Name: Financial Intelligence, Revised Edition
ISBN: 9781422144114

Karen Berman

Joe Knight

Explains what business numbers mean and why they matter, and addresses issues that have become more important in recent years, including questions about the financial crisis and accounting literacy.

A Manager's Guide to Knowing What the Numbers Really Mean

Financial Intelligence, Revised Edition

Sagar Rathna Sabapathy

Capital Expenditures: 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 pur- chase 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. 

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

Accruals: An accrual is the portion of a 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 costs to revenues ina 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.

Depreciation: Depreciation is the method accountants use to allocate the cost of equipment and other assets to the total cost of prod- ucts 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 investments other than land are depreciated. Accountants attempt to spread the cost of the expenditure over the useful life of the item. There's more about depreciation in parts 2 and 3.

 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, and so on.

A 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. A finan- cially savvy manager knows that all the financial statements ultimately flow to the balance sheet. We'll explain all these notions in part 3.

The Matching Principle The matching principle is a fundamental accounting rule for preparing an in- come statement. It simply states, "Match the cost with its associated revenue 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 PURPO0SE OF THE INCOME STATEMENT In principle, the income statement tries to measure whether the prod- ucts 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 (incuding 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

Different names for the income statement 

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 orearnings statement." All these terms refer to the same document. Often the word consolidated appears as part of the title. If it does, you are probably looking at an income statement for a whole company, with totals for major categories rather than highly detailed line items. ne statement could drive a per-

ONE BIG RULE ing foot- ear end- So those are the rules for reading. But don't forget the one big rule that should be in the forefront of your thinking whenever you confront an in- come statement. That rule says: Remember that many numbers on the income statement reflect estimates and assumptions. Accountants have decided to include some transac- tions hee and not there. They have decided to estimate one way and not another. Zscal ains nd/ ice fic if 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. 

accounting is the art of using limited data to come as close as possible to an accurate description of how well a company is performing, Revenue on the income statement is an estimate, a best guess. 

Just as an aside, the most common source of acco unting fraud has been and probably always will be in that top line: sales. Many companies play with revenue recognition in questionable ways. The issue is particularly acute in the software industry. Software companies often sell their prod- ucts to resellers, who then sell the products to end users. Manufacturers, 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.) And it isn'tjust soft-

Cost of Goods Sold (COGS) and Cost of 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.

You can think of operating expenses as the cholesterol in a business. Good cholesterol makes you healthy, while bad cholesterol clogs your ar- teries. Good operating expenses make your business strong, and bad op- erating expenses drag down your bottom line and prevent you from tak- ing advantage of business opportunities. (Another name for bad operating expenses is "unnecessary bureaucracy" Also lard" You can probably come up with others.) ng eYnenses You might think

The book Inc. magazine calls one of "the best, clearest guides to the numbers" on the market. Inc. magazine calls it one of "the best, clearest guides to the numbers" on the market. Readers agree, saying it's exactly "what I need to know" and calling it a "must-read" for decision makers without expertise in finance. Since its release in 2006, Financial Intelligence has become a favorite among managers who need a guided tour through the numbers--helping them to understand not only what the numbers really mean, but also why they matter. This new, completely updated edition brings the numbers up to date and continues to teach the basics of finance to managers who need to use financial data to drive their business. It also addresses issues that have become even more important in recent years--including questions around the financial crisis and those around broader financial and accounting literacy. Accessible, jargon-free, and filled with entertaining stories of real companies, Financial Intelligence gives nonfinancial managers the confidence to understand the nuance beyond the numbers--to help bring everyday work to a new level.

Financial Intelligence, Revised Edition A Manager's Guide to Knowing What the Numbers Really Mean

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