What you will learn from readingFinancial Intelligence for Entrepreneurs:
– Provide a deep understanding of the basics of financial management and measurement.
– What income statements, balance sheets, and cash flow statements really reveal.
– The different models of recognising revenue, and how this impacts companies profits.
Financial Intelligence for Entrepreneurs
This is the go to guide for understanding the financial side of business. A must read for entrepreneurs and aspiring business owners to get a grip on the language of business.
Profit = Freedom:
In familiar phrase generally attributed to Peter Drucker, 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. If your company is profitable, you can run it the way you want to. When a company stops being profitable, other people, lenders, outside investors, suppliers, even customers-begin to poke their noses into the business. The company loses its autonomy.
The art of Finance:
The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Accounting and finance are not reality; they are a reflection of reality, and the accuracy of that reflection depends on the ability of bookkeepers, accountants, and finance professionals to make reasonable assumptions and to calculate reasonable estimates.
Financial intelligence in this context means understanding where the numbers are “hard” (that is, well supported and relatively uncontroversial) and where they are “soft” (that is, highly dependent on those judgment calls).
Look for the biases:
If your business owns any significant tangible assets, you should understand how your accountants depreciate them. The accountants’ practices will go far toward determining your company’s bottom line. You are using that bottom-line number to make decisions about what the business can and should do next.
The millions of companies that are privately held, of course, aren’t valued at all on the market. When they are bought or sold, the buyers and sellers must rely on other methods of valuation. Talk about the art of finance: much of the art here lies in choosing the valuation method. Different methods produce different results-which, of course, injects a bias into the numbers.
Profit is based on revenue. Revenue, remember, is recognised 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. You can be making money as shown by the income statement, but you may not be generating cash fast enough to pay your bills.
Decisions about when revenue is recognised are a key element of the art of finance.
The guideline that accountants use for recording or recognising 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.
The “sales” figure on a company’s top line always reflects the accountants’ judgments about when they should recognise revenue. And where there is judgment, there is room for dispute-not to mention manipulation.
Different companies, different accounting styles:
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 that allow for partial revenue recognition when a project reaches certain milestones.
The key, as accountants like to say, is reasonableness and consistency. So long as a company’s logic is reasonable, and so long as that logic is applied consistently, whatever it wants to do is OK.
Balance Sheet Analysis:
The balance sheet, in short, helps 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.
You can assess a companies health using the balance sheet!
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.
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.
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 are necessary to maintain a healthy business.
The Cash Flow Statement:
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.
Since profit starts with revenue, it always reflects customers’ promises to pay. Cash flow, by contrast, always reflects cash transactions.
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.
How to calculate free cash flow? First, get your cash flow statement.
Next, take net cash from operations, and deduct the amount invested in capital equipment, as shown in the investment section of the statement 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.
There are four categories of ratios that owners, managers, and other stakeholders in a business typically use to analyse the company’s performance: profitability, leverage, liquidity, and efficiency.