manager in the company was suggesting that Set-point invest $80,000 in a new machining center so that it could produce certain parts in-house rather than relying on an outside vendor. Joe wasn’t wild about the proposal for several reasons, but before he could speak up, a shop assembly technician asked the manager the following questions:

Did you figure out the monthly cash flow return we will get on this new equipment? Eighty thousand dollars is a lot of money! Do you realize that we are in the spring, and the business is typically slow, and cash is tight during the summer? Have you figured in the cost of labor to run the machine? We are all pretty busy in the shop; you will probably have to hire someone to run this equipment. And are there better ways we could spend that cash to grow the business?

After this grilling, the manager dropped the proposal. The assembly technician might not have been an expert in net present value calculations, but he sure understood the concepts

You’ve been talking with your boss about buying a new piece of equipment for the plant, or maybe mounting a new marketing campaign. He ends the meeting abruptly. “Sounds good,” he says. “Write me up a proposal with the ROI and have it on my desk by Monday.”

Don’t panic: here’s a step-by-step guide to preparing your proposal.

Remember that ROI means return on investment—just another way of saying, “Prepare an analysis of this capital expenditure.” The boss wants to know whether the investment is worth it, and he wants calculations to back it up. Collect all the data you can about the cost of the investment. In the case of a new machine, total costs would include the purchase price, shipping costs, installation, factory downtime, debugging, and so on. Where you must make estimates, note that fact. Treat the total as your initial cash outlay. You will also need to determine the machine’s useful life, not an easy task (but part of the art we enjoy so much!). You might talk to the manufacturer and to others who have purchased the equipment to help you answer the question. Determine the benefits of the new investment, in terms of what it will save the company or what it will help the company earn. A calculation for a new machine should include any cost savings from greater output speed, less rework, a reduction in the number of people required to operate the equipment, increased sales because customers are happier, and so on. The tricky part here is that you need to figure out how all these factors translate into an estimate of cash flow. Don’t be afraid to ask for help from your finance department—they’re trained in this kind of thing and should be willing to help. Find out the company’s hurdle rate for this kind of investment. Calculate the net present value of the project using this hurdle rate. Calculate payback and internal rate of return as well. You’ll probably get questions about what they are from your boss, so you need to have the answers ready. Write up the proposal. Keep it brief. Describe the project, outline the costs and benefits (both financial and otherwise), and describe the risks. Discuss how it fits with the company’s strategy or competitive situation. Then give your recommendations. Include your NPV, payback, and IRR calculations in case there are questions about how you arrived at your results.

Managers sometimes go overboard in writing up capital expenditure proposals. It’s probably human nature: we all like new things, and it’s usually pretty easy to make the numbers turn out so that the investment looks good. But we advise conservatism and caution. Explain exactly where you think the estimates are good and where you think they may be shaky. Do a sensitivity analysis, and show (if you can) that the estimate makes sense even if cash flows don’t materialize at quite the level you hope. A conservative proposal is one that is likely to be funded—and one that is likely to add the most to the company’s value in the long run.

Better balance sheet management makes a business more efficient at converting inputs to outputs and ultimately to cash. It speeds up the cash conversion cycle. Companies that can generate more cash in less time have greater freedom of action; they aren’t so dependent on outside investors or lenders.

Working capital is a category of resources that includes cash, inventory, and receivables, minus whatever a company owes in the short term. It comes straight from the balance sheet, and it’s often calculated according to the following formula: working capital = current assets - current liabilities

This equation can be broken down further. Current assets, as we have seen, includes items such as cash, receivables, and inventory. Current liabilities includes payables and other short-term obligations. But these aren’t isolated balance sheet line items; they represent different stages of the production cycle and different forms of working capital.

To understand this, imagine a small manufacturing company. Every production cycle begins with cash, which is the first component of working capital. The company takes the cash and buys some raw materials. That creates raw-materials inventory, a second component of working capital. Then the raw materials are used in production, creating work-in-process inventory and eventually finished-goods inventory, also part of the “inventory” component of working capital. Finally, the company sells the goods to customers, creating receivables, which are the third and last component of working capital. In a service business, the cycle is similar but simpler. For example, our own company—the Business Literacy Institute—is partly a training business. Its operating cycle involves the time required to go from the initial development of training materials, to completion of training classes, and finally to collection of the bill. The more efficient we are in finishing a project and following up on collections, the healthier our profitability and cash flow will be. In fact, the best way to make money in a service business is to provide the service quickly and well, then collect as soon as possible. Throughout this cycle, the form taken by working capital changes. But the amount doesn’t change unless more cash enters the system—for example, from loans or from equity investments.

Of course, if the company buys on credit, then some of the cash remains intact—but a corresponding “payables” line is created on the liabilities side of the balance sheet. So that must be deducted from the three other components to get an accurate picture of the company’s working capital.

Overall, how much working capital is appropriate for a company? This question doesn’t allow an easy answer. Every company needs enough cash and inventory to do its job. The larger it is, and the faster it is growing, the more working capital it is likely to need. But the real challenge is to use working capital efficiently. The three working capital accounts that nonfinancial managers can truly affect are accounts receivable, inventory, and (to a lesser extent) accounts payable

Most companies use their cash to finance customers’ purchase of products or services. That’s the “accounts receivable” line on the balance sheet—the amount of money customers owe at a given point in time, based on the value of what they have purchased before that date.

The key ratio that measures accounts receivable, is days sales outstanding, or DSO—that is, the average number of days it takes to collect on these receivables. The longer a company’s DSO, the more working capital is required to run the business. Customers have more of its cash in the form of products or services not yet paid for, so that cash isn’t available to buy inventory, deliver more services, and so on. Conversely, the shorter a company’s DSO, the less working capital is required to run the business. It follows that the more people who understand DSO and work to bring it down, the more cash the company will have at its disposal.

The first step in managing DSO is to understand what it is and in which direction it has been heading. If it’s higher than it ought to be, and particularly if it’s trending upward (which it nearly always seems to be), managers need to begin asking questions.

Operations and R&D managers, for example, must ask themselves whether there are any problems with the products that might make customers less willing to pay their bills. Is the company selling what customers want and expect? Is there a problem with delivery? Quality problems and late deliveries often provoke late payment, just because customers are not pleased with the products they’re receiving and decide that they will take their own sweet time about payment. Managers in quality assurance, market research, product development, and so on thus have an effect on receivables, as do managers in production and shipping. In a service company, people who are out delivering the service need to ask themselves the same questions. If service customers aren’t satisfied with what they’re getting, they too will take their time about paying.

Customer-facing managers—those in sales and customer service— have to ask a similar set of questions. Are our customers healthy? What is the standard in their industry for paying bills? Are they in a region of the world that pays fast or slow? Salespeople typically have the first contact with a customer, so it is up to them to flag any concerns about the customer’s financial health. Once the sale is made, customer-service reps need to pick up the ball and learn what’s going on. What’s happening at the customer’s shop? Are they working overtime? Laying people off? Meanwhile, salespeople need to work with the folks in credit and customer service so that everybody understands the terms up front and will notice when a customer is late. At one company we worked with, the delivery people knew the most about customers’ situations because they were at their facilities every day. They would alert sales and accounting if there seemed to be issues cropping up in a customer’s business.

Credit managers need to ask whether the terms offered are good for the company and whether they fit the credit histories of the customers. They need to make judgments about whether the company is giving credit too easily or whether it is too tough in its credit policies. There’s always a trade-off between increasing sales on the one hand and issuing credit to poorer credit risks on the other. Credit managers need to set the precise terms they’re willing to offer. Is net thirty days satisfactory—or should we allow net sixty? They need to determine strategies such as offering discounts for early pay. For example, “2/10 net 30” means that customers get a discount of 2 percent if they pay their bill in ten days and no discount if they wait thirty days. Sometimes a 1 percent or 2 percent discount can help a struggling company collect its receivables and thereby lower its DSO—but of course it does so by eating into profitability.

Many managers (and consultants!) these days are focusing on inventory. They work to reduce inventory wherever possible. They use buzzwords such as lean manufacturing, just-in-time inventory management, and economic order quantity (EOQ). The reason for all this attention is exactly what we’re talking about here. Managing inventory efficiently reduces working capital requirements by freeing up large amounts of cash.

The challenge for inventory management, of course, isn’t to reduce inventory to zero, which would probably leave a lot of customers unsatisfied. The challenge is to reduce it to a minimum level while still ensuring that every raw material and every part will be available when needed and every product will be ready for sale when a customer wants it. A manufacturer needs to be constantly ordering raw material, making things, and holding them for delivery to customers. Wholesalers and retailers need to replenish their stocks regularly, and avoid the dreaded “stockout”—an item that isn’t available when a customer wants it. Yet every item in inventory can be regarded as frozen cash, which is to say cash that the company cannot use for other purposes. Exactly how much inventory is required to satisfy customers while minimizing that frozen cash, well, that’s the million-dollar question (and the reason for all those consultants).

Many U.S. plants operate on a principle that eats up tremendous amounts of working capital. When business is slow, they nevertheless keep on churning out product in order to maintain factory efficiency. Plant managers focus on keeping unit costs down, often because that goal has been pounded into their heads for so long that they no longer question it. They have been trained to do it, told to do it, and paid (with bonuses) for achieving it.

When business is good, the goal makes perfect sense: keeping unit costs down is simply a way of managing all the costs of production in an efficient manner. (This is the old approach of focusing only on the income statement, which is fine as far as it goes.) When demand is slow, however, the plant manager must consider the company’s cash as well as its unit costs. A plant that continues to turn out product in these circumstances is just creating more inventory that will sit on a shelf taking up space. Coming to work and reading a book might be better than building product that is not ready to be sold.

How much can a company save through astute inventory management? Look again at our sample company: cutting just one day out of the DII number—reducing it from 74 days to 73—would increase cash by nearly $19 million. Any large company can save millions of dollars of cash, and thereby reduce working capital requirements— just by making modest improvements in its inventory management

Another way to understand working capital is to study the cash conversion cycle. It’s essentially a timeline relating the stages of production (the operating cycle) to the company’s investment in working capital. The timeline has three levels.

Understanding these three levels and their measures provides a powerful way of understanding the business, and should help you make financially intelligent decisions.

Starting at the left, the company purchases raw materials. That begins the accounts payable period and the inventory period. In the next phase, the company has to pay for those raw materials. That begins the cash conversion cycle itself—that is, the cash has now been paid out, and the job is to see how fast it can come back. Yet the company is still in its inventory period; it hasn’t actually sold any finished goods yet.

Eventually, the company does sell its finished goods, ending the inventory period. But it is just entering the accounts receivable period; it still hasn’t received any cash. Finally, it does collect the cash on its sales, which ends both the accounts receivable period and the cash conversion cycle.

Why is all of this important? Because with it, we can determine how many days all this takes and then understand how many days a company’s cash is tied up. That’s an important number for managers and leaders to know. Armed with the information, managers can potentially find ways to “save” lots of cash for their company. To figure it out, use the following formula:

cash conversion cycle = DSO + DII - DPO In other words, take days sales outstanding, add days in inventory, and subtract the number of days payable outstanding. That tells you, in days, how fast the company recovers its cash, from the moment it pays its payables to the moment it collects its receivables.

The cash conversion cycle gives you a way of calculating how much cash it takes to finance the business: you just take sales per day and multiply it by the number of days in the cash conversion cycle. Here are the calculations for our sample company: 54 days + 74 days - 55 days = 73 days 73 days x $24,136,000 sales/day = $1,761,928,000 This business requires working capital of around $1.8 billion just to finance its operations. That isn’t unusual for a large corporation. Even small companies require a lot of working capital relative to their sales if their cash conversion cycle is as long as sixty days. Companies of any size can get themselves into trouble on this score. Tyco International was famous for acquiring six hundred companies in two years. All those acquisitions entailed a lot of challenges, but one serious one involved huge increases in the cash conversion cycle. The reason? Tyco often was acquiring companies in the same industry, and competing products were added to its product list. With several very similar products in inventory, the inventory didn’t move as fast as it once had—and inventory days began to spiral out of control, increasing in some parts of the business by more than ten days. In a multinational company with more than $30 billion in revenue, increases on that scale can deplete cash by several hundred million dollars! (This is an issue that Tyco has addressed in recent years by closing down the acquisition pipeline and focusing on the operations of the business.)

The cash conversion cycle can be shortened by: decreasing DSO, decreasing inventory, and increasing DPO. Find out what your company’s cycle is and which direction it’s heading in.

Want to manage accounts receivable more effectively? DSO is not the only measure to look at. Another is what’s called the aging of receivables. Often, reviewing aging is the key to understanding the true situation in your company’s receivables.

Here’s why. As we mentioned earlier, DSO is by definition an average. For example, if you have $1 million in receivables that are under ten days and $1 million that are more than ninety days, your overall DSO is about fifty days. That doesn’t sound too bad—but in fact, your company may be in substantial trouble, because half of its customers don’t seem to be paying their bills. Another business of the same size might have a DSO figure of fifty days with only $250,000 over ninety days. That business isn’t in the same sort of trouble.

An aging analysis will present you with just these kinds of figures: total receivables under thirty days, total for thirty to sixty days, and so on. It’s usually worth checking out that analysis as well as your overall DSO number to get the full picture of your receivables.