Finance: What Managers Have to Know

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0:52Hi, I'm Sarah Green from HarvardBusiness.org. I'm joined today by Joe Knight, Co-owner of the Business Literacy Institute and author with Karen Berman of the Financial Intelligence book series. He's also the author of a blog on HarvardBusiness.org called Financial Intelligence. Joe, thanks so much for joining us today.

1:11Joe Knight:Thanks for having me. Joe, how is your approach to teaching finance different than the typical academic approach? You know, one of the things I had to learn when I taught finance is that I had about 40 minutes and I had a bunch of people that were technical that weren't that interested. and I had to figure out a way to get at what's important and teach them why they need to know the numbers and how they affect them. Recently our book was listed as one of the best 100 by 800 CEO Reed. And as part of that I was involved in a session where several authors got together on a panel and presented their books.

1:43Joe Knight:And I happened to be sitting, seated next to Bob Kaplan who was picked as one of the best 100 with his well-known book, The Balanced Scorecard. And at the end of the session, after we presented to the Harvard alumni in the session, the moderator mentioned why he liked each of the books. And when he got to my book, he said, you know, the reason why I like Joe's book, Financial Intelligence, is because he taught us how to read the statements without bringing up credit or debit once. And everybody laughed and the session was over. And as people were coming out of the audience, Bob Kaplan was sitting next to me, leaned over and said, Joe, how can you teach finance without going over the double entry accounting system and credits and debits?

2:19Joe Knight:and we started debating about it. And after that experience, I kind of reflected on that and I realized that Bob Kaplan's teaching academic people, people at the Harvard Business School getting an MBA and he has a full semester and he has these people for two-hour blocks and he should be teaching a lot of detail in the double-entry accounting system. I learned to teach finance by telling the people on the shop floor that are making machines in our company what they need to know to drive success in the business. And they don't need to know credits or debits. They need to know why gross profit per hour is so critical.

2:52And they need to know when their gross profit per hour is high enough, how much profit we'll make, because that'll affect their bonus and affect the success of the business. And so I come at it from more of a practical position where these people just need to know what they need to know. Some of these people don't want to be accountants. They don't want to be full-time financial analysts.

3:09Joe Knight:But they do need to know what scores need to be at certain levels to be successful. And that's all that I'm trying to do is help them understand what scores are important and why they need to know them. And that doesn't require a lesson on the double entry accounting system and credits or debits, no matter how exciting that may appear to be. Joe, you talk a lot about the art of finance, but what's so artistic about a P &L? And do we really want finance to be artistic? Isn't that what got the Enron guys in trouble? Well, actually, we don't want our finance to be artistic. The challenge is, is accountants have to take transactions that happen in many different ways and fit them into a month, a quarter of a year.

3:49Joe Knight:So there's a lot of estimates and assumptions that go into creating a statement. And some of that becomes very artistic, if you will. We think of accounting as a science, but in reality, there's a lot of estimates and assumptions. And a lot of the statements can come from the personality or the opinion of the person creating the numbers. Consequently, when management goes to look at those numbers, they find out that they might not be exactly what they thought they were because it's based on estimates and assumptions and art. What's the difference between finance and accounting? Because you use both those terms there.

4:19Joe Knight:We do. And I think you should understand that everyone needs to understand that finance is actually analyzing and looking at numbers and making decisions about how to run a business, how to get the numbers, how to manage cash flow and understand those kinds of things. Accounting, on the other hand, their task is to take transactions and figure out how to create historical information about what's happening with a business. Finance people. This episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome, that's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50-page restoration block, or finally break down that long article you've had open for weeks.

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5:22Joe Knight:We'll take that historical information and use it to make business decisions. If you don't have good accounting that you can rely on, and by good accounting, I mean accounting that is consistent, considerably applied, and accurate, then you're not going to have good financial analysis. So the basis of any good system is a good, solid, historical accounting system. And a lot of that relies on the integrity and the competency of the accountants putting in the numbers. We tend to think of finance as a specialized area, finance and accounting both. And I think most general managers want to leave the numbers to the numbers guys or women.

6:01Is that a problem?

6:04Joe Knight:I think it is a big problem. I come from a world where we shared our numbers. I own a small business called Setpoint Systems Incorporated, and we do manufacturing automation. We built a few roller coasters, in fact. And in that business, we learned that when we shared the numbers with the employees and showed them how the business was performing, they turned around and did tremendous things for our business. In fact, I coined kind of a little phrase, I call it psychic ownership. When the employees understand the numbers and they can see what's going on in the business financially, they feel like it's their business.

6:35Joe Knight:And they feel like when the numbers aren't right, they're going to figure out a way to turn them around and make things better. And even though they're not owners, they still act like owners and they behave like owners in the way they perform. And I think getting the numbers out to the people in an operational way And finding those one or two key numbers that drive success in your business and bringing them to everyone is very powerful in a business. It should go way beyond just the accounting and finance people. But in some sense, our whole economy is built on specialization, right? Otherwise, we would still be hunting and gathering.

7:06So how do you find that balance? Well, I think business is like a game. And if you don't understand the finances, you're basically playing a game where you don't know score. And so I believe that no matter what your background is, whether you're an engineer or if you're in sales and marketing or you're in operations or if you're on the floor putting a product together, if you don't know how score is kept, you're going to get in trouble. And so I think that finance is one of those things that needs to be universally understood in any business. And when I say any business, I say that very broadly.

7:37We use the term not-for-profit. But guess what? Not-for-profit businesses also have to make a profit. In other words, even not-for-profits have to generate more income than what goes out or they won't survive. I like to use the term not-for-tax because that's really what not-for-profit means. But every organization has to generate more inflow than outflow. And that's a simple thing that everyone has to understand in a business. So what's the least that a general manager or employee in a business needs to know about finance? Well, I think at the very minimum, any employee should understand one or two key metrics or numbers that will drive success in the business.

8:13And one of the things we find is that it's easy to teach these metrics if there's one or two. One of the problems that finance people have is they want to share all the numbers. And we could get into 20 or 30 metrics and it confuses people. But if you find one or two, maybe three key numbers that define success in your business and then you link that to key drivers that bring rewards to the employees through bonus, and you train them on those numbers, it becomes very powerful as long as you don't go too far with it. So every business is different. Industries are different. But if you can find those few key metrics and really drive them through your organization, it's going to make a big difference.

8:50What's an example maybe of some metrics that you think are probably universally applicable across most businesses? Well, you know, I would say that there are very few that are totally universal because every business is different. But I can tell you about Setpoint's key numbers. A couple of numbers we focus on because we're a manufacturing business that works on big projects is the percentage of our labor that's directly applied to projects, number one. And number two, the dollars we generate for every direct hour we spend. Now, in our business, that drives success. And those two… This episode is brought to you by Google Chrome.

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9:59What propels you? Propel with Gatorade Electrolytes. Two numbers, gross profit per hour, and percentage of labor direct is a great metric for a project-based business. Any project-based business, if those two numbers are in the right range, you're going to be profitable. And our people know that. So in their businesses, how do general managers and employees know what the right questions are to ask of their financial people? Well, first of all, I think there are no bad questions. And I think because finance does have that estimate or that art to it that we talked about earlier, it's the responsibility of the management group to ask questions of the numbers and to understand where the finance person got the numbers when they put them together.

10:39One of the things that people might not realize is as a financial analyst or as an accountant, early in my career, for example, when I was at Ford Motor Company, if the numbers didn't balance and it was seven at night and I was really tired. I'd work on it for another few hours and then it was 10, then 11. At about midnight, I'd make the numbers balanced and I'd just go home. Now the next morning when we had our meeting, I wouldn't raise my hand and say, guess what, I just made up that number last night. So you need to understand that we're making estimates when we prepare those statements and it's okay to ask questions and to challenge the numbers and to question things.

11:10Because if not, you're making decisions, business decisions, based on the analyst numbers that were maybe plugged or maybe estimated or even in some cases fraudulent. And so it's really important that everyone get involved in the numbers and understand the numbers. Another thing that's important about understanding the numbers is if everyone looks at the numbers and watches them on a weekly basis, it becomes very difficult for fraud to creep into a business because everyone's seeing that and involved in the numbers. And so that's another reason why finance should be viewed by many people. One of the things we learned is in fraud cases, virtually every one of them were discovered by someone in the organization who understood finance and noticed something was wrong.

11:51So it makes sense that if more people understood the numbers, there would be more people that were on top of the numbers and could understand and find cases of fraud. Let's talk a little bit about cash and profits because we've been hearing a lot about those in 2009, maybe because no one seems to have very much of either of them. What's the difference there? And just talk to me a little bit about those elusive goals. Okay. Well, first of all, the shift has been to cash flow. In this environment, everyone knows that if you have cash, you're going to survive. The credit markets have tightened up.

12:22Now, I'm in a small business, and especially for small businesses, it's very difficult to raise money right now. So there's a big premium on generating cash flow. The problem is a lot of people don't understand this. Profit and cash flow are two different things. There's three primary reasons why that's the case. First, profit is recognized when you make a sale. Unfortunately, we count sales when we ship a product or when we've done the work or completed the project, not when we collected the money. So consequently, we might have invoiced millions of dollars, but we might not see that money for 60 days.

12:56And in a tough economy, it could be as long as 90 days. and so you could have a lot of sales which generate profit and wait 90 days, 60 days to receive the cash. A second reason why cash and profit don't match is because sometimes in business we take a lot of our cash and use it to buy big pieces of equipment, a truck, a building, and those trucks and buildings eat up all our cash but we depreciate the cost of those over several years and so our cash is gone but we appear profitable because of depreciation. So that's another reason. And then third, we don't incur expenses on the income statement when we actually pay the expense.

13:31We incur the expense when we receive the service. An example of that would be payroll. When we pay our employees on June 1st, we're actually paying them for work they did in May. So we're going to charge the income statement in May for payroll we paid in June. So again, cash went out in June, the expense was charged in May. So all of these moving parts are happening. we could have profit at the bottom here and cash could be here or here or anywhere and so it's very hard to track the two side by side consequently the cash this episode is brought to you by google chrome you think you know a browser but gemini and chrome that's new it can help you with practically anything on the web like restoring a vintage motorcycle from a 50-page restoration block or finally break down that long article you've had open for weeks gemini and chrome is here for it.

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14:44Joe Knight:Flashflow statement has become more and more important over the last few years. Let's talk about another emerging trend, transparency. That's a word that we maybe didn't hear very much 10 years ago. Now it's everywhere, whether you're talking about ethics or sustainability or finance. How have you seen that playing out? You know, it's interesting. I train a lot of big corporations. And over the last few years, I have not, if I go back three or four years ago, I never heard the word transparency. Now several of my clients ask if we'll teach a module on transparency. And the issue is, is we believe now that a company that's publicly traded should be transparent financially.

15:23So the thinking is, is an outsider, an investor, can go online to edgar.gov or to a typical government site, go through the SEC, look up the numbers on that company, and get some indication of what's really happening in the business. A company like Enron was the opposite of transparency. Enron spent tremendous amounts of effort and time trying to figure out ways to keep the real numbers from getting public. And so the opposite would be, let's let the news go out as it is. Let's share the numbers as they are really happening. Let's be transparent to our investors, to the outside stakeholders in the business.

16:00And in the case with fraud and with companies going bankrupt and all these problems we've seen in the banking system, transparency is becoming a very, very important topic and one that is a big focus in American business today. Joe, thanks so much for joining us today. You're very welcome. That's Joe Knight, co-author of Financial Intelligence, the book series, and the blog on HarvardBusiness.org.

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