Financial Intelligence

for IT Professionals
 Financial
Intelligence
for IT
Professionals
The Story of the Numbers

Dr. Julie Bonner

First edition published 2022
by CRC Press
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I dedicate this book to all the accounting students I have taught
who never wanted to be an accountant over the years. You have
helped me learn how to teach this subject in the best ways for the
non-accounting and non–finance-focused professionals.
In addition, I dedicate this book to my family, who find creative
ways to allow me to take on projects like this!
Contents

List of Figures and Tables xiii

P r e fa c e xvii
Acknowledgments xix
List of A b b r e v i at i o n s xxi
Definitions xxiii

P a r t O n e : W h y B e i n g F i n a n c i a lly S av v y M at t e r s 1
Topic 1: How Financial Clarity Gives You
Professional Leverage 2
Do You Know If Your Employer Could Be in Trouble
Financially? 3
Do You Want to Start Your Own Business? 3
Do You Want to Grow Your Business or Otherwise
Invest in Other Businesses? 4
Do You Desire to Obtain a Managerial, Directorial, or
Executive Position? 5
Topic 2: How Understanding the Numbers Gives
You an Edge 5
The Difference between Finance and Accounting 6
Utilizing Your Financial Resources Effectively 6
Break Down Silos 7
Understanding Financial Decisions and the Connection
to Financial Performance 7
Assess Promotional Opportunities 8

vii
viii C o n t en t s

Topic 3: Why Numbers and Accounting Can

Be Confusing 8
Myth #1: “I Cannot Learn This Subject Because
It Is Math-Based” 9
Myth #2: “I Cannot Learn This Subject Because
I Am Not Smart” 9
Myth #3: “I Cannot Learn This Subject Because
It Is BORING!” 10
The Truth of Why Accounting and Finance Can Be
Challenging to Learn 11
Bottom Line 12
Topic 4: How the Book Is Arranged for Your
Learning Journey 12
Regarding Readers in Different Countries 12
Relating Personal Finance to Corporate Finance 13
What to Watch Out For 15
Examples 15
Context 16
Exercises 16
How to Learn 16
Tools for Your Learning 17
Other Resources 18
Departmental Learning Groups or Study Groups 19
Part One: Exercises, Practice, and Resources 20
Notes 20

P a r t T w o : R e v e n u e a n d E x p e n s e – T h e B a s i c s of

I n c o m e S tat e m e n t s 21
Translating This Information 22
Topic 5: Profit and Cash Are NOT the Same 23
Why Profit and Cash Are Not the Same? 23
Procurement to Payment Cycle 24
Order to Cash Cycle 25
Topic 6: Overview of Profit and Loss Statement 26
Reporting Periods 26
Fiscal Years 27
Periods of Time 27
Be Aware! 28
Major Sections of the Profit and Loss Statement 28
Revenue 29
Cost of Goods Sold 31
Gross Margin 32
Operating Expenses 32
Operating Income 33
Net Profit 33
 C o n t en t s ix

Topic 7: Breaking Down the Profit and Loss Statement 33

Revenue Recognition and Timing Issues 35
Deeper Dive into Cost of Goods Sold 38
Part Two: What to Watch Out For 41
Part Two: Exercises, Practice, and Resources 42
Notes 44

Part Three: Assets, Liabilities, and Equity –

U n d e r s ta n d i n g t h e B a l a n c e S h e e t 47
Periods of Time 47
Translating This Information 48
Topic 8: Short Term versus Long Term 49
Topic 9: Assets 50
Current Asset: Cash 51
Current Asset: Accounts Receivable 51
Current Asset: Inventory 52
Long-Term Asset: Property, Plant, and Equipment 55
Depreciation 55
Amortization 57
Topic 10: Liabilities 58
Current Liability: Accounts Payable 58
Long-Term Liabilities 60
Topic 11: Equity 60
Stock 60
Retained Earnings 61
Part Three: What to Watch Out For 61
Part Three: Exercises, Practice, and Resources 62
Notes 63

P a r t F o u r : C a s h F l o w S tat e m e n t s  65
Topic 12: How Profit and Cash Are Related to
Financial Statements 66
Topic 13: Operating, Financing, and Investing Activities 67
Cash Generated or Used from Operating Activities 67
Cash Generated or Used from Investing Activities 68
Cash Generated or Used from Financing Activities 69
Topic 14: How All Financial Statements Fit Together 69
Income Statement to Balance Sheet 70
Income Statement to Cash Flow Statement 72
Balance Sheet to Cash Flow Statement 74
Topic 15: Working Capital Management 75
Accounts Receivable 75
Inventory 76
Accounts Payable 77
Part Four: What to Watch Out For 78
x C o n t en t s

Part Four: Exercises, Practice, and Resources 79

Notes 80

Part Five: The Power of F i n a n c i a l R at i o s 81

Topic 16: Profitability Ratios 83
Gross Profit Margin 84
Net Profit Margin 85
Connecting Back to the 10-k 87
Topic 17: Solvency Ratios 88
Debt to Assets 88
Equity to Assets 89
Debt to Equity 89
Zoom Results 89
LogMeIn Results 91
Connecting Back to the 10-k 92
More about Developing a “Gut Feel” 93
Topic 18: Liquidity Ratios 95
Current Ratio 95
Quick Ratio 95
Zoom Results 96
LogMeIn Results 97
Connecting Back to the 10-k 97
Topic 19: Efficiency or Activity Ratios 98
Inventory Turnover Ratio 98
Days Sales in Inventory 99
Accounts Receivable Turnover 99
Days Sales Outstanding 101
Accounts Payable Turnover 101
Days Payable Outstanding 103
Cash Conversion Cycle 104
Connecting Back to the 10-k 105
Ties to Cash Flow and Working Capital Management 105
Topic 20: Other Financial Formulas of Interest 106
EBITDA 106
Free Cash Flow 107
Horizontal Analysis 108
Part Five: What to Watch Out For 111
Part Five: Exercises, Practice, and Resources 111
Notes 113

Part Six: Special Topics 115

Topic 21: Internal Controls 116
Segregation of Duties 116
Asset and System Access Controls 117
Physical Counts of Assets 117
Cycle Counting 118
 C o n t en t s xi

Reconciliations 118
Approval Authority 119
Procedures and Audits 120
Topic 22: Protecting Financial Information in Excel 120
Problem 1: Accessing File Content 121
Problem 2: Erasing Content in a Cell 122
Problem 3: Consistency in Data Entry 123
Problem 4: Audit and Informational Tabs 124
Problem 5: Embedded Calculation Factors 125
Topic 23: Budgeting and Variances 127
Budgeting 127
Historical Averages 128
Trendline Analysis 130
Cost Drivers 130
Topic 24: Contractor or Full-Time Employee? 133
Reasons for Contracting Labor 133
Modeling Analysis 134
Topic 25: Small Business 135
Overall Business Resources 135
Reports 136
QuickBooks and Software 137
Financial Data Analysis 139
Pricing Products and Services 141
Business Plans 143
Business versus Personal 145
Receipts and Documentation 145
Taxes 146
Social Security and Medicare 146
Payroll Taxes 148
Other Tax Demands 149
Financial Human Resources 149
Bookkeeper/Accountant 149
Personal Finance/Wealth Advisor 150
Bank Reconciliations 150
Contractor Payments 151
Funding 152
Clarity of the Business Model 152
Do the Numbers Make Sense? 153
Part Six: Exercises, Practice, and Resources 156
Notes 159

A pp e n d i c e s  161

Index 171
Figures and Tables

Figure 1 Example Personal Income Statement 14

Figure 2 Example Company Income Statement 14

Figure 3 Example Personal Balance Sheet 14

Figure 4 Example Company Balance Sheet 15

Table 1 Procurement to Payment Cycle 24

Table 2 Order to Cash Cycle 26

Figure 5 Credit Card Transaction Timeline 29

Figure 6 Customer Invoice Transaction Timeline 30

Figure 7 Gift Card Transaction Timeline 30

Figure 8 Product Inventory Timeline 31

Figure 9 Sample A/R Aging Summary 52

Figure 10 Revenue to Assets 70

Figure 11 Expenses to Liabilities 70

Figure 12 Net Income to Equity 71

Figure 13 Detailed Sections of Profit and Loss 72

Figure 14 Income Statement to Cash Flow 73

x iii
xiv Fi gure s a n d Ta b l e s

Figure 15 Balance Sheet to Cash Flow Statement 74

Figure 16 Example of A/R Aging Report 75

Figure 17 LOGM and ZM Revenue and Gross Profit Data 84

Figure 18 ZM and LOGM Gross Profit Margin Results 84

Figure 19 LOGM and ZM Revenue and Net Profit Data 86

Figure 20 ZM and LOGM Net Profit Margin Results 86

Figure 21 LogMeIn Results: Unusual Item 88

Figure 22 Zoom Solvency Data 89

Figure 23 Zoom Solvency Ratios 90

Figure 24 Zoom 2019 Split of Debt and Equity to Assets 90

Figure 25 Zoom 2020 Split of Debt and Equity to Assets 91

Figure 26 LogMeIn Solvency Data 91

Figure 27 LogMeIn Solvency Ratios 92

Figure 28 Zoom Liquidity Ratio Data Input 96

Figure 29 Zoom Current Ratio and Quick Ratio 96

Figure 30 LogMeIn Liquidity Ratio Data Input 97

Figure 31 LogMeIn Current and Quick Ratio Results 97

Figure 32 Zoom Input Data for A/R Turnover 99

Figure 33 Zoom Accounts Receivable Turnover 100

Figure 34 LogMeIn Input Data for A/R Turnover 100

Figure 35 LogMeIn A/R Turnover Calculation 100

Figure 36 Zoom Days Sales Outstanding 101

Figure 37 LogMeIn Days Sales Outstanding 101

Figure 38 Zoom Input Data for A/P Turnover 102

Figure 39 Zoom A/P Turnover Calculation 102

Figure 40 LogMeIn Input Data for A/P Turnover 102

Figure 41 LogMeIn A/P Turnover Calculation 103

Figure 42 Zoom Days Payables Outstanding 103

 Fi gure s a n d Ta b l e s xv

Figure 43 LogMeIn Days Payables Outstanding 104

Figure 44 Zoom Cash Conversion Cycle 104

Figure 45 LogMeIn Cash Conversion Cycle 104

Figure 46 LogMeIn Horizontal Analysis P&L 110

Figure 47 Call Center Data Forecasting Example 128

Figure 48 Support Center Data for Forecasting Chart 129

Figure 49 Assessing Patterns in Ten Years of Sales Data 130

Figure 50 Sample Gross Margin Analysis 140

Figure 51 Sample - Correct Balance 155

Figure 52 Sample - Incorrect Balance 155

Preface

As a student, I have had challenges with certain subjects. I believed

the idea that girls have a much more difficult experience trying to
learn math. Thank goodness I eventually figured out that while
aptitude does matter, the teacher can make an enormous difference
in a learning outcome. I have spent over 20 years teaching non-
finance and accounting majors to learn how to embrace the world of
interpreting financial information.
Eventually, when I became a teacher and then tenured univer-
sity professor, I had to figure out how to build a curriculum that
students could follow to learn this material. Through that experi-
ence, I learned two essential things: 1) you have to teach to different
learning styles, and 2) digital content helps tremendously!
For example, when you learn certain subjects, you may already
be experienced in certain things like leadership, management,
human resources, and other business topics. Accounting and
finance are usually a foreign world to most students. Students are
not aware that they have some thinking and experience connections
to this subject; thus, I found it helpful early on to connect the mate-
rial to their lives. For instance, explaining to a student why they
have a debit card at their bank is linked to how accounting logic
works. Frankly, most people do not see how the world of finance
x vii
x viii P refac e

and accounting is something they encounter daily, and they may not
realize the connection.
It is best to supplement your reading of the material with other
resources. For example, as you study a concept, you can increase
your knowledge by searching for YouTube videos on the subjects.
I am not the only subject matter expert, and you gain new perspec-
tives by listening to various sources. Having alternatives to learn-
ing can break up the monotony of reading words on a page all the
time. Many students have told me that the video content and pod-
cast episodes make it easy to learn when on the go, thus creating
more opportunities for the information to sink into the thinking
pathways.
In addition to all the learning strategy approaches, none is as
important as the underlying book. As I delved into the world of
curriculum design, there were no textbooks that addressed the non-
financial professional. There were a few on Amazon, and I relied on
them at first. As different textbooks publishers met with me over
the years, I would reiterate that a textbook for the non-financial
manager does not exist in their catalog.
Eventually, Taylor & Francis Group saw my vision for a book
written specifically with IT managers and entrepreneurs in mind.
A written text would bring together the learning strategy, the tools,
and the specific accounting and finance situations these profession-
als could encounter.
In this book, you will learn about this subject in the methods that
I find most beneficial to the non-financial professional. You will
engage with the concepts, and you will take action in various ways
to learn the materials. But the most important thing of all – prac-
tice. It is in the DOING that you learn best. I know because I help
non-financial professionals do precisely that in my career!
Acknowledgments

First and foremost, I want to thank Barbara (Johnson) Elmore. As

a kid, I never thought I would ever learn math. While the account-
ing world is not a math challenge, it is a conceptual challenge, and
I learned from Barbara that the TEACHER MATTERS when
learning technical subjects. Without her, this book would have
never happened.
Furthermore, there are scores of students that have participated
in courses that I have taught who never wanted to learn anything
about the world of accounting and finance. These students often
did not see the value of learning this subject matter. However, my
mission was to help them embrace the numbers, to help each stu-
dent know that they could gain an advantage in the world if they
allowed me to teach them some new skills. A vast majority of those
students accepted the challenge. While I cannot name every single
one of you, I am forever indebted to your willingness to step up to
the plate! My teaching goal led me to many teaching discoveries to
get the information across to students.

xix
xx Ac k n o w l ed g m en t s

A huge thank-you to Daniel Kershaw, the editorial assistant to

Taylor & Francis Group. There are so many books out there for
accounting and finance professionals. He had the vision to see a
much bigger market for the non-financial professional to learn how
to leverage the information contained in this book!
Abbreviations

EBITDA Earnings Before Interest, Taxes, Depreciation, and

Amortization
EBIT Earnings Before Interest and Taxes
GAAP Generally Accepted Accounting Principles
IFRS International Financial Reporting Standards
SBA Small Business Administration
SCORE Service Corps of Retired Executives
SEC Securities and Exchange Commission

xxi
Definitions

10-k is a financial report that publicly traded companies provide to

the Securities and Exchange Commission and therefore are avail-
able to the public for analysis.
Accounting is the structure and mechanics that create the financial
numbers in a business.
Accounting equation is assets = liabilities plus stockholder equity.
This equation represents the three sections of the balance sheet.
Accounts payable is a current liability account on the balance sheet
representing the total amount of bills owed by the company to
creditors.
Accounts payable turnover ratio is a ratio that can be calculated
and tells you how often you are paying off the accounts payable
balance within a year (a use of cash).
Accounts receivable is a current asset account on the balance sheet
representing the open invoices paid by a company’s customers.
Accounts receivable turnover ratio is a ratio that can be calculated
and tells you how often the accounts receivable balance turns into
cash (a generation of cash).
Accrual basis of accounting is where you will record a transac-
tion for your financial statements even if that transaction has not
affected the cash balance in your bank account yet.
xxiii
x xiv D efiniti o ns

Activity ratios are the ratios that track the working capital man-
agement performance of the company. Activity ratios include
ratios of accounts receivable, accounts payable, and inventory.
Allocation is a methodology that a company uses to split indirect
costs by hours, production units, or other cost drivers.
Amortization is how an intangible assets cost is spread out over
time.
Approval authority is an internal control that specifically and
explicitly states who can purchase what and how much for a
company.
Asset access controls is an internal control strategy that ensures
that assets that have a value that could cause theft are handled in
ways that ensure they are not stolen – including asset tags, inven-
tory counts, and restricting access by locked storage.
Assets are items that have value to a company that can be used to
generate cash flow. Assets can include property, buildings, truck
or car fleets, machinery, inventory, among many.
Audits are a common practice whereby accountants examine the
business standard operating procedures, especially those that
impact assets, for adherence to policy as a way of determining if a
company is at risk with the management of any of its assets.
Balance sheet is a financial statement that gives you information
about a business’s assets, liabilities, and equity.
Budgeting is a process by which a company, department, or busi-
ness section forecasts its revenues and expenses.
Cash basis of accounting is where you will record a transaction for
your financial statements only when the transaction has impacted
the cash balance in your bank account.
Cash conversion cycle is a metric that combines information
regarding accounts receivable, accounts payable, and inventory to
examine how well these working capital accounts are turning and
generating or using cash in the business.
Cash flow statement is a financial statement that analyzes how
cash has been generated and used in the company. This is a
reconciliation of the cash balance that exists on the balance
sheet.
 D efiniti o ns xxv

Common stock are offered to the public for an ownership stake in

the company. This is a way that a corporation can generate cash by
making new offerings of stock on the stock exchange.
Contractors are individuals you hire that are paid separately from
payroll and they may only work for you for a project or a shorter
period time. Contractors receive a 1099 a year-end.
Cost driver is an activity that drives costs to go up or down.
Example: Hiring new employees is a driver of costs of software
subscriptions, salaries, healthcare, etc.
Cost of goods sold represents the costs of manufacturing or assem-
bling the products sold or the costs of the services the company
provides to consumers.
Current assets are the assets converted to cash in the time frame of
a year or less. These include cash (which is are already in its final
form of cash), accounts receivable, and inventory.
Current liabilities are the bills due for a company in a time frame
of a year or less. The most common account in current liabilities is
the accounts payable balance.
Current ratio is a ratio that examines a company’s ability to pay its
liabilities in the short term (a year or less).
Cycle counting is a methodology that some companies use to
manage inventory count. Rather than counting all inventory once
a year, you will divide your inventory into categories looking at
the value of the inventory and the turnover rates.
Days sales in inventory is a metric that turns the inventory turn-
over rate into how many days it takes to turn inventory into cash.
This is a metric that then can be used in calculating the cash
conversion cycle.
Days payables outstanding is a metric that turns the accounts pay-
able turnover rate into how many days it takes to hold on to cash
in the accounts payable balance. This is a metric that then can be
used in calculating the cash conversion cycle.
Days sales outstanding is a metric that turns the accounts receiv-
able turnover rate into how many days it takes to turn accounts
receivable into cash. This metric that then can be used in calculat-
ing the cash conversion cycle.
x xvi D efiniti o ns

Debt to equity ratio is a metric that assesses how much financing is

going on in the company through debt or equity.
Debt to assets ratio is a metric that assesses how much the total
assets of a company are financed through debt.
Deferred revenue represents revenue that cannot yet be recognized
on the profit and loss statement.
Depreciation is a method of expensing a tangible asset over its use-
ful life.
Direct costs are those costs that can be traced directly to your
product or service.
Discretionary income or loss is a term used by individuals to show
the amount of money left over after all bills have been paid. It is a
comparable concept to thinking about the net income or loss that
a company earns.
Draw is an amount of money that a small business owner may pull
out of the business rather than taking a salary from the business.
Earnings Before Interest and Taxes (EBIT) is a number that
shows you how well the operations are doing in a business. While
interest and taxes occur in a business, those are not operating
expenses.
Earnings Before Interest, Taxes, Depreciation and Amortization
(EBITDA) is a number that takes out the effect of non-operat-
ing expenses of interest and taxes and takes out non-cash expenses
of depreciation and amortization.
Employees are people that work for you part-time or full-time and
are paid through a payroll system.
Equity is a section listed on the balance sheet. Equity represents
the buildup of the company net worth through selling stocks (if
the company is publicly traded) and retained earnings (the accu-
mulation of the net profits and losses over time).
Equity to assets ratio is a metric that assesses the company’s equity
compared to the total assets.
Expenses are on the profit and loss statement.
Finance is the interpretation and strategies of the financial num-
bers in a business.
Financing activities are represented on the cash flow statement
that shows how a company is generating or using cash through
 D efiniti o ns x x vii

debt. These balances can represent loans from banks or bonds

issued to investors that must be paid back.
Finished goods inventory represents products that are ready to sell
to customers. These products often are produced using raw mate-
rials or component parts inventories.
Fiscal year represents the time frame of a year that the company
uses to generate financial statements. Not all companies start
their fiscal year on January 1.
Fixed Assets (syn. property, plant, and equipment): Assets like prop-
erty, buildings, machinery, fleets of autos, or other assets help a
company in its operations. These assets will be owned for more
than one year.
Flexible budget is one where you develop several versions of bud-
gets, based on various assumptions about inputs and outputs to
determine which version best matches the reality of the actual
financial performance.
Free cash flow is the amount of cash on hand that has no “demand”
on it and thus the company can use it for any purpose. Think of it
as the companies “emergency fund.”
Gross margin The gross margin represents the difference between
total revenue minus cost of goods sold. The gross margin is the
money that is used to cover operating expenses, income taxes, and
interest.
Gross profit margin ratio is a metric that show the ratio of gross
profit to revenue. This number represents every dollar of revenue
that will cover operating expenses, interest, taxes, depreciation,
and amortization.
Headcount is the total number of employees you have as well as
projected headcount in a budget. This can also include contractors
for budget line items that use contractors.
Historical averages is a method to look at averages to establish a
budget forecast for a line item.
Horizontal analysis is a methodology of seeing how different
accounts on different financial statements changed over time.
Income is the amount of money an individual brings into the
household. This is compared to revenue for a corporation to
ground concepts in finance for businesses.
xxviii D efiniti o ns

Income statement (syn. profit and loss statement, P&L, statement

of operations). An income statement is a financial statement that
businesses use to capture the profitability of the company. This
financial statement includes revenue minus expenses equals the
net profit or loss.
Indirect costs are the costs we know go to servicing clients or man-
ufacturing products, but it is harder to trace these costs directly to
the client or product.
Internal controls are procedures and documentation used by busi-
nesses to ensure that the company’s assets are protected from
theft or other misuse.
Inventory is an account on the balance sheet representing the total
value of items that are eventually sold to customers. There are dif-
ferent types of inventory and a company may have replacements
parts for machinery that are never sold.
Inventory turnover ratio is a metric that determines how many
times in a year the company is turning its inventory balance into
cash.
Investing activities represent a section on the cash flow statement
that shows how a business generates or uses cash from investing
activities. Investing activities can be investments into certificates
of deposit or treasuries and this can include the investments that
a company makes into long-term assets.
Liabilities is a section on the balance sheet that represents short-
term and long-term liabilities. This section will include the bal-
ance of bills that are owed to suppliers, and longer-term loans
and debts.
Limited Liability Company (LLC) is a legal form of business that
protects you, as an individual, from increased exposure of legal
liability.
Liquidity ratios are metrics that look at the short-term liquidity of
the company. Another way to think about it is how well a com-
pany can pays its bills in the short term.
Long term is a period of time that is longer than one year.
Long-term assets are the assets of value that will be on the balance
sheet for more than a year. This can include items like machinery,
property, equipment and other assets that are considered fixed
 D efiniti o ns x xix

assets. The most common account is called property, plant, and

equipment (i.e., fixed assets).
Long-term liabilities are the liabilities of a company that will be
on the balance sheet for more than one year. This can include
bonds, loans, and other items.
Master budget represents the organization’s overall goals in terms
of expectations and forecasting of those goals into monetary
terms. The master budget then cascades down through the orga-
nization into departmental budgets, capital budgets, sales bud-
gets, etc.
Modeling is the development of forecasting, budgeting, or other
financial models. These are often developed in Excel, or they pass
through Excel for data transformation to get loaded back into
financial software.
Net income or loss (syn. net profit or loss): This is a line on the income
statement (or profit and loss statement). This is the bottom-line
number after all expenses have been deducted from revenue.
Net profit margin ratio is a metric that assesses how much money
is left over after all expenses have been deducted from revenue on
the profit and loss statement.
Net worth statement is similar in concept to the equity that is
built up in a company. Net worth is the term used to apply to a
person.
Obsolete inventory is the inventory that no longer has a purpose
in production, or maintenance, or has met an expiration date.
Operating activities is a section on the cash flow statement. This
section represents the operating activities of the business itself –
selling products and services and managing all of the processes
for the order to cash cycle and the procurement to payment
cycle.
Operating expenses are the expenses that a company incurs that
are not directly related to the direct sales of products and ser-
vices. Another way to identify these expenses are the expenses
that occur even if a sale does NOT occur.
Operating income is the amount (operating income or loss) left
over after costs of goods sold and operating expenses have been
deducted from revenue.
xxx D efiniti o ns

Order to cash cycle is a concept that describes the entire process of

customers ordering product, the company delivering those prod-
ucts, and turning the sales into cash.
Period of time is a naming convention that happens on financial
statements. For example, a profit and loss statement represents a
period of time, which can be a month, a quarter, or a year.
Physical counts are a practice of internal controls to ensure that
inventory is valued appropriately and being used appropriately.
Procedures are the documentation of internal controls. All inter-
nal control procedures should be documented and available upon
request. Auditors (both internal and external) use these to verify
if procedures are being following as outlined.
Procurement to payment cycle is how a company purchases prod-
ucts and services and then pays for those products/services.
Profit and loss statement (syn. income statement) A profit and loss
statement is a financial statement that businesses use to capture
the profitability of the company. This financial statement includes
revenue minus expenses equals the net profit or loss.
Profitability ratios are metrics that are used to assess the profit-
ability of a company.
Property, plant, and equipment (syn. fixed assets): Assets like prop-
erty, buildings, machinery, fleets of autos, or other assets that help
a company in its operations. These assets will be owned for more
than one year.
Quick ratio is a metric that assesses how well a company can pay its
bills in the short-term. However, this is different from the Current
Ratio because it takes out the effect of the inventory balance.
QuickBooks is a software product that is very popular among
accountants for small business books and reporting. It is pro-
duced by a company called Intuit.
Ratios are metrics that examine various different accounts on the
financial statements to assess a company’s financial performance.
Raw materials inventory is an inventory of individual parts that
will be used to produce a finished good. For example, if you
build computers, you would have microprocessors, other boards,
screens, and various other raw materials that go into the produc-
tion of the computer.
 D efiniti o ns xxxi

Reconciliations is a method by which a company can ensure that

its assets are fairly represented on the balance sheet.
Retained earnings is an account in the equity section of the bal-
ance sheet where the net profits and losses accumulate over time
from the profit and loss statement.
Revenue represents the sales of products and services of the com-
pany for the period. (syn. sales, total sales, net sales)
Revenue recognition is a technique that companies use to deter-
mine when a sale will be represented on the profit and loss
statement.
Segregation of duties is an internal control that reduces risk of loss
of assets by diving up work among several individuals.
Short-term (current) is a time frame that is under one year.
Sole proprietor is the simplest form a business to create.
Solvency ratios are metrics that assess the long-term performance
of a company. You can use these ratios to assess if the company
will continue to operate into the foreseeable future.
Static budget is a budget that only has one version based on the
best assumptions and modeling available to the company.
System access controls is an internal control that assesses
who needs access to what systems and functions within a
company.
Trendline analysis is a methodology by which you look at histori-
cal performance to establish financial data patterns to help fore-
cast a budget line item.
Variance analysis is the process of comparing a financial plan ver-
sus the actual financial performance.
Work in process inventory is an inventory that is between raw
materials and finished goods. In other words, a computer may
be in the assembly process and that would be inventory that is a
work in process.
Working capital is a word that is the management of the cash,
accounts receivable, inventory, and accounts payable balances.
Working capital management helps you assess how well a com-
pany turns inventory and accounts receivable into cash and how
long you can hold on to cash before paying off the accounts pay-
able balances.
 Part One
W hy B ein g Finan cially
S av v y M at ters

Most of the time, if you are a non-accounting and non-finance pro-

fessional, you can get through most days of your life without having
to think much about topics that touch the finance and accounting
world. However, as you move through your professional and per-
sonal life, there will be times when you absolutely should be famil-
iar with accounting and finance terminology.
There is nothing worse than finding yourself in a professional
situation where you do NOT take action because you do not under-
stand this world. You get caught with financial repercussions in a
role where having a baseline understanding of these concepts would
have helped you avoid pain or embarrassment. The book aims to
prepare you for financial situations you encounter in your career
progression and how to utilize all resources for your learning.
In Part One of this book, you discover the many reasons why you
can help yourself achieve more in your career and personal life if you
embrace learning the world of finance and accounting. Of course,
you are not training to be an accountant. Instead, you gain confi-
dence in interpreting accounting and finance information that you
could encounter in your life, professionally and personally.
Additionally, you work on various situations that prepare you for
what would require you to understand the financial impacts of the
decisions and choices you can encounter through your professional
and personal life. For instance, you will have professional choices,
such as taking on a job that requires a certain amount of finan-
cial savvy, or you will have personal decisions about investing your
hard-earned money. Either way, you want to be prepared for those
moments!

DOI: 10.1201/9781003110613-1 1
2 FIN A N CIA L IN T EL LI G EN C E

Included in this landscape, you will also be thinking about

when it might be a good time to move on from an employment
situation. People have been surprised with a business closing, and
few employees saw it coming. You do not want that to be you! For
instance, during the financial crisis in 2009, General Motors went
into bankruptcy proceedings. Was it possible to see this coming?
Yes, there were clues, especially in the cash flow statement.
Finally, this initial introduction will give you an idea of how you
can learn this material. Learning this material is NOT hard, but it
does require practice. Thus, you learn the background of why this
topic is important and how the book presents your learning oppor-
tunity, but you follow a road map on how you can train yourself in
learning these topics.
As you start on the topics in this introductory section, some of
the information resonates with you more than others. When you are
learning accounting topics in other areas of the book, if you are trig-
gered emotionally by understanding the material because of match
anxiety or other challenges – come back to this section as often as
possible. Figure out which myth or trap about learning this mate-
rial is tripping you up and re-set your determination. Many students
have learned this material and gain a lot of confidence, and I am
sure you can add your name to the list!

Topic 1: How Financial Clarity Gives You Professional Leverage

Why would anyone other than a geeky, numbers-oriented, pocket

protector-wearing individual want to know anything about the
world of accounting and finance? You might be thinking, “I can
have a perfectly nice career not knowing anything about this topic.”
Why should you be open to this information that can bring tangible
results to your life and career? Here are a few very tangible reasons
to learn about this topic, no matter what your training or back-
ground may be in the world of finance and accounting.
Since learning is an activity that requires an investment of time,
anyone learning a subject must identify reasons why you want to
invest in a topic of study, especially since accounting and finance are
topics that, on the surface, feel too difficult to comprehend. As you
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 3

read these reasons, your job is to assess how much these ideas align
with your circumstances. Any learning inquiry must have a signifi-
cant “why,” or you will not follow through with learning.

Do You Know If Your Employer Could Be in Trouble Financially?

In 2001, Enron Corporation went bankrupt1. In the process, employ-

ees lost their retirement funds. Could this happen to you? Is it inevi-
table that we are at the mercy of others and their financial decisions?
Was it possible for Enron employees to question what was going on
and have had the insight to see the financial consequences beforehand?
Employees can study company financials and see these troubling signs
in the financial performance of a company. You have to learn from
financial debacles like Enron and other companies to know what the
warning signs are to make your own decisions about staying or leaving.
Along the way, when a company is setting itself up for failure,
there can be signs of financial distress. The bankruptcy of Enron took
a while to arrive. Plus, some decisions do not look like an issue on
the surface. In some cases, you may not know exactly how a financial
decision is executed. However, the more you study companies you
work for and their financial decisions, you will start to see patterns
that can cause you to pause and reflect. While you may not know all
of the details, you can train your brain and your gut to sense when
something might be going wrong, and then you can make your own
choices that are best for you, your family, and your career.
Part of your understanding of what to look for will come with a
consistent analysis of a company. There are things to think about all
along the way. One thing that will help you find these issues is the
book sections that show you how to do ratio analysis. However, as
you study a company over time, you will become very familiar with
their performance, and that is crucial to noticing something going
askew in the financial decisions the company is making.

Do You Want to Start Your Own Business?

Starting a business may be your goal. Starting a business may

require a significant investment of energy from a person in time and
4 FIN A N CIA L IN T EL LI G EN C E

other resources. Small businesses often fail because of fiscal man-

agement challenges, especially in terms of cash flow management.
Thus, learning about the financial aspects of planning and running
a business is crucial to your success. In starting your own business,
you will want to know some specific things about finance, such as
planning finances, assessing financial statements, and the essentials
of cash flow management. People have started businesses with vary-
ing levels of financial understanding. Still, those who are successful
over time have to understand finances even if they do not keep the
books and do the accounting.
In starting your own business, you may want to purchase an
existing business. One of the reasons you may want to do that is
because you do not want to go through the start-up pains. However,
you will want to know how to read financial statements and specific
questions you want to ask about the business’s financial model in
purchasing a business. In this book, you will learn how to do these
critical pieces of analysis, OR at the very least, you will feel com-
fortable hiring a professional to help you!

Do You Want to Grow Your Business or Otherwise Invest in Other Businesses?

For some individuals, you want to study financial information

regarding companies that you can invest in with the stock market.
Examining financial information is a fundamental analysis that can
help inform you about your investment decisions. For most people,
these decisions are made by fund managers, and then you can buy
into a fund of different stocks. But someone is doing this analysis,
and you can learn how to do this analysis if you want to make your
own decisions about investing directly in companies.
In addition to investing through stocks, you may own a busi-
ness someday and decide that you want to grow your business.
One way you can develop a business is to purchase another com-
pany like yours or invest in a complementary business. When you
merge with or acquire another business, you will need to assess
financial information and dig into the financial backbone of the
company. Either way, you will use the same approach for financial
analysis.
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 5

The ratio analysis we conduct in the book will give you insight
into any company for investment purposes. At first, doing ratio
analysis may feel tedious because you have to build your template,
and training your mind to understand the numbers can feel daunt-
ing at first. However, the book teaches you how to think about these
numbers, what they represent, and what they tell you about financial
performance. The key to understanding is practice, which is why I
suggest practicing on a company your work for or have worked for
so that you have the context for these numbers, and that will build
your confidence as you start to look at another company.

Do You Desire to Obtain a Managerial, Directorial, or Executive Position?

Some individuals enjoy being in a contributor role in a company.

However, for some, the goals are higher. Some people want to
move up into management or become a department director or an
executive. Regardless of the level of employment, you can impress
an interviewer by having some knowledge of the financial aspects
of a company. This strategy can be as simple as having read infor-
mation about a product or service that has been having challenges,
and you can ask them about the gross margins on the product. Or
that you have seen particular financial performance in the head-
lines, and you can ask an intelligent question about that to a poten-
tial employer.

Topic 2: How Understanding the Numbers Gives You an Edge

It is possible to have great careers and escape having to engage with

numbers, but there is a high likelihood that as you advance, or if
you want to start your own company, numbers will become a part
of your life. It is possible to have an excellent accounting resource,
such as an accountant, to work with, but to empower yourself is the
purpose of this book. You may still want to employ an accountant,
but you will be much more in control if you understand what to
look for and how to monitor an accountant. No matter your career
trajectory, having a baseline of financial literacy is essential to your
career path.
6 FIN A N CIA L IN T EL LI G EN C E

The Difference between Finance and Accounting

Accounting is a specific discipline that encompasses all of the build-

ing blocks of how financial information is created. In this book, you
will primarily NOT be learning accounting because a large part of
the accounting world is about journal entries, preparing reconcili-
ations, and preparing financial statements. Generally, accountants
will be tasked with those activities. You will learn specific terms
associated with the accounting world so you can ask questions or
resolve issues, but you will not be learning the rules of debits and
credits, for example.
Finance is the world that encompasses how you use financial
information to make decisions in a business. These worlds do over-
lap, but essentially, you will be more focused on the finance side of
this world than the accounting side.
For example, a CFO (chief financial officer), if your company has
one of those, will be in charge of all of the accounting and finance
functions within the company. Thus, all finance and accounting
departments will report up to that role. However, the accounting
and finance functions will be split among smaller groups.
Accounting departments would be functions like groups that
process accounts payable, auditing departments, manage cost
accounting, or process accounts receivable. Finance departments
may be functions like capital budgeting, mergers and acquisitions
departments, or financial reporting.
In a small business, all of these roles, or departments, might
be housed in only a few people who wear multiple hats and per-
form many of these roles rather than separate departments. A
small business will possibly contract out for these roles when
they need them.

Utilizing Your Financial Resources Effectively

Besides knowing the numbers and what they mean, you also want
to consider how you will take advantage and leverage all the finan-
cial resources you have at your disposal. For example, do you know
where to find financial information on a company? Do you have a
relationship with financially literate people?
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 7

Part of your work to increase your financial literacy is to learn

where financial information is located and how to assess that finan-
cial information. Talk to people about this information, and the
more you do this, you will find that you will understand a lot more
about this world over time. These habits will help you to develop
your knowledge and develop a gut feel for the numbers.

Break Down Silos

We live in a world that encourages people to have specialized knowl-

edge. This approach is great for team members in an organization
because you want highly specialized people. However, as you move
up in an organization, or if you are going to be an entrepreneur,
you may still have special skills, but you will have to learn more
about other aspects of a business. As an entrepreneur or business
executive, you want to develop relationships and leverage your time
through other individuals. Whether these individuals work for you
or not, if you cultivate these relationships in the right way, nothing
can get in your way of achieving what you want to achieve in busi-
ness. Even as a team contributor, utilize this time to get to know
accountants. There will be tips on what kinds of questions to ask
throughout the book, just to help you get started.

Understanding Financial Decisions and the Connection to Financial

Performance

If you decide to buy pens for your business, do you know where that
shows up in a financial statement? How about purchasing a com-
puter? What if you take out a loan at the bank? What if you need
a truck or car for your business? Do you know how to handle that
transaction and what it means for your income statement, cash flow,
or balance sheet?
You may not know right now, but you will by the time you fin-
ish the book. When you know how the financial statements work
together as a complete financial information package, you will have
a wealth of knowledge that will set you apart in your career. You
will know how any decision you make will impact the financial
8 FIN A N CIA L IN T EL LI G EN C E

statements. That is informational power that will help you make

solid decisions regarding spending, saving, or investing your money.

Assess Promotional Opportunities

At some point in your career, you may find that the next level of
promotion will require you to understand some financial informa-
tion. This knowledge gap could be the concept of budgeting, and it
could be expense management, or a capital budget, to name a few
possibilities. Does that intimidate you? Does it strike fear in your
heart?
With this book, you will be able to understand more about how
to manage these tasks. You will be able to establish a framework by
which you can understand the mechanics and utilize your resources
to address these matters with confidence. Plus, if you are poten-
tially responsible for a department or division, asking for financial
information to prepare for an interview is a solid strategy. Then you
can prepare questions that will show that you can assess financial
performance. There would be nothing worse than taking on a role
that no one told you of the financial challenges the group was hav-
ing, so you want to be prepared to take on roles with a complete
understanding of the financial landscape.
In addition, even if a particular role does not ask you to know
about these financial topics, you can include questions about prod-
ucts, services, and management of the company by showing that
you do understand these topics. The interviewer may not know the
answer to your question BUT asking the question will be impressive.

Topic 3: Why Numbers and Accounting Can Be Confusing

You may have tried to learn accounting and finance in the past.
Accounting and finance are typically NOT intuitive to learn.
Students in accounting and finance classes may have convinced
themselves that certain truths exist for not understanding this field
of study. However, often these reasons are MYTHS. Part of the
job of this book is to debunk these myths and provide you with a
roadmap of how you learn this subject.
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 9

Myth #1: “I Cannot Learn This Subject Because It Is Math-Based”

While accounting and finance have math involved, you are never
expected to do anything beyond simple math. For example, you will
need to add subtraction, multiplication, or division in this subject
area. You may need to do percentages. However, that is about as
complicated as it gets.
The true challenge that accounting and finance present to some-
one trying to learn this subject is that you must understand the con-
ceptual framework of accounting and finance to make sense of the
math. One of the hardest things to learn is the reason for debits and
credits; however, we will not dive into that within this book because
those rules of debits and credits are most important to a person who
creates journal entries. In this book, the audience is intended to be
someone that needs to USE and INTERPRET financial informa-
tion AFTER all the journal entries have been completed. Therefore,
as you go through this book, any accounting or finance concept will
be explained in a way that connects you to a concrete understanding
of the concept. Then the math will be fully explained so that you
will know the conceptual framework and the specific application to
practice with confidence.

Myth #2: “I Cannot Learn This Subject Because I Am Not Smart”

There can be several reasons why a student may feel this way. One
reason might be that the student has never been successful in more
“technical” courses. Another reason might be that a student has not
done well academically. The bottom line is the teacher can often
matter a great deal in how a student learns a subject. My profes-
sional teaching life has been devoted to finding the best ways for
students to learn this material. My passion for this subject and my
dedicated energy to helping students learn have made me successful
at teaching this subject. The only students I cannot help are those
that refuse to learn the material, and there have only been a handful
of students like that in my professional career.
Everything we touch has financial implications to our lives –
including being employed by a company or starting your own
10 FIN A N CIA L IN T EL LI G EN C E

business. Thus, learning this topic can give you an edge in your
personal and professional life. To get there, you must have the fol-
lowing ingredients: a willing student (you), an engaging teacher
(me), and the time to practice. Each of these ingredients is equally
important. It is rare to learn this field in one lesson or one class,
but if you practice, over time, you will gain a solid understanding
of the field and what matters to you, and you may very well be
surprised at how much you know. I am willing to bet that if you
engage with this material, you may be listening to the news or the
radio and hear financial information presented, and you WILL
realize just how knowledgeable you are in this world of accounting
and finance!

Myth #3: “I Cannot Learn This Subject Because It Is BORING!”

While it could be true that any subject is boring, sometimes that

viewpoint comes from not having the right teacher for you. You may
NOT have known that you could not learn the subject because of
the instructor.
An example from my background: I thought I could not learn
math. I struggled with math in my early education. I remember
being in first grade, learning fractions, and the information would
not go in my head. From that time on, at times, I would struggle
with math classes. I wanted to go to college and knew that I needed
higher levels of math even to be considered for college, so I kept
subjecting myself to increasing levels of math classes.
Early in high school, I took algebra I and geometry. I barely sur-
vived them. I probably passed because of a grading curve applied by
the math teacher. You do not have to know any upper-level math
to learn finance and accounting! I am only giving you an example
to show WHY the teacher matters in learning certain subjects.
In algebra I and geometry, I had a teacher that could get off
topic easily. It became a game for my class to ask him questions
about politics to divert him from his lecture on the subject material.
This strategy was often successful. Thus, I was often left to try and
teach myself this subject matter. That is NEVER a good learning
environment.
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 11

When I came into my final years of high school and took alge-
bra II and trigonometry from a DIFFERENT teacher, I found out
why. This woman showed me why a teacher matters in teaching
certain subjects. She not only loved her subject, but she also knew
how to reach ME. That is extremely important. She knew how stu-
dents could struggle, and she would frame information in a way that
could reach my brain.
The bottom line is this: I find accounting and finance fascinat-
ing. I want to pass that love for this subject over to you so that you
KNOW, without a shadow of a doubt, that you CAN learn and
apply this subject. You do not have to know everything about it to
be effective, but if you know that you have a solid foundation to
build upon, then there is no stopping you from your professional or
personal growth.

The Truth of Why Accounting and Finance Can Be Challenging to Learn

First, accounting and finance is a conceptual framework. Have you

ever learned card games or board games? Is it possible to learn how
to play chess using the rules of checkers? It would be impossible
to learn chess by using the rules of checkers. We know that intui-
tively. The same is true for accounting and finance. If we try to learn
accounting and finance by the rules of math, we are already setting
ourselves up for failure. Some of the rules of accounting and finance
run counter to any math rules.
Second, accounting and finance, while there are guidelines
around the discipline, they are just guidelines. The rules of finance
and accounting sometimes are not governed by law – and even if
there is a law, as you know, the “interpretation” of the law can mat-
ter. Many students want accounting and finance to be clear in the
“right” or “wrong” application of the information, and you will often
not find that to be true in this world. Just as we hope the discipline
of law to have clear “right” and “wrong,” you hear many times of
cases being thrown out of court on technicalities or someone win-
ning based on the interpretation of a single word. The same is true
in the accounting and finance field. There can be laws that govern
this field, and there are guidelines, and thus, it can be infuriating to
12 FIN A N CIA L IN T EL LI G EN C E

a student that sometimes there is no clear answer. Accounting and

finance tend to be taught based on “right” and “wrong” answers, but
the truth is, financial performance is a continuum. The more you can
accept that, the better you will be able to engage with this information.
Finally, in this world of finance and accounting, there is a lack of
standard terminology. Several times in this book, there will be an
alert about how various accounts are named or Google information
in this book and find different methodologies of doing the same
thing. This challenge is probably the single most infuriating thing
for a student. However, the book will point these traps out to you to
avoid these pitfalls in your learning.

Bottom Line

At the end of it all, know this: I have worked with hundreds, possi-
bly even thousands, of students and clients from many backgrounds
and educational levels. If you want to learn this subject, I want to
teach it, and that combination will make a successful learning envi-
ronment for you.

Topic 4: How the Book Is Arranged for Your Learning Journey

It is important to understand the types of activities you can engage

with in the book and the format of how the information will be
presented for your learning. This section will learn about the differ-
ent strategies employed in the book to help you apply and learn. It is
important to know that application is where the learning occurs – it
is in the DOING that you know you can APPLY the information.
Think of it this way, simply reading about this subject may advance
your skills, but applying the skills will help you know that you can
USE the information successfully.

Regarding Readers in Different Countries

This book centers on experience and the rules of accounting in

the United States. However, there are two major approaches to
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 13

accounting guidance and rules in the world – the Generally Accepted

Accounting Principles (GAAP) approach and the International
Financial Reporting Standards (IFRS)2.
The purpose of this book is not to teach the differences in rules
between the two approaches. The purpose of this book is to teach
you how to THINK about what you will find in financial state-
ments. For example, regardless of country, the first item on a profit
and loss statement of a for-profit business will be the sales or reve-
nue of the company. In that sense, the information will be the same.
However, under IFRS versus GAAP, the treatment or guidance on
revenue recognition may be different.
This book aims to teach you what revenue is, what revenue rec-
ognition is (among other topics), and to have you feel comfortable
reading financial information contained in financial reporting. As
you dig deeper, it is expected that you will always have questions,
but one book will not cover everything you could need to know.
However, this book will teach you where to find information and
identify resources of groups and individuals you can contact as your
knowledge of financial intelligence deepens.

Relating Personal Finance to Corporate Finance

One excellent way to start learning about the world of finance is

to find a place in your own experience to connect the learning to
make sense of this framework. The best way to do this is to connect
the world of company financial information to your personal finan-
cial information. Now, some of you who read this book may never
have learned about your financial situation. However, throughout
the book and the examples, one method to help you learn will be
to relate what you are learning to your financial situation. This may
require you to do a bit of extra work to determine your own personal
financial situation for some of you. At the same time, this is not a
required element of the learning journey.
For example, we may have a budget for each of us, individually
or as a family. Maybe we keep track of all money coming into our
household and all money going out of the household. Thus, our
14 FIN A N CIA L IN T EL LI G EN C E

budget will look something like this (we will go into much more
detail later in the book) (Figure 1):

Figure 1 Example Personal Income Statement

For a company, their profit and loss statement will look similar
(Figure 2):

Figure 2 Example Company Income Statement

For us, as a household, we plan on hopefully having some discre-

tionary income left over at the end of the month, just as a company
is looking to have some net income left over at the end of a month.
Now, this is rudimentary, just to show you that the process is simi-
lar. There are many nuances to learn here, but the mechanism, or
the framework, is almost the same. Thus, if you have a budget or
know your financial picture, you can use methods in this book to
assess your finances, which is a great learning anchor.
Consider the balance sheet and a household (we will go into
much more detail later about the specifics of this financial state-
ment). An individual or home has (Figure 3):

Figure 3 Example Personal Balance Sheet

 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 15

For a company, the same approach holds true, with slightly dif-
ferent naming conventions:
A company has (Figure 4):

Figure 4 Example Company Balance Sheet

What to Watch Out For

Periodically, you will see notes about “what to watch out for.” This
strategy is related to the fact that terminology can be such a problem
in learning this subject. Thus, there are words and terms used in the
book that can be called different things. Non-standard terms are
confusing to students in the beginning. Once you learn the alterna-
tive names, it will be easy from that point forward not to be con-
fused by different terms that mean the same thing.
For example, above, in the examples of the income statement and
the balance sheet, the mechanism is the SAME. Still, the wording
is slightly different between a household financial situation and a
business situation. Thus, knowing that discretionary income for a
household is the same idea as net income for a business. For a bal-
ance sheet, the net worth for a household is the same idea as the
equity built up in a business.

Examples

As each term or topic is discussed, you will be given resources to

understand everything. This approach includes relating the infor-
mation to personal examples, but you will also be studying an infor-
mation technology business. The examples will include a company
that is traded on one of the major stock exchanges and a small busi-
ness examples.
16 FIN A N CIA L IN T EL LI G EN C E

Context

As you learn each topic, term, or calculation, you will be reminded

of the context of why you are learning. Either as an employee, an
investor, or as an entrepreneur, most of the time, the reasons to learn
the topics are the same, and sometimes there are slight differences
in how one person may view information versus another person.
Remember, most books and textbooks are written for the account-
ing and accountant community. Thus, even in college preparations,
the average manager does not learn much about accounting and
finance relevant to their job. This book is focused entirely on how
you can decipher financial information and be aware of how you
may interact with this information in your career aspirations.

Exercises

Not only will you have examples shown to you in the book, but you
will also have opportunities to practice on your own. It is recom-
mended that you practice as much as you can and get into a pattern
of practice. The book will give you guidelines on how this can be
done and how your practice can become part of your life to not
feel like a heavy burden. By consistently studying this information,
you will find that news about companies and their financial perfor-
mance will take on a new meaning and have much more clarity for
you. That, alone, will grow your confidence more than anything.

How to Learn

Throughout the book, there will be pointers and viewpoints about

how to learn this material. These are models that give you a way
of understanding the learning journey that you are going through,
which can be very helpful in understanding the entirety of the
learning process and this material.
Remember, some subjects are a little more relatable to our lives.
For instance, if you learn about leadership, we often have experi-
ence of good and bad leaders. Thus, when we read information about
leadership theories and leadership strategies, we have a place for
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 17

information to hook onto in our brains. However, with accounting

and finance, we may have learned a little bit through our personal
lives, but there are not many “hooks” in our mind for this information
to flow to, so we have to build the learning channels along the way.
Ultimately, the BEST way to learn this material is to read or
watch a video about a topic, watch a video or read material on
exactly how to think about a process and any calculations that go
along with the topic, and then practice it yourself. Not just practice
it once, but MULTIPLE times. You want to build a habit, over
time, of working with this information, and after a while, you will
have built your intuition that right now has very little support struc-
ture. By the time you are done with the book and a few months of
practice, you will have honed a skill that will divide you signifi-
cantly from your competition.

Tools for Your Learning

There will be resources throughout the book for you to use. For
example, you will be guided to use the 10-k of technology compa-
nies. For United States companies that are publicly traded on the
stock market, an annual report (the 10-k) must be published to the
Securities and Exchange Commission (SEC)3. This 10-k has ben-
eficial information that an investor, employee, or entrepreneur can
use for analysis. For purposes of examples, the book will compare
two technology companies that are currently publicly traded in the
United States, Zoom Communications (stock symbol ZM) and
LogMeIn (stock symbol LOGM). By studying these two compa-
nies, you will see how the numbers tell the story of financial deci-
sions these companies have made over time.
For Zoom Communications, their reporting to the SEC occurs
on January 31 each year, and LogMeIn, their reporting to the SEC,
occurs on December 31 of each year. Therefore, for example, in
this book, the year 2020 for Zoom is the year February 1, 2019,
until January 31, 2020; thus, that is the year 2019 since most of
the months fall in 2019. For LogMeIn, the year 2019 represents
January 1, 2019, until December 31, 2019. Thus, the year 2020 for
Zoom Communications and the year 2019 for LogMeIn are the
18 FIN A N CIA L IN T EL LI G EN C E

same years for comparison purposes. When you are examining

company 10-k forms, you will want to keep this in mind.
For all the examples in this book where Zoom Communications
are compared to LogMeIn, Year 1 (YR1) will represent 2019 for
LogMeIn and 2020 for Zoom Communications. Year 2 (YR2) will
mean 2018 for LogMeIn and 2019 for Zoom Communications.
In addition, it is essential to note that financial statements for
LogMeIn and Zoom Communications are in “thousands.” This
means that if you see a number in this book that is $100,000 (or any
number), the TRUE number will be $1,000,000. When you exam-
ine the financial statements for these two companies, the financial
statements will say (right underneath the name of the financial
statement if you are looking at the 10-k document) the numbers are
represented “in thousands.” Hence, you have to add three zeroes to
each number if you want the actual number.
Furthermore, you will be given activities where you can go try out
your application of what you are learning in the book. Remember,
the first time you go through an exercise, it might take a little bit to
get the hang of the process, but if you do these exercises regularly,
you will become very efficient in the calculations!
Finally, there are video resources I will point you to that will help
with the information contained throughout the book. A video can
be an effective way to obtain information. Everyone has different
learning styles and having video, reading, and practical exercises will
hopefully find the right combination of learning for you.

Other Resources

There is nothing better to teach you concepts than studying your

employer. If you are examining your own companies’ financial
statements, find an accountant who can explain things to you about
the financial statements. Now, do not meet with them cold. Do
your homework first so that you can take well-informed questions
to them. Thus, as you are working on your analysis, you can talk to
them about the results or if you have read the financial statements
correctly. This approach also gives you the advantage of learning
how to interact with accounting and financial professionals. You
 W H Y BEIN G FIN A N CIA L LY S AV V Y M AT T ERS 19

will want to talk to the person, or group, that produces the financial
statements. In larger companies, that will often be a group of people
responsible for financial reporting.
In addition to these resources, if you are considering starting a
business, the Small Business Administration (SBA) has a group of
retired executives that help provide support for individuals planning
to start a business4. Often, you can be paired with someone with
experience in the industry or area of what you want to build, and
they are a free resource.
Finally, the company Intuit, which produces the accounting soft-
ware of QuickBooks, has accounting and bookkeeping pro advisors.
However, many of them do require payment, so I only offer that as
a possibility the closer you get to implementing a business of your
own. If you do start a business, you want to find an accountant that
can be a reliable resource in helping you build your business and
possibly has expertise in your industry assisting other clients in lik-
ing you.

Departmental Learning Groups or Study Groups

If you are in a department where you want to teach your staff finan-
cial literacy, you could start a book study group using this book
to learn together. The book is written with practical exercises to
help you understand the material. Using the book as a framework
of studying as a group can make for a rich and rewarding learning
experience for the entire group. Thus, as you go along and learn
about the different financial resources, you can learn to leverage all
the company’s internal knowledge to develop financial savvy in each
other. By using this approach, you could potentially study a com-
petitor if they are publicly traded.
IF you decide to use this book as a development tool in your
department, you recommend that you pull in an accountant in your
organization to assist you in the learning. An accountant in your
organization will answer many questions for you, like this book
related to your products, services, costs, etc. Suppose an accountant
in your company is not willing to do so. In that case, any accoun-
tant that is comfortable in helping to teach you, i.e., a faculty at a
20 FIN A N CIA L IN T EL LI G EN C E

local university or an accounting professional, can help direct you to

­specific questions to ask your accounting department!

Part One: Exercises, Practice, and Resources

Take some time to think about these questions before you proceed:
• What are your goals for your career as an IT professional?
Do you plan on climbing the ladder to a role that requires
you to be comfortable with finance and accounting?
• Are you thinking about starting your own IT-based business?
• Do you want to understand more about finance for investing?
• What have been your challenges in the past in learning
material concentrated around finance and accounting?
• Which myths about learning this material have you aligned
with in the past?
• Do you have an IT-based company that you would like to
study along with the material in this book? The company you
already work for is a great candidate to study using the con-
cepts in this book! If you do (and it is highly recommended),
make sure that you know the stock ticker symbol or obtain
financial reports for the company through the accounting
department. If the stock is traded on a stock exchange, then
you can Google a phrase like “what is the stock ticker sym-
bol for XYZ company.” Once you have that ticker or know
where you can obtain the financial statements if the com-
pany is not publicly traded, then you are ready to go!

Notes
1 Thomas, W. C. (2002). The Rise and Fall of Enron: When a company
looks too good to be true, it usually is. Journal of Accountancy. Retrieved
from https://www.journalofaccountancy.com/issues/2002/apr/therise-
andfallofenron.html
2 Majaski, C. (2019). IFRS vs. U.S. GAAP: What’s the Difference?
Retrieved from https://www.investopedia.com/ask/answers/09/ifrs-
gaap.asp
3 Form 10-k. Retrieved from https://www.investor.gov/introduction-
investing/investing-basics/glossary/form-10-k
4 Small Business Administration. Retrieved from https://www.sba.gov/
 Part Two
R e v enue and E xpense
The Basics of Income Statements

Before we go too much further, a definition of accounting and a

definition of finance would be helpful. For purposes of this book,
finance is about the interpretation and strategies of the financial
numbers in a business, and accounting is the structure and mechan-
ics that create those financial numbers in a company.
For example, in creating a financial statement, many details go
into that summarized statement. For instance, a company will gen-
erate sales, but the financial statement will show only one number
for ALL sales. Thus, all that detailed work to create the consoli-
dated sales number is what accounting is all about. However, once
you know the total sales for your company and you start analyz-
ing that information, you are getting into the interpretation of the
financial information. Thus you are then in the world of finance.
The income statement is an essential financial statement to
understand1. Within this topic area, you will learn why the income
statement represents an ESTIMATE of profit. Thus, it is essen-
tial to note that estimated profits do NOT equate to the company's
cash. There are many reasons for this, and you may find the book
repeating information about this critical distinction. The repetition
matters – because it is a crucial difference that must be understood
to make sense of financial information.
Every section of the income statement will be reviewed to under-
stand the business activity that each section represents. Along the
way, you will be given details about different naming conventions,
not only for this financial statement itself but for the different
accounts represented on the financial statement itself. As stated
before, the various approaches to naming conventions will often

DOI: 10.1201/9781003110613-2 21
22 FIN A N CIA L IN T EL LI G EN C E

trip up a student in learning how to interpret financial information.

Once you know that one naming convention you see is the same as
another different name, then you are far ahead on the learning curve.
In addition, you will be introduced to reporting periods and vari-
ous other types of information that can be applied to other financial
statements. It is good to learn about those topics on the first financial
statement you know about so that you are familiar with the issues
when they are brought up again on the other financial statements.
Finally, you will also be introduced to the concepts of “cash”
accounting and “accrual” accounting. At a baseline level, the impor-
tant distinction is that cash accounting is like how we manage our
checkbooks and bank balance. We, as individuals, operate our lives
on a cash basis of accounting. We see money come into our bank
account, and we see money go out of the bank account.
However, a publicly traded company must follow the accrual
accounting rules. All that means is that a company MUST record
transactions, EVEN if these transactions do NOT affect the bank
balance yet. Thus, publicly traded companies have a much fuller
representation of their financial position in financial statements.
But that does mean that you must understand the timing issues that
this can mean for interpreting cash flow in a business.

Translating This Information

As you are reading this section, remember that we have money com-
ing into and out of our personal finances as individuals. Company
finances work the same way. Thus, a company will generate
REVENUE from its distinct types of sales to customers (products,
services, subscriptions, or gift cards)2. However, a personal house-
hold will have INCOME from various sources.
At the same time, companies and individuals will have
EXPENSES3. Expenses are the services and products we must pay
for to run the business or run the household. Thus, a company can
pay RENT just like an individual may pay RENT.
Eventually, after all the expenses are deducted, a business will
have a NET INCOME or LOSS, and an individual will have a
DISCRETIONARY INCOME or LOSS. Regardless of the
 RE V ENUE A N D E X P ENSE 23

naming convention, the concept is the same. For a company, the net
income can then be deployed in the organization to be in their cash
reserves, or the company can choose to invest in capital projects like
building a new manufacturing facility, or the company can pay divi-
dends with the money if they have shareholders. For an individual,
we can make similar decisions, such as keeping that money in a sav-
ings account, investing it, make an improvement on our home, etc.
The ONLY other nuance here is how a company or an individual
may account for these items. Typically, most individuals operate on
a cash basis of accounting, meaning that our profit and loss are
built on transactions that flow through our bank account ONLY4.
Many small businesses work the same way.
However, publicly traded companies have to account for trans-
actions EVEN IF the transaction has NOT impacted the bank
account yet. This approach is called the ACCRUAL BASIS of
accounting5. You will be reminded of this concept often through
this part of the book!

Topic 5: Profit and Cash Are NOT the Same

It might be a surprise to think that profit and cash are often not
equivalent. This concept is important to understand as an employee,
an investor, or an entrepreneur. First, we will go through WHY
this occurs. Then we will discuss the different major accounts of
the profit and loss statement (you will also see the profit and loss
statement called an income statement OR you may see it called the
statement of operations). This concept will be revisited several times
in the book because of the importance of understanding the differ-
ence between these two accounts in the financial statements.

Why Profit and Cash Are Not the Same?

To understand why profit does not equal cash, you will have to
understand the difference between the cash basis of accounting and
the accrual basis of accounting. You want to think about these two
approaches in terms of producing a profit and loss statement.
If we think about your finances, you operate off the cash basis of
accounting. For example, if you pay an electricity bill, the impact
24 FIN A N CIA L IN T EL LI G EN C E

of that payment is felt as soon as you see the money go out of your
checking account. Thus, the cash basis of accounting means that
we do not record the transaction unless the transaction impacts the
bank account. Therefore, if you created a profit and loss statement
for your finances, you would use the transactions in and out of your
bank account to create that financial statement.
However, if you were to use an accrual basis of accounting, if
you had received that electricity bill but you had not paid it yet, you
would still include that bill in the calculation of your profit and loss.
This approach is true even if the transaction has not been paid yet or
cleared out of your bank account. Therefore, in accrual accounting,
there can be time lags between recording a transaction and WHEN
that transaction impacts the bank account as the money is coming
in or money going out.

Procurement to Payment Cycle

The procurement to payment cycle is the planning and contract-

ing of purchases, receipt of those purchases, and the payment of the
corresponding invoices cycle that occurs in businesses worldwide6.
Typically, this process will occur like this (with some differences
depending on the industry):
A purchase order is created.
The products/services are received.
Invoice is received from a supplier.
Supplier is paid out of the bank.
Now, consider the following table of those same events, and using
the cash basis or accrual basis, you will see which transactions would
be used to create financial statements (Table 1):

Table 1 Procurement to Payment Cycle

CASH BASIS ACCRUAL BASIS

Purchase Order No transaction No transaction
Receipt No transaction Liability
Invoice No transaction Accounts payable
Payment Cash Cash
 RE V ENUE A N D E X P ENSE 25

While BOTH approaches do not record any transaction for the

purchase order, the accrual basis of accounting is taking that order
through a “life cycle” of different accounts marking the various
steps to the process.
Think about what this means if you are looking at a small busi-
ness that you want to invest in, and the business only follows the
cash basis of accounting rules. Would you be able to assess, with
accuracy, the outstanding payment obligations of the company?
It may prove to be difficult. A lot of small business owners kind
of “know,” in their heads, what they have purchased and what is
outstanding to be paid. The reason accrual accounting exists is
so that the business owners and investors can see at any point in
time what outstanding payment obligations there are at any point
in time.
Even the accrual basis of accounting can leave out open purchase
orders that have not been received yet. However, at a company that
uses accrual accounting, you should be able to ask for a report of
all of the open purchase orders, and that will give you an idea of
what is coming on the horizon that has not impacted the financial
statements yet. Understanding this timing nuance to read financial
statements is crucial to your success in making sense of the finan-
cial statements and what obligations are outstanding for a company
acquisition.

Order to Cash Cycle

In addition to the procurement to payment cycle, there is also an

order to cash cycle in businesses. The order to cash cycle is selling
products and services, delivering those sales, and the payment of
the corresponding customer invoices cycle that occurs in companies
worldwide7. Typically, this process will occur like this (with some
differences depending on the industry):
A company sells a product.
A company delivers the products.
A company sends the invoice to the customer.
The customer pays the invoice.
26 FIN A N CIA L IN T EL LI G EN C E

Now, consider the following table of those same events, and using
the cash basis or accrual basis, you will see which transactions would
be used to create financial statements (Table 2):

Table 2 Order to Cash Cycle

CASH BASIS ACCRUAL BASIS

Sales Order No transaction No transaction
Inventory Pick No transaction Inventory
Invoice No transaction Accounts receivable
Payment Cash Cash

This book will not go into the specific examples of journal entries
that represent this cycle. However, the most important learning
here is that more of the cycle is recorded in the financial statements
if you are looking at financial statements that are produced on an
accrual basis of the accounting approach.

Topic 6: Overview of Profit and Loss Statement

A profit and loss statement is only an estimation of profits and losses.

Along with that basic piece of information to understand, you also
want to make sure that you understand a few other pieces of infor-
mation about the presentation of information on this financial
statement.

Reporting Periods

You can see some interesting dates and time frames for reporting
periods for a profit and loss statement. We will first discuss fiscal
years and then discuss periods of time. This information is impor-
tant for being able to compare different companies. For example,
in studying LogMeIn and Zoom, in the comparison of financial
data, we recognize that the fiscal years are different. It does not
matter that they are different; you need to realize that you could
get confused by the dates if you are not aware of these different
time frames.
 RE V ENUE A N D E X P ENSE 27

Fiscal Years

A fiscal year is a defined financial reporting period for a company8.

You might assume that every company works off a calendar year as
their fiscal year. Some companies do use a calendar year for finan-
cial reporting, but many do not.
Why might it be different? Very often, the reason may be lost to
time and the company memory of when that decision was made,
but generally speaking, retail companies are often the companies
that can have different time frames other than the calendar year
for financial reporting. For example, Microsoft has a fiscal year
of July 1 until the following June 30. Thus, when you look at a
profit and loss statement for Microsoft for June 30, 2019, you are
looking at a financial reporting period of July 1, 2018, to June 30,
2019. There are six months in the previous year and six months
in the current year. Many think that summer is a slower time of
year, and if you think about it, many vacations happen in the sum-
mer, so why not have your year-end activities completed by the
time most people are taking a vacation? It could be a reasonable
justification.
Also, you may see some companies that have a retail component
ending their fiscal years in September. There could be an inventory
reason behind the thinking for this situation. The largest amount of
inventory for a retail company could occur in the last quarter of the
calendar year. Retail companies are getting ready for Thanksgiving
and Christmas sales periods in the United States.

Periods of Time

The period of time may represent a month or a period of time in

terms of four or five weeks. You will be able to tell what account-
ing periods are being used by looking at the profit and loss state-
ment itself. Each profit and loss statement will say something
to the effect of “….for the period….”. This “period” could be a
specific month of a specific year, or for a specific quarter, or a
specific year.
If a period of time for the profit and loss statement is for a month,
you may see something like, “Prepared for the month ending August
28 FIN A N CIA L IN T EL LI G EN C E

31, YYYY”. Or, if the profit and loss statement is for the year, it
may say something like, “Prepared for the year ending December
31, YYYY”.
If a company is following a four-week, four-week, five-week
calendar, then the month, quarter, or year ending date will move
around a little bit. For example, if a fiscal year ends in September,
the year-end date could be September 29, September 30, or
October 1.

Be Aware!

Sometimes, unusual or extraordinary items show up on the income

statement. These items do not occur regularly and will be identified
as extraordinary items. These items can have an unusual or variable
impact on financial performance, usually impacting net income the
most.
For example, in 2013, Starbucks had to pay out a dispute with
Kraft Foods9. In all of the years of studying the financial perfor-
mance of Starbucks, every year, the company had anywhere from
$.10 cents to $.13 cents of net profit consistently, but in 2013 the net
profit was practically zero.
In calculating the net profit margin, if you took OUT the
impact of the payout to Kraft, then net profit was still in range
of what I was used to seeing in their financial performance. Thus,
relying on financial intelligence, the performance was easily
explained, AND if all things had been normal, then performance
would have fallen in line with any other year studied. Thus, when
you see any unusual items like this, calculate financial ratios (see
Part Five) with and without the unusual items to see and assess
the impact.

Major Sections of the Profit and Loss Statement

The first financial statement to study is the profit and loss state-
ment, the statement of operations, or you may also hear it called
the income statement. A profit and loss statement summarizes the
revenue and expenses for a specific period of time10.
 RE V ENUE A N D E X P ENSE 29

Here are the major accounts to understand that appear on this

statement:

Revenue

Revenue represents the sales of products and services of the com-

pany for the period (this may be a month, a quarter, or a year). When
you are examining a profit and loss statement, this account could be
called revenue, net revenue, sales, or net sales. When you look at
one month of revenue or one quarter, or one year, that may not tell
you much about performance. Thus, when you are examining any
financial information, you will want to look at trends over time to
get an idea of consistent performance over time.
In a profit and loss statement built through the cash basis of
accounting, you would know that this represents the cash that has
been paid to the company, and the money has already been received
at the bank. Suppose the profit and loss statement has been built
using the accrual method. In that case, it will be important to
understand how much cash is still outstanding as represented by
accounts receivable on the balance sheet.
Another important thing to watch for here is the typical treatment
and timing of different approaches to recording revenue under the
accrual method. You will want to be clear on the timing differences
between gift cards, credit card transactions, and invoicing. Here we
will consider each one of these and the timing issues each can create.
First, consider a credit card transaction. In this scenario, a cus-
tomer buys a product from you and pays for it with a credit card.
The timing between sending the customer the invoice and getting
your cash is short. Depending on the credit card company, the cash
will be in your bank account within 24–48 hours. Thus, the timing of
converting accounts receivable to cash will look like this (Figure 5):

Figure 5 Credit Card Transaction Timeline

30 FIN A N CIA L IN T EL LI G EN C E

Second, if you allow your customer to have 30 days to pay

their invoice, you will have to wait for the cash a bit longer.
The same mechanisms are in place, i.e., you send an invoice to
the customer, but the customer can take several more days to pay.
Thus, the accounts receivable will be sitting on the balance sheet
for a longer period of days. The timing could then look like this
(Figure 6):

Figure 6 Customer Invoice Transaction Timeline

Finally, if you sell gift cards, cash timing works very differently.
The most significant difference about cash and revenue timing in
these transactions is that the company receives the CASH before
the REVENUE is recorded. In other words, a gift card is not a
product, and it is a promise of providing a product later. Thus, if a
customer obtains a gift card and places $100 on the gift card, the
company gets the use of that cash once deposited into the compa-
nies bank account. The customer may not take delivery of a product
until the following week or several months later, and only when the
actual product is obtained, the company keeps that $100 value on
the balance sheet as a liability. This process is commonly referred to
as deferred revenue11 (Figure 7).

Figure 7 Gift Card Transaction Timeline

 RE V ENUE A N D E X P ENSE 31

Cost of Goods Sold

Cost of goods sold represents the costs of manufacturing or assem-

bling the products that are sold or the costs of the services the com-
pany provides to consumers12. When you examine a profit and loss
statement, the cost of goods sold account is subtracted from the
revenue. Sometimes, you will find a profit and loss statement that
calls this account cost of revenue.
Cost of goods sold has a timing effect that needs to be under-
stood as well. Plus, this account on the profit and loss statement is
estimated and reconciled to actual costs at the end of the year. How
does this happen?
For example, if your company builds computers, you will be buy-
ing motherboards, screens, keyboards, and other items that go into
building a computer throughout the year. For example, suppose that
you receive 100 screens this month. Will you build 100 computers
this month? Maybe you will, but will you also sell those 100 com-
puters in the same month? Most likely not.
When you think about a company like Lenovo that build com-
puters on a grand scale, when inventory is received when a computer
is sold could be more than 30 days.
In addition, think about how you build a computer. For some
people, starting a business out of their garage, you might build one
computer, by hand, in a few hours. However, building computers on
a massive scale will require some investment in equipment to either
help automate the process, if you can, or at least make moving com-
puters from station to station more efficient.
Thus, building a computer from scratch and by hand will require
you to have parts on hand and a person to do the labor of building
that computer. The same is true in a larger company. The only dif-
ference is you may build a lot fewer computers because of a lack of
automation (Figure 8).

Figure 8 Product Inventory Timeline

32 FIN A N CIA L IN T EL LI G EN C E

Gross Margin

Gross margin, or gross profit, is a straight calculation. Gross mar-

gin is the difference between revenue minus cost of goods sold13.
Gross margin, on the profit and loss statement, is a calculated
number. You will take the revenue for the period, subtract the cost
of goods sold, and you will arrive at your gross margin. Gross mar-
gin represents the difference between what you sell your products
and services for and the costs it takes to provide/manufacture those
products and services.
Think of it this way: If you sell a product or service, you will have
costs directly associated with that sale. Another way to think of this
is typical, and if you do not have any sales, you will not have any
cost of goods sold.

Operating Expenses

Operating expenses are the expenses that it takes to run the com-
pany with no connection to the cost of sales (or the cost of goods
sold)14. For example, suppose you have a company that manufac-
tures a product. In that case, the product manufacturing costs will be
reflected in the cost of goods sold, and the sales of the product will be
reflected in revenue. The operating expenses will be the other kinds
of costs to run the business – the administrative departments that are
NOT part of the manufacturing and delivery of products or services.
Operating expenses are the costs of running the business in gen-
eral. Another way to think about this is what are the costs that
you must pay, in the business, that have nothing to do with selling
products or services. For example, office rent for an administrative
office is an operating expense. If you ever ask, “what does it cost me
to run my business” then the portion of the operating expenses of
the income statement is where you would look for the answer.
Thus, within this section, one of the largest accounts will be
called something like “Sales and General Administration.” You
might even hear this called “SG&A.” All the expenses for informa-
tion technology departments, legal departments, sales and market-
ing departments, accounting departments, and others.
 RE V ENUE A N D E X P ENSE 33

Do not confuse operating expenses with the expenses associ-

ated with the manufacturing part's operations. Expenses associated
with the operations of the manufacturing and distribution part of
a business will be in the cost of goods sold. For example, if you sell
computers, there is a cost to building or sourcing a computer that is
directly associated with the sale. Also, if you provide information
technology consulting services, then one of your highest direct costs
of providing those services will be the cost of the labor (consultants).
Another way to think about this is to consider what happened
in the COVID-19 pandemic experienced worldwide in early 2020.
Many small businesses and large businesses found themselves in a
period of time where they may not have made any sales. However,
even if they did not make any sale in a particular month, the com-
pany would still have operating expenses to pay. This concept is why
a company needs to set aside its cash for a rainy day, just like each of
us running a household needs to do!

Operating Income

Operating income is the amount left over from gross profit after
operating expenses are deducted. It is a straightforward calculation
of gross profit minus operating expenses equals operating income15.

Net Profit

Net profit is the bottom-line number of the amount of money that

is left over after all the expenses have been deducted16. One of the
more common items deducted after operating income are things like
interest expense. Interest expense accounts are the number of interest
payments for bonds that have been issued. Since bonds are a financ-
ing strategy by a company but have nothing to do with running a
company, these line items always come after the operating income.

Topic 7: Breaking Down the Profit and Loss Statement

A fundamental concept to understand is the interplay between

revenue, cost of goods sold, and gross margin on the profit and loss
34 FIN A N CIA L IN T EL LI G EN C E

statement. These are the first three major groupings of items you
will see on a profit and loss statement.
What do you want to see in this section? Well, one thing you
want to see is that revenue is consistent over time and possibly
growing. You want to know that cost of goods sold is consistent,
and it might grow in relation to revenue if revenue is going up.
However, the key factor here is that the gross margin remains
steady and consistent.
What this means is that industries typically have a range of gross
margins within industry. For example, restaurants tend to operate
on smaller gross margins. However, some higher-end restaurants
could work off better margins, and it will depend on your business
model. Still, typically speaking, restaurants can go out of business
more often in economic downturns because the margins are thin-
ner. Computer technology companies can enjoy significantly higher
gross margins because the technology sometimes does not cost a lot
to produce.
In addition, another reason this matters a great deal is that when
you are starting a business, you want to make SURE that you
understand what it COSTS to produce your product or service. For
instance, a colleague, who works with companies on marketing and
sales strategies was hired by a restaurant and the restaurant wanted
her to help them increase sales.
This colleague had the smarts to ask the owners about how they
planned out the costs of each meal they prepared. By analyzing this
data first, it was discovered that there were mistakes in the recipes
of the dining options and some math mistakes. Thus, even if she had
brought in more business, the restaurant would have lost even more
money. Once the restaurant corrected the pricing issues and had a
good, accurate margin, several cash flow problems started to dis-
sipate. Then, working on sales and marketing strategies made sense.
Now, in the case of technology companies, gross margins can
usually be excellent. Technology companies usually have nice hefty
margins because technology companies can often take advantage
of lower production costs. According to Wilhelm (2019), tech-
nology-based companies can enjoy gross profits that are usually
above 50%17.
 RE V ENUE A N D E X P ENSE 35

Thus, technology-based companies are usually generating cash

with smaller costs of production. Later, in the book, you will be
assessing the gross margin and net margin of any company. These
financial metrics will tell you just how well a technology company
can leverage the most profits that it can by lowering costs. In addi-
tion, you will also be examining how well a company manages its
cash flow. You will be able to assess this through the cash flow state-
ment itself and the activity, or efficiency ratios, of accounts receivable
turnover, inventory turnover, and accounts payable turnover and how
all of these ratios inform the cash conversion cycle of a company.

Revenue Recognition and Timing Issues

Here, you will dive into a bit more detail as to why timing issues are
at the heart of why profit does not equal cash. We will focus first on
revenue recognition and why there are timing issues with cash when
examining this concept.
First, revenue recognition is the idea that revenue is recognized
at a point in time, generally when products or services are exchanged
between the seller and the buyer18. There are some exceptions to
that rule, but this is a general idea.
So how does this play out in reality? Here are two examples:
First example: You are a technology company that sells mother-
boards for computers. A computer manufacturer orders a shipment
of motherboards from you for $100,000. Your company has given
the customer 30 days to pay the invoice. The purchase is made on
July 10, the shipment goes out on July 15, delivery will be made on
July 20, but the invoice is due on August 15.
In this case, you are receiving the cash AFTER the product has
been delivered to the customer. Using this example, the day that is
important for the profit and loss statement is July 15 – because that
is the day that typically “ownership” of the motherboards passes
from your company to the customer. That is also the date that the
invoice is generated. Thus, on July 15, the profit and loss statement
will show a revenue item for $100,000.
However, July 15 is NOT the date that your company will receive
the cash from this transaction. Since you have given the customer
36 FIN A N CIA L IN T EL LI G EN C E

30 days to pay, the expectation is that you will have the money come
into your bank account right about August 15, when the terms are
due. Even though revenue is in the profit and loss statement on July
15, you will have a corresponding accounts receivable item on July
15 because you have NOT received the cash yet. When the cash is
received on August 15, then the accounts receivable will be cleared
out, and cash will come into the bank account. How quickly the
money is actually in the bank will depend on HOW you are paid –
if the amount is paid by check, or credit card, or a bank-to-bank
transfer will potentially make the process quicker or add a few days
to the process.
Second example: Suppose that you are an educator on technical
products, and you own an online store that is full of classes that
people can take at their leisure once purchased. Most of your courses
sell for $50 per enrolled student. You also run promotions around
Father’s Day, Mother’s Day, Christmas, and other holidays, selling
gift cards for any amount from $100 to $500. Suppose someone has
gone online and purchased a $500 gift card for a Christmas gift for
someone to buy courses from your site.
In this situation, you are receiving the money BEFORE any
product is exchanged with the customer. The gift card itself, that
little piece of plastic, is NOT a product. That gift card represents
a liability to your company because you owe whoever receives this
card $500 worth of classes. The person who receives the card could
purchase the courses next week, next month, next year; you never
know when the customer will claim the products. However, you can
use the cash from selling that little piece of plastic as soon as the
cash is in your bank.
When the piece of plastic is sold (the gift card), your business
will receive $500, but that amount will also show on your balance
sheet as an owed liability. Until the customer comes forward, with
the gift card, to claim the courses, ONLY then will you recognize
revenue on your profit and loss statement, and the liability will be
removed from the balance sheet.
Therefore, later in the book, you will be learning about ratio
analysis. One of the ratios directly related to revenue and cash is the
accounts receivable turnover rate and the days' sales outstanding.
 RE V ENUE A N D E X P ENSE 37

Third example: Another revenue recognition pattern is when

subscriptions are used or annual billing for service. In these cases,
if a person pays for an annual subscription to your service, and the
customer pays the one-time payment for the whole year up front,
you are not allowed (if you are under accrual accounting rules)
to recognize all of that revenue at the time of payment. Instead,
your company will have received cash for payment, but you will
recognize 1/12th of the annual subscription each month for the term
of the service.
If you take the 2019 LogMeIn (LOGM) 10-k pdf file or the
Zoom Communications (ZM) 10-k pdf file, and you search for
“revenue recognition,” you will find a few areas contained in the
document that pertains to this rule. For LOGM (2019) 10-k, for
revenue recognition, you find that “we derive our revenue pri-
marily from subscription fees for our premium services” (p. 37)19.
Currently, a yearly subscription for one of LOGM’s products is
$349.9920. Without considering any tax collections that may have
to be completed on a purchase, the base price must be spread over
12 months or reporting periods. Thus, if the sale of a subscription
is made in July, the company can recognize 1/12 of the total. Thus,
in July, the company can realize $29.17 in revenue ($349.99/12), and
the company will have 11 more months to recognize the remaining
$320.82 of the subscription rate ($349.99 – $29.17). This concept
represents the deferred revenue that will be recognized over the
remaining life of the subscription.
For the 10-k for Zoom (2019), you will find that “we derive rev-
enue from subscription agreements” (p. 46)21. Furthermore, accord-
ing to the 10-k for Zoom (2019), “contract liabilities consist of
deferred revenue” (p. 47). With Zoom, customers can buy a product
on a monthly subscription or an annual subscription 22.
Therefore, if you buy the Pro subscription every month, Zoom
will recognize $14.99 per month in revenue. In this case, there
would be no deferred revenue. However, if a person obtained a Pro
annual subscription for $149.90, then the first month, Zoom will
recognize $12.49 in revenue ($149.99/12). Then the company would
have a remaining deferred revenue balance of $137.50 ($149.99 –
$12.49) that will be recognized over the next 11 months.
38 FIN A N CIA L IN T EL LI G EN C E

What happens if you are not publicly traded? For instance, you
could be evaluating a company to purchase that will start your
entrepreneurial career. The same rules do not bind a company that is
not publicly traded. For instance, a small business could be operat-
ing under the cash basis of accounting; thus, they recognize revenue
as soon as the money comes into the bank.
Thus, you could be looking at a company that creates software that
consumers subscribe to for $99 for the entire year. As soon as the $99
comes into the bank, the company may recognize the whole amount.
The issue is that the entire $99 should be spread over the year because
of rules around revenue recognition are important to follow.
If you acquire a company, one thing to think about is how to
move the company from a cash basis to an accrual basis of account-
ing. You never know when a publicly traded company may come
to you and want to acquire your business. In preparations for that
possibility, as your company matures, you may want to consider
moving more toward an accrual basis of accounting methodology,
which will mean that the $99 annual subscription would be spread
over 12 months. Thus, you would recognize $8.25 in revenue each
month. This approach will take a small project to get this changed
in your processes and procedures, and you may need some account-
ing support and your information technology department to make
that happen. Being able to show a potential acquisition partner that
you are already operating your small business as a corporation could
be very attractive to a potential buyer.

Deeper Dive into Cost of Goods Sold

In the book so far, cost of goods sold has been described as the costs
that it takes to produce and deliver a product or service directly. Well,
what exactly does this mean? Especially when it comes to being an
entrepreneur, this idea can be very murky. For any of you working in
a company, you can ask the accountants about how they identify costs
directly related to producing the products or services of your company.
Remember when we discussed the fact that terminology is a large
part of the challenge to learning about the world of accounting?
Here you see where terms can get confusing as well. For instance,
 RE V ENUE A N D E X P ENSE 39

when you look at definitions of cost of goods sold, the description

will be that these are the DIRECT costs of producing goods and
services. However, within the cost of goods sold, you can have direct
and indirect costs. The confusing part is that you see the term direct
and that it is being used in two slightly different contexts.
Thus, the cost of goods sold is considered a direct cost of produc-
ing goods and services because we cannot classify those costs as
general operating costs. However, costs of goods sold can comprise
direct costs and indirect costs. So, we need to break this down into
an example.
If you have a business that builds computers, it is often very clear
that direct materials and labor costs produce the computers. For
instance, you will have a technician that builds that computer – so
if that is all the technician does during the day. All of the salary
and benefits for that person goes into the direct costs of building
the computer, and this will definitely need to be a part of the costs
of goods sold.
Plus, the parts that go into the computer would be direct costs
that go into the cost of goods sold.
What are some of the direct costs that could be considered? Here
are some of the items you may consider to source for the computers:
• Central processing unit
• Hard drive
• Screen
• External ports
• Memory
• Drives
• Keyboard parts
Of course, you may also want to think about what peripherals
you may want to sell, either separately or in a bundle. These types
of items you may buy elsewhere and mark them up within a bundle
of products. Items to consider are mice, keyboards, external screens,
and other items.
However, what about if this computer production was confined
to a single building where all computer production was completed?
Maybe many technicians are working in the same building, and there
40 FIN A N CIA L IN T EL LI G EN C E

is an inventory warehouse that keeps them supplied with computer

parts. So, what about the forklift drivers that bring pallets of parts
to the technicians? Many would consider the forklift workers to be
indirect in producing the computers. The forklift workers are not
directly building the computers, but they are assisting the process.
Very often, if production is enclosed in a building or set of buildings,
all those costs of running the facility would be a part of the cost of
goods sold as either direct costs of production or indirect costs of
production.
Especially for a business that sells products manufactured or
assembled, lenders will EXPECT to see that you understand and
account for the cost of goods sold. If you search through the 10-k’s
for the two companies studied in this book, you will find that “cost
of revenue” is the account used rather than “cost of goods sold.”
Now, these two companies have largely moved to digital formats for
their software solutions.
Do you remember buying a disc with the software code embed-
ded in it that you would install on computers? That seems to be a
bygone era. Today, we install software from executable files that can
be housed on the cloud. Thus, if you search through LogMeIn and
Zoom 10-k files, you will see that cloud hosting is often a direct
cost of developing and delivering digital products.
In addition, you will find that software development costs are
amortized over time. For example, in the balance sheet section
of this book (Part Three), there is information about assets and
depreciating those assets over time. Software development is an
asset; the software has value, it can cost millions of dollars to develop
software from scratch, and new additions and enhancements to the
product can cost a lot of money.
Thus, assume that you have a software idea and it takes $20M
to develop the initial version of the software. Just like buying a
building, you would not likely take the hit on the income statement
for the total cost, and you would instead capitalize the costs and
write it off over, say, 20 to 30 years. When you see “amortization,”
think of it as “depreciation” for a digital asset. For example, Zoom
software and LogMeIn software, even as digital products, have
an enormous value to both companies, and they cost quite a lot
 RE V ENUE A N D E X P ENSE 41

of money to develop. Just like it can take a lot of money to build a

tangle asset like a building.

Part Two: What to Watch Out For

• Profit and loss statements are also called income statements,

P&L statements, or statements of operations.
• Be aware that financial statements can be reported with
three zeros or six zeros left off the numbers. Thus, if a state-
ment says it is reported “in thousands,” you will add three
zeros to the numbers. Or, if the statement says the numbers
are reported “in millions,” then the numbers will need six
zeros added to them to know the full value of a line item on
the financial statement.
• Revenue is synonymous with sales, net sales, or net revenue.
• Cost of goods sold can also be called cost of revenue or cost
of sales.
• Remember, profit and cash are often not the same things,
especially when a company is not operating off a cash basis
of recording transactions.
• Determine if subscriptions drive revenue. Determine if the
subscriptions are monthly or annual or a combination of
both.
• Many small businesses work on a calendar year as a fis-
cal year, but publicly traded companies may not work off
a calendar year as their fiscal year. Be clear about the fiscal
year so that when you are examining documents, you do
not get confused with dates (especially if you are comparing
companies).
• Many companies also use reporting periods of calen-
dar months. However, not every company uses calendar
months. Some publicly traded companies will use a 4-4-5
monthly calendar system so that every reporting period
ends on a Friday or Sunday. This can also be important for
your assessment of company financial data because dates
could be confusing to you if you do not have that framework
understood in your mind.
42 FIN A N CIA L IN T EL LI G EN C E

• Deferred revenue is a mechanism used by companies to

store revenue that has not been earned yet. Make sure that
you understand if the company uses deferred revenue or rec-
ognizes revenue on a cash basis.
• Revenue and cost of goods sold are directly related to the
sale of products and services.
• Operating expenses are expenses that occur in a business
regardless of whether the company has made any sales or
not.
• Technology companies are often companies that can have
higher gross margins than a lot of other industries. It is
important to know what is normal for your industry.
• If you are studying a company you work for, find an
­accountant to help you. Finding answers on your own is
fine, but part of the learning is to leverage the available
resources!
• Suppose you are studying a company that you do not work
for nor have worked for in the past. In that case, you will
have to rely on Internet searches possibly to find answers to
questions that you may struggle with, or you can possibly
find an accountant in your network that might be willing to
assist your learning journey.
• Watch for extraordinary items. If you find something
unusual or is not a regular occurrence, be sure to run your
analysis with AND without the extraordinary items.

Part Two: Exercises, Practice, and Resources

Learning activities:
1.  Conduct a search on “revenue,” “revenue recognition” in the
10-k of your selected companies, and what do you learn about
the business and how timing issues work in the company?
2.  If you work for a company that you are studying, you can
book a time with an accountant, take them to coffee, and
learn about how the company's timing of cash and profit
work. Several different accountants could help explain
how this works in your company, and some examples of
 RE V ENUE A N D E X P ENSE 43

accountants to reach out to are: accounts payable managers,

accounts receivable managers, and cost accountants.
3.  Look to see if you can find deferred revenue on the bal-
ance sheet. Search for the 10-k (or other financial notes)
to determine if any notes explain deferred revenues for the
companies you are studying.
4.  Establish if the companies use a subscription model. If
they do, ask them how they handle those subscriptions from
a revenue recognition standpoint. Or, see if you can find
notes on this in the 10-k.
5.  Do the companies you are studying have gift cards? How do
they handle this, and can you find notes in the 10-k about
how much cash is being generated from these activities?
How does the company handle balances that appear not ever
to be used to exchange for products and services? What rules
do they use to write those amounts off of the balance sheet?
6.  Can you find any information about why the fiscal year
works as it does for the company you are studying? Why
might it be different than a calendar year?
7.  What questions pop up for you as you research your cho-
sen company? What resources in the company can you tap
beyond the 10-k to help answer those questions?
8.  Pull at least five years (more if you have access to more
years) of income statements. Are the accounts growing?
Are expenses growing faster than revenue? Is there steady
growth in numbers, or does each year show a lot of varia-
tion? Use the principles of horizontal analysis in Topic 20 of
this book to prepare the calculations.
9.  What types of costs are in the cost of goods sold? How does
the company calculate the cost of goods sold?
10.  Does the company use standard costs in the cost of goods
sold? How are they calculated?
11.  How does the company establish mark-ups on products
and services? A couple of sources for this might be a pur-
chasing department or the accounting department.
12.  What is the gross margin on the consolidated income
statement?
44 FIN A N CIA L IN T EL LI G EN C E

13.  If you have access to more detailed information on dif-

ferent products or services, calculate the gross margins. Do
certain products subsidize other products? Are all products
profitable? If you can dive into more granular detail, then
you can find some interesting things sometimes. Sometimes,
a company may have “loss” leader items that get customers
into the store.
14.  What all is included in operating expenses for the company?
Many different types of expenses go into administrative
expenses, so do as much of a deep dive into this account as
you can. You may not have access to this type of information
unless you work for the company. Otherwise, you may only
be able to find what you can discover in the 10-k.
15.  Are there any extraordinary or unusual items on any
income statement? If there are, look for notes about those
on the 10-k – they should be explained.
16.  Are revenues, gross margins, and net profits staying con-
sistent over time? What is the trend?
17.  Most often, you may be comparing year over year.
However, you can also compare quarter to quarter, or first
quarter to first quarter, or second quarter to second quar-
ter. Different ways of slicing the data can give you specific
insights!
18.  At this juncture in your study, which company is performing
best?

Notes
1 Income statement – definition, importance, and example. Retrieved from
https://www.zoho.com/books/guides/what-is-an-income-statement.
html#:~:text=An%20income%20statement%20is%20a,financial%20
health%20of%20your%20business.
2 What is revenue? Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/accounting/revenue/
3 What is an expense? Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/accounting/expenses/
4 Cash basis of accounting (2021). Retrieved from https://www.accoun-
tingtools.com/articles/what-is-the-cash-basis-of-accounting.html
 RE V ENUE A N D E X P ENSE 45

5 Accrual basis of accounting definition. Retrieved from https://www.

accountingcoach.com/terms/A/accrual-basis-of-accounting
6 What is procure to pay? Retrieved from https://www.ariba.com/solu-
tions/business-needs/what-is-procure-to-pay#:~:text=Procure%2Dto%2
Dpay%20is%20the,and%20reconciliation%3B%20invoicing%20and
%20payment.
7 Step by step: What you should know about the order-to-cash process.
Retrieved from https://www.salesforce.com/products/cpq/resources/
what-to-know-about-order-to-cash-process/
8 Fiscal year (FY): definition and importance (2021). Retrieved from
https://smartasset.com/taxes/fiscal-year
9 Starbucks, (2013). Starbucks Concludes Packaged Coffee Dispute with
Kraft. Retrieved from https://stories.starbucks.com/press/2013/
starbucks-concludes-packaged-coffee-dispute-with-kraft/
10 Reiff, N. (2020). Profit and Loss Statement (P&L). Retrieved from
https://www.investopedia.com/terms/p/plstatement.asp
11 What is deferred revenue? Retrieved from https://www.accountingcoach.
com/blog/deferred-revenue#:~:text=Deferred%20revenue%20is%20
money%20received,be%20reported%20as%20a%20liability.
12 What is cost of goods sold (COGS) and how to calculate it. Retrieved from
https://www.freshbooks.com/hub/accounting/cost-of-goods-sold-cogs
13 What is gross margin? Retrieved from https://www.accountingcoach.
com/blog/what-is-gross-margin
14 Examples of operatings expenses (2021). Retrieved from https://www.
accountingtools.com/articles/what-are-examples-of-operating-
expenses.html
15 What is operating income? Retrieved from https://corporatefinancein-
stitute.com/resources/knowledge/accounting/operating-income/
16 What is net profit? Definition and examples. Retrieved from https://
marketbusinessnews.com/financial-glossary/net-profit-definition-
meaning/
17 Wilhelm, A. (2019). Gross Margins, Revenue Multiples, and 2019
IPO’s.Retrieved from https://news.crunchbase.com/news/gross-margins-
revenue-multiples-and-2019-ipos/
18 What is revenue recognition? Retrieved from https://corporatefinancein-
stitute.com/resources/knowledge/accounting/revenue-recognition/
19 LOGM (2019). 10-k. Retrieved from sec.gov at https://www.sec.gov/
ix?doc=/Archives/edgar/data/1420302/000156459020004769/logm-
10k_20191231.htm
20 Logmein.com, subscription pricing. Retrieved from https://www.logmein.
com/buy
21 Zoom (2019). 10-k. Retrieved from https://investors.zoom.us/sec-
filings/sec-filing/10-k/0001585521-20-000095
22 Zoom.us, subscription pricing. Retrieved from https://zoom.us/pricing
 Part Three
A s se ts , L iabilities , and
E quit y
Understanding the Balance Sheet

One of the first things to know about a balance sheet is that the
statement sections MUST BALANCE (hence the name)1. You may
also hear accountants referring to this as the “accounting equation2.”
They are talking about the balance sheet because the total value of
ASSETS must qualify the total value of the LIABILITIES and
EQUITY in the company. The entire structure of how financial
statements are built (in software like QuickBooks, SAP, ORACLE,
or any other software that generates financial statements) is based
on this idea of “balance.” However, that is a topic for your accoun-
tant to understand, but the balance sheet must balance is what you
need to know. Thus, you would know something is severely wrong
in the company financials if the balance sheet was out of balance.
Assets will represent different items that have value to the orga-
nization and will be used in the business. Liabilities will be the
items that a company owes, either short-term bills that are due like
having to pay a vendor or long-term amounts owed like a 10-year
loan that must be paid back to a creditor. Equity, in a business, is
where all your profits in the business go. If you are publicly traded,
the common stock will be valued in this section.

Periods of Time

For a balance sheet, the balances in the accounts continue to grow

or decline over time, in Topic 6, where we discussed the fact that a
profit and loss statement represents only a specific time frame. Thus,
a profit and loss statement may be only for the month of August.

DOI: 10.1201/9781003110613-3 47
48 FIN A N CIA L IN T EL LI G EN C E

However, a balance sheet is an accumulation of all of the transactions

made over the company’s life. When you look at a balance sheet,
instead of saying “….for the period of….”, it will say “….as of…” a
particular date.
Another way to think about it is this: Once you are working
and earning a paycheck and paying bills on your household, your
cash balance in a checking account is just an ongoing balance. The
balance will ebb and flow over your lifetime, but the amount of cash
you have on hand at any given moment is “as of ” that date. The same
situation exists for a company and its balance sheet.
Another example: we as individuals may own a home and have
a mortgage that we are paying off over 20–30 years. The house will
be a long-term asset to us, just like if a company buys a building.
We both will carry that asset on our balance sheet for as long as we
own that asset. Plus, over time, we will be paying off that long-term
liability on the balance sheet.
Think of it this way, if this helps: The balance sheet carries all
the financial decisions the company has made over its entire life as
a company. You may even hear people talk about why they prefer
certain financial statements over others. Personally, all of the
financial statements should be a concern in understanding how they
work together. However, you can make your own decisions about
which one carries more weight in your analysis as you build your
financial acumen!

Translating This Information

As you are reading this section, remember that we have the same
financial information in managing our household as individuals.
Instead of calling it a balance sheet, we will call it a net worth
statement. Thus, anytime you hear anyone talking about their net
worth, you now know that they are talking about their balance
sheet!
A company will have ASSETS, and an individual will have
ASSETS. For a company, this can be buildings, cars, trucks
(like delivery vehicles), land, equipment, cash, inventory, etc3. An
individual can have similar items, but we typically have vehicles,
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 49

a house, investments in securities or other financial instruments,

land, jewelry, and other items.
In addition, for a company and an individual, you will have
LIABILITIES4. For a company, their liabilities could include sev-
eral things – they could have mortgages on buildings, they could
have issued bonds to generate cash, but the bonds have to be paid
back, and they have bills to pay just like an individual does. For an
individual, we will have credit card balances to pay, vendors to pay,
mortgages to pay, etc.
The only difference between a company and an individual is the
difference between EQUITY and NET WORTH5. These sec-
tions of the balance sheet essentially represent the same thing. The
net worth is essentially the equity we have built in our household,
but we call it net worth instead of equity.

Topic 8: Short Term versus Long Term

You will notice that there are time distinctions of short term (current)
and long term on the balance sheet. Generally, speaking accoun-
tants use a one-year time frame to determine short-term assets and
liabilities. Thus, when you think about this, you are thinking about
“how quickly can this asset be turned into cash”? Accountants use
a one-year time frame to identify if an asset is a short-term asset6.
If we apply this rule to the cash account on the balance sheet,
cash is already in the form of cash. Thus, cash is the “most liquid”
asset that a company has, and that is why it is listed first on every
balance sheet you will ever examine.
Then, usually, what you will see listed second on the balance sheet
is accounts receivable. Accounts receivable will generally be turned
into cash in a short amount of time, and it will depend on credit
terms that a company gives to suppliers. Thus, if a company says to
Customer A based on your credit rating, we will provide you with
terms of paying your invoices within 30 days. If they tell Customer
B, you can pay your invoices within 45 days, and if your customers
take the full amount of days to pay, then when you average the data
out, the invoices would turn into cash much faster than a one-year
time frame. As you are examining a company’s balance sheet, the
50 FIN A N CIA L IN T EL LI G EN C E

short-term assets will be listed in the order of how fast they can be
turned into cash.
Beyond the one-year time frame, you will have long-term assets7.
The most common long-term assets a company will have are the
assets that will exist for over one year and are often not turned into
cash, but they often generate cash. One of the most common assets
in this category is the “property, plant and equipment” or “fixed
assets.” This category on the balance sheet represents things like
machinery that are used in production. A machine used in produc-
tion might be on the balance sheet for 10 years, 20 years, 30 years,
or longer. It is because of that time frame that the asset will be clas-
sified as a long-term asset.
The same framework is used for liabilities on the balance sheet.
Often, the most common short-term liability that you will see on
the balance sheet is accounts payable. This account represents the
amount of money that has to be spent with suppliers. For example,
your company will be a customer of other companies. Those
companies will sell products to you, and you may be given terms
like 30 days to pay invoices to them. Thus, you want to think about
them in terms of how long it takes to use the cash for liabilities. For
accounts payable, this will be a time frame shorter than one year.
These accounts will often represent the debt obligations that a
company has to pay over a longer time frame than one year for long-
term liabilities. For example, a company can take out a loan with
the bank to be paid back over five years, or a company can take out a
mortgage to pay for a production facility to be paid back over 20 or
30 years, or a company can issue bonds that have to be repaid over
a long period of time.

Topic 9: Assets

The balance sheet is called the “balance sheet” because it MUST

balance. There are three major sections to the balance sheet: assets,
liabilities, and equity. This is also known as the accounting equa-
tion, which is represented by the following equation:

Assets  Liabilities  Equity

 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 51

In this section, you will learn even more about how to assess
assets, liabilities, and equity on the balance sheet.

Current Asset: Cash

Cash should be straightforward to understand because it represents

the cash that a company has in the bank. However, there is also
another term called “Cash Equivalents.” Cash equivalents represent
investments that the company could turn into cash within a few hours
or within a day8. Another way to think about cash equivalents is how
“liquid” they are, which means how quickly they can turn into cash.
Using this conversion idea, the ability to turn an asset into
cash, the cash is the company’s most liquid asset. In addition, cash
equivalents can be turned into cash so quickly they are often listed
together on a balance sheet.
A cash equivalent can be a deposit certificate, a treasury bill issued
by the U.S. government, or money market funds. These investment
types can be turned into cash in a very short period of time, thus
making them a cash equivalent. These are the safer investments
where a company can use cash to earn a modest return on the cash
while having the flexibility to pull the money back into cash to use
for operations or other investments.

Current Asset: Accounts Receivable

All the current assets are listed in the order of how liquid they are or
how quickly the asset can be turned into cash. Generally, the second
item you will see on the balance sheet in the current assets section
will be accounts receivable. Accounts receivable represent the sales
of the company that has not been turned into cash9.
You have already learned what accounts receivable represents
on the balance sheet. Now, you want to know how the company is
managing that asset. There are a couple of ways that you can assess
how well accounts receivable is managed.
One of the ways is to look at the aging of the accounts receivable.
In most accounting software, this is one of the common reports that
can be run. The report will list all the customer’s open invoices and
52 FIN A N CIA L IN T EL LI G EN C E

let you know if the invoice is 30 days old, 60 days old, 120 days old,
or older. Accounting software will often allow you to determine the
days of the categories, but these are common groupings. The impor-
tant thing here is that you want all of your invoices to be within
current terms for the customer. Thus, if you have given a customer
30 days to pay, you do not want to see that invoice NOT PAID on
day 35 after the invoice was generated.
Typical accounts receivable aging report would look something
like this (Figure 9):

Figure 9 Sample A/R Aging Summary

One thing to note, some small businesses may run on credit card
transactions for the most part. In that case, you may not see a lot of
accounts receivable balances that are open. For instance, suppose that
you are a business that produces an online software product, and you
charge a yearly subscription for the software. You will likely have
credit card information stored in your system, and you will charge that
credit card each year. When a credit card is charged, you may send
the customer an invoice, but you have already charged the credit card.
There will be no need to be watching accounts receivable balances. In
this case, you want to know how many people keep their subscription
over time and how many people request refunds on their subscription.

Current Asset: Inventory

Inventory is a current asset, but inventory can often turn slower

into cash than other current assets10. One thing to make sure that
you understand is that there can be different kinds of inventory
accounts.
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 53

One type of inventory is called raw materials inventory. Raw

materials are the ingredients that are used in manufacturing or
assembling a product11. The raw materials will sit in the inventory
until they are pulled to manufacture or assemble a product. So, if
you are a company that builds computers, you would buy all of the
individual components and have them in your raw material inven-
tory until you pull parts to build a computer.
Then, when the raw materials are pulled for the manufacture or
assembly process, the inventory is transferred into work in process
type of inventory account. Thus, even if the production process only
takes ten minutes or if it takes several days, the materials will sit in
that account until the product is manufactured or assembled. While
working on assembling a computer, the parts will be in work in pro-
cess inventory until the computer is built.
Once a production or assembly job completes, the materials now are
transformed into a new product, and a finished good is called a com-
puter12. This finished good will also have labor costs included for the
assembly, and the computer will now be waiting to be moved to a retail
store inventory (if you have a store presence) and to be sold to a customer.
In addition to these inventories, you may also have an accesso-
ries inventory. You may also want to sell accessories like separate
keyboards, mice, mousepads, and other items that you buy directly
at a bulk or warehouse direct discount and sell to customers. These
products you buy, mark them up and sell them directly to customers.
Depending on the size of the computer manufacturing and
assembly, you may have some automated manufacturing. Thus,
you may need some spare parts for these machines. The spare parts
inventory is not something sold to the customer, and it is for the
assembly process only. Thus, this is a specific inventory that has not
ever turned into cash, this type of inventory is only a use of cash.
Suppose you are examining a business for purchase or expansion
of your current business. In that case, you may want to make sure
that you ask about the size of this inventory and how well it is being
managed and take out the effect of this inventory on the days sales
outstanding and inventory turnover ratios.
The key to the turnover metrics on your inventory is to ensure
that your inventory is being purchased, converted into a finished
54 FIN A N CIA L IN T EL LI G EN C E

good, and then sold as quickly as possible. This turnover rate by

product category, or specific product, can tell you a great deal about
how efficiently you are managing your inventory.
Think about it this way, suppose a company has $100,000 average
inventory, and the cost of goods sold of products is $600,000. In
this case, your inventory, IN TOTAL, is moving six times a year
($600,000 / $100,000). Thus, every two months, you are turning all
of your inventory into cash.
However, are all the product categories moving among all your
products included in the inventory at the same rate? Can we say for sure
that all inventory is turned at this rate? No, you cannot say that. To bet-
ter understand the efficiency, you hopefully can use this same formula
and capture the turnover rate of every single item or group of items.
For example, you could have some products moving very slowly
and some products moving very fast. What if you found that some
products were moving very slow? There could be a few reasons for
this. One reason could be that you have products in inventory that
you no longer sell. Another reason could be that you just bought too
much at one time of certain products that are just not moving as fast.
Often, software today can help you do this analysis, but not every
software program may have this capability. However, a good accoun-
tant can help you with these calculations and help develop a process
by which you can assess turnover. The important thing to remember
is that cash is tied up in inventory, so staying on top of turnover makes
the operations more efficient. Plus, if you start having inventory that
is not used anymore, you can figure out if a donation needs to be
made or sell the items for a little bit of money back to the company.
Sometimes the inventory that does not move will meet an expira-
tion date. For example, grocery products and other food items can
have an expiration date where all you can do is perhaps write off that
inventory. The key to managing this type of inventory is making
sure that you have good, solid prediction formulas to help you keep
just the right amount of inventory on hand.
Otherwise, the other culprit of extending inventory turnover is
obsolete items. Obsolete inventory is the inventory that no longer
has a useful application in your business13. For instance, you may
have parts for a machine you no longer use. An important part of
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 55

managing inventory will be keeping a list of parts associated with

its “parent.” Thus, if you make personal computers if you have a par-
ticular part that makes “Laptop X” – like a particular hard drive-you
want to make sure that Laptop X and that hard drive are associated.
Thus, if you STOP producing Laptop X, then you can assess all of
the parts that made that went into producing that laptop. That way,
if you can re-use those parts on another laptop, then great, other-
wise, you can get that inventory out of your storage to make way for
other inventory, and you might even get a little of your money back
if you can sell it, or scrap it, and worse case is you give it away.

Long-Term Asset: Property, Plant, and Equipment

Often, the largest long-term asset of a company is the account called

“Property, Plant and Equipment,” or you can also see this called
“Fixed Assets.” These are assets that are never sold to the customer,
but they often assist in generating cash14. Any production and ware-
housing equipment or buildings that will house production and ware-
housing equipment have the purpose of generating products for sale.
For example, suppose a machine that you buy is worth several
hundred thousand dollars that help you automate a part of the
manufacturing process of building a computer. In that case, you will
capture the value of that machine in a fixed assets account on the
balance sheet. Thus, many people who study the financial statements
of different companies look at the return on assets financial ratio.

Depreciation

Depreciation is an accounting procedure that allows you to rec-

ognize the expense of investment into buildings or machinery, or
other assets on your income statement over time15. For example, if
you are investing in a piece of machinery worth $500,000, you can
depreciate that asset over its useful life. Perhaps your fixed assets
person or your CPA will determine that the asset’s useful life is 20
years, and your CPA expects that the value of the piece of machin-
ery will only be $20,000 after the 20 years of use.
Before getting into the mechanism of depreciation calculations,
think about why this mechanism exists. One reason for this is that
56 FIN A N CIA L IN T EL LI G EN C E

$500,000 is a considerable expense to hit the income statement all

at once. Think about the price tag of purchasing or constructing a
building. The price tag could be millions of dollars, so that would be
a significant impact on your income statement in one period.
Secondly, depreciation expense is connected to the “accumulated
depreciation” on the balance sheet. The accumulated depreciation
account offsets the asset’s original purchase price so that you always
know the “book value” of the asset16.
There are several different methods by which a fixed assets
accountant would spread the depreciation expense over the asset’s
life, but the simplest way to do it is to approach it by the straight-
line method17. This method means is that we will take the original
purchase price minus the salvage value divided by the asset’s life
In our example, then, the formula would look like this:

Original Purchase
Price $500,000
Useful Life 20 years
Salvage Value $20,000
= ($500, 000 – $20,000)/(20 years × 12 months)
= $480,000/240 months
= $2,000 depreciation expense/month

Thus, over time, each month, the company will record a depre-
ciation expense of $2,000 with an offset of a corresponding $2,000
credit in accumulated depreciation. Over time, over the 240 months,
the accumulated depreciation account will eventually have accumu-
lated $480,000, and the original purchase price of $500,000 will
still be on the balance sheet as an asset. The net value, or the salvage
value, at month 241 will be $500,000–$480,000 = $20,000.
The asset could be disposed of or sold before that 240th month or
after, and the proceeds would be compared with whatever the dif-
ference is between the original purchase price and the accumulated
depreciation. More importantly, though, the depreciation expense,
to reiterate, is NOT PAID to any government agency. Thus, this is
an accounting entry to help the business keep a book value of assets,
but this is a NON-CASH entry.
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 57

Amortization

Amortization is an accounting procedure that allows you to rec-

ognize the expense of investment into non-tangible assets on your
income statement over time18. The idea is the same as depreciation,
and it is just that this procedure is being applied to something like
goodwill or even to software licensing. Goodwill is often the differ-
ence in the purchase price of a business acquisition and the value of
the business acquisition. Licensing can be very expensive, but the
license is intangible. Every company will have a policy or practice
that establishes a threshold of how much total cost can be expensed to
the income statement or capitalized as a project and then amortized
over time. For some companies, this could be $20,000, or $100,000,
or more19 (see also Part Two, Deeper Dive into Cost of Goods Sold).
For example, in one company I worked for, the information tech-
nology department had an interesting rule and terminology for this
idea. It may be something that you may hear of in your career. In
this company, they had a cutoff of $300K, and if the cost of a proj-
ect went above this number, then the project would be capitalized
and amortized. The project may be amortized for 10 years up to 30
years, depending on how long they assessed the life of the technol-
ogy asset.
In addition, the company called money spent below the $300K
mark to be “hard” money, meaning that the money would all impact
the income statement as incurred. A project over $300K was consid-
ered “soft” money, meaning that the impact to the income statement
would be spread over a much longer period of time.
Another nuance to this idea is how human resources are used in
an information technology department. For example, if you have
an information technology department that has a mix of full-time
direct employees and you also employ various consulting compa-
nies, which resources would you consider using for a capitalized
(soft money) project versus a non-capitalized (hard money) proj-
ect? Consulting resources tend to be more expensive than full-time
direct employees (even with benefits added). A company may very
well be more heavily weighted to outside consulting resources for
soft money projects.
58 FIN A N CIA L IN T EL LI G EN C E

Topic 10: Liabilities

In this section, you will learn even more about the liabilities recorded
on the balance sheet. Liabilities will also be classified as current
(short-term) and long-term liabilities.

Current Liability: Accounts Payable

Accounts payable most often will represent the amounts owed to

suppliers20. Every month, as a business is operating, the company is
incurring costs. There are various types of costs: buying parts from
suppliers, paying contractors and services vendors, paying rents,
paying for insurance, and possibly paying benefits for employees,
just to name a few!
From a processing perspective, a company will often set up
purchase orders for products and services. Not all companies do
this, but if a company is publicly traded, they will do it this way. The
nice thing about purchase orders is that the creation sets up many
default information about future transactions. One of the default
pieces of information will be an account number representing the
expense account or another type of account, where the charges will
be processed when the products and services are received.
So, what does this mean for you? Well, in many IT departments,
you will be potentially managing a budget. Thus, you could have
a line item for some type of monthly expense, perhaps for a
maintenance contract. When the purchase order was set up, the
account number was set at that time.
What if your department merges with another department?
The account number that defaults on the purchase order will not
change just because there was a reorganization within the com-
pany. Therefore, many managers have been frustrated because
their budget details have line items that are going to the wrong
accounts. Now you know that to fix that, you need to go to the
purchasing or accounts payable department to fix the source of the
problem!
Many of the coding issues will have a source in the accounting
department, so the key is to know for any particular account on
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 59

the profit and loss statement or the balance sheet to identify the
SOURCE of information for that account. For example, use the
revenue account as an example. Revenue represents sales of the
business of products and services. So, where are the sources of infor-
mation about revenue?
The source document will usually be an invoice that is created.
The source may not always be an invoice, but it is a place to start.
However, that invoice will have certain default information associ-
ated with it. When the customer is entered into the system, there
could be a default revenue account that is associated with the cus-
tomer. Or the products and services could drive the revenue account
that is the default. Thus, if the business has restructured, a customer
may belong in a different department, you would have to make sure
that any default accounts are restructured.
In addition, some businesses may not have revenue driven by
invoices. Some or all revenue could be driven by credit card transac-
tions or direct payments to a bank account. Thus, the transaction
may be accounted for by an accountant or by a journal entry.
The challenge you may have is knowing how to find that source
of data, but it is important to identify and document where the
source of data is so that you can fix errors at the source. For
those of you that may be involved in budgeting, and the sources
of data in budgets should be part of the budget development.
You will save an enormous amount of time and be much more
efficient and thus relates to savings of time and money for your
department!
In terms of accounts payable, everything will go back to either
the customer record in the system or the products and services
that are purchased on purchase orders. Thus, the same logic
applies to make sure and document where the source of the data
is in your budget. And small businesses could just have expenses
coming through the bank account by debit card purchases or
bank transfers. Thus, the accountant or bookkeeper may be
coding those entries. A lot of software today can build default
account numbers for recurring transactions, and therefore that
would be the source of the error if errors start showing up in
your books.
60 FIN A N CIA L IN T EL LI G EN C E

Long-Term Liabilities

Long-term liabilities are those debts that are paid over more than
a year21. Another way that a company may refer to these long-term
liabilities is by the nomenclature of “noncurrent” liabilities or “long-
term debt.”
A company could raise cash by issuing a bond to the public. An
investor can then invest in that bond, but it is a liability that the
company must pay back to the investors. Bonds can be issued for a
year or up to 30 years. Now, any part of a bond that is owed within
one year will be classified as a short-term liability, but the remain-
ing liability amount will be listed as long-term liabilities.
For example, you could be paying a $1 million loan over 30
years, and the first year of the 30-year loan will be considered a
CURRENT liability, and the rest of the long-term liability would
be in the long-term liability section. Every year of the long-term
liability would get reclassified this way, so it is important to watch
for this when examining the liabilities section 22.
A company can also have other types of long-term liabilities on
its books. The company can enter into long-term loans with a bank,
possibly have a mortgage on physical buildings, and other types of
long-term debt that are repaid over a long period of time.

Topic 11: Equity

In this section, you will learn even more about the equity section of
the balance sheet. Equity is the net worth of a company, just like an
individual can build up his or her net worth23. There are two major
categories of accounts that are within this section on the balance sheet.

Stock For a company that is publicly traded, you will see various
types of stock accounts in the equity section. The most common
type of stock is “common stock,” and it is this type of stock that is
sold on the major exchanges in the United States (like the New York
Stock Exchange or the NASDAQ )24. Issuing stock is a great way to
raise cash for a company.
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 61

Retained Earnings

The retained earnings balance represents the profits or losses

the company has incurred over time25. A common question that
is asked is, but wait, are the profits and losses recorded on the
income statement? The answer to that is YES, they are. However,
the income statement represents the profit or loss for one period
of time.
Let us explore what this means. Assume that a company works
on a reporting period of a calendar month. Each month, during
the closing of the books that accountants do in the company, the
accounting software will clear out the balances in all the revenue
accounts and the expense accounts on the income statement and
move those balances to the retained earnings account. Thus, every
accounting period, the income statement “starts over” with zero bal-
ances in the revenue and expense accounts.
Therefore, when you assess the retained earnings balance, you
are looking at profits and losses for the company over the life of that
company. What you want to see is a healthy generation of equity
built up in the company.
In addition, the equity section of a balance sheet of a publicly
traded company will also have different types of stock that have
been issued. Most commonly, common stock will be listed in this
section. Common stock is the stock that is offered to the general
public through trading exchanges.

Part Three: What to Watch Out For

• Balance sheets must balance. Assets = Liabilities + Equity.

• Cash, accounts receivable, inventory, and accounts payable
are considered the working capital of the company.
• Inventory could be turned into cash a lot slower than other
current assets like accounts receivable.
• Cash equivalents can be turned into cash very quickly.
• Long-term liabilities should have a current liability amount
for the year that is being paid off in the current year.
62 FIN A N CIA L IN T EL LI G EN C E

Part Three: Exercises, Practice, and Resources

Learning activities:
1. In the 10-k, can you find information on short-term versus
long-term assets and liabilities? Does the 10-k give you any
information on how these are calculated?
2. Can you find any information on the different kinds
of inventory accounts that are in use in the company?
Remember, the inventory listed is a consolidated number
and can represent all kinds of different inventory accounts.
3. Does the company have cash equivalents? What does that
represent for the company?
4. Are you able to get your hands on an accounts receivable
aging schedule?
5. Are you able to get your hands on an accounts payable aging
schedule?
6. If a company does have different kinds of inventory, look to
calculate turnover rates on the different types of inventory.
7. If you work for the company you are studying, ask to see the
aging of the accounts receivable balances.
8. If you are assessing a company for possible purchase, if the com-
pany does not have aging of accounts receivable, as for a report
to be created or an accountant help build this report for you.
9. If the company has fixed assets (i.e., property, plant, and
equipment), can you find out what makes up this balance?
Is it raw land? Is it buildings? Fleets of cars? How are they
depreciated?
10. How much depreciation expense is deducted every year for
these assets (property, plant, and equipment)?
11. Does the company have technology assets that are being
amortized? Can you find solid reasons why some assets are
depreciated and which assets are amortized?
12. Pull at least five years (more if you have access to more
years) of balance sheets. Are the accounts growing? Are lia-
bilities growing faster than equity? Is there steady growth in
numbers, or does each year show a lot of variation? Use the
 A S SE T S, LIA BILITIE S, A N D EQ UIT Y 63

principles of horizontal analysis in Topic 20 of this book to

prepare the calculations.
13. What kinds of long-term liabilities does the company have?
What were they investing in for the liabilities?
14. How do retained earnings look? Is it showing many periods
of gains or losses?
15. Most often, you may be comparing year over year. However,
you can also compare quarter to quarter, or first quarter to
first quarter, or second quarter to second quarter. Different
ways of slicing the data can give you specific insights!
16. At this juncture in your study, which company is performing
best? You can include both the income statement and
balance sheet in your assessment overall.
17. Assess hard and soft money projects. Examine how a com-
pany utilizes amortization.

Notes
1 What is the balance sheet? Retrieved from https://corporatefinanceinsti-
tute.com/resources/knowledge/accounting/balance-sheet/
2 What is the accounting equation? Retrieved from https://corporatefi-
nanceinstitute.com/resources/knowledge/accounting/
accounting-equation/
3 What are the main types of assets? Retrieved from https://corporatefi-
nanceinstitute.com/resources/knowledge/accounting/types-of-assets/
4 What are the main types of liabilities? Retrieved from https://corpo-
ratefinanceinstitute.com/resources/knowledge/accounting/types-of-
liabilities/
5 Shareholder equity vs. net worth – Top 5 differences you should know.
Retrieved from https://www.wallstreetmojo.com/shareholder-equity-
vs-net-worth/
6 Short-term asset definition. Retrieved from https://www.accounting-
tools.com/articles/what-is-a-short-term-asset.html
7 What is a long-term asset? Retrieved from https://www.accounting-
coach.com/blog/what-is-a-long-term-asset
8 What are cash equivalents? Retrieved from https://corporatefinancein-
stitute.com/resources/knowledge/accounting/cash-equivalents/
9 Accounts payable versus accounts receivable. Retrieved from https://cor-
poratefinanceinstitute.com/resources/knowledge/accounting/
accounts-payable-vs-accounts-receivable/
64 FIN A N CIA L IN T EL LI G EN C E

10 What is inventory? Types, examples, and analysis (2020). Retrieved from

https://www.netsuite.com/portal/resource/articles/inventor y-
management/inventory.shtml
11 Raw materials inventory definition. Retrieved from https://www.accoun-
tingtools.com/articles/2017/5/13/raw-materials-inventory#:~:text=
Raw%20materials%20inventory%20is%20the,process%20or%20fin-
ished%20goods%20production.&text=These%20are%20materials%20
not%20incorporated,consumed%20during%20the%20production%20
process.
12 Finished goods inventory: formula, calculation, and turnover. Retrieved
from https://www.bluecart.com/blog/finished-goods-inventory
13 What is obsolete inventory? Retrieved from https://www.accounting-
coach.com/blog/what-is-obsolete-inventory
14 PP&E (Property, Plant and Equipment). Retrieved from https://corpo-
r atefinanc einstitute.com/resources/knowledge/accounting/
ppe-property-plant-equipment/
15 What is depreciation and how to calculate it (2020). Retrieved from
https://bench.co/blog/tax-tips/depreciation/
16 Accumulated depreciation. Retrieved from https://corporatefinanceinsti-
tute.com/resources/knowledge/accounting/accumulated-depreciation/
17 Straight line depreciation. Retrieved from https://corporatefinanceinsti-
tute.com/resources/knowledge/accounting/straight-line-depreciation/
18 Amortization. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/accounting/amortization/
19 Wehner, C. (n.d.). Accounting for Computer Software Costs. Retrieved
from https://www.gma-cpa.com/blog/accounting-for-computer-software-
costs
20 Accounts payable. Retrieved from https://www.accountingcoach.com/
accounts-payable/explanation
21 Accounting 101 basics of long term liability. Retrieved from https://
smallbusiness.chron.com/accounting-101-basics-long-term-
liability-60869.html
22 Halton, C. (2020). Current Portion of Long-Term Debt (CPLTD).
Retrieved from https://www.investopedia.com/terms/c/currentportion-
longtermdebt.asp
23 Stockholders Equity. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/accounting/stockholders-equity-guide/
24 What is common stock? Retrieved from https://www.thebalance.com/
common-stocks-3305892
25 Retained earnings. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/accounting/retained-earnings-guide/
 Part Four
C ash Flow S tatements

A cash flow statement shows how the cash balance is changing in

your business1. For publicly traded companies who are required to
use the accrual basis of accounting, or for any other business that
elects to use accrual-based accounting, you now know that this
means a company is recognizing cash inflow and cash outflow before
the cash is exchanged. Thus, a cash flow statement is a reconciliation
of the cash to the accrual-based accounting system.
A cash flow statement is based on how cash is GENERATED
or USED in the business. When you look at a cash flow statement,
there are three sections:
1. Cash generated or used from operations
2. Cash generated or used from investing
3. Cash generated or used from financing
Many small businesses are based on the cash basis of accounting,
and therefore, the cash flow does not need to be reconciled at all.
But this assumes that ALL transactions, as they come in and out of
your bank account, are being coded to revenue or expense accounts.
If, for some reason, they are not being coded to revenue and expense,
but are coded to balance sheet accounts, then you may have a need
for a cash flow statement.
Most software today will create a cash flow statement. If you are
studying a publicly traded business, then the cash flow statement
is available to you in the 10-k. If you are analyzing a business to
purchase, you would have to learn how to create a cash flow state-
ment or have an accounting professional help prepare a cash flow
statement. If the company you are analyzing is on QuickBooks or
some other software type, the company can likely prepare that cash
flow statement.

DOI: 10.1201/9781003110613-4 65
66 FIN A N CIA L IN T EL LI G EN C E

The important thing to remember is that cash flow is truly

focused on the additions and subtractions from the cash balance.
This approach is different than the income statement that is rec-
ognizing revenue and expenses in the period incurred. A publicly
traded company has to follow specific rules about revenue and
expense recognition; the profits are estimated and do not reflect
actual cash gained or spent.

Topic 12: How Profit and Cash Are Related to Financial Statements

Throughout the book, the idea that profit and cash are not the same
has been pointed out several times. Now that you are aware of this,
and we have talked through different accounts on the profit and loss
statement and the balance sheet, we will summarize information
using the information you have learned before.
In the profit and loss statement, a company is generating or using
cash to generate profits. Thus, revenue generation is a cash generation
activity. You now know that the cash for the revenue can generate
before, at the same time, or after the revenue recognition occurred.
The cost of goods sold is cash used to generate the profits on the
sale of products and services. Gross profit then shows you the net
profits generated from the revenue minus the cost of goods sold.
From the gross profit, you will have operating expenses,
representing the cash being used to run the rest of the company.
These expenses occur regardless of if there is a sale or not of goods
and services.
Eventually, a company will have a net profit (hopefully). This
amount of money is cleared OUT of the profit and loss statement
and into the equity section of the balance sheet. The clearing out
process means that every revenue account, every cost of goods sold
account, and every expense account is reduced to zero, and the
summarized amounts go into the retained earnings account in the
equity section of the balance sheet.
Thus, on the balance sheet, the retained earnings represent the
company's profits over the company's life.
In addition, asset accounts and liabilities accounts will change
over time. For example, in one reporting period, the accounts
 C A SH F L O W S TAT EM EN T S 67

receivable balance might be $100,000, and in the next reporting

period, the accounts receivable balance could be higher or lower
than the month before. Suppose the accounts receivable balance
went up to $150,000 (from $100,000 the period before). In that case,
this could mean an increase in credit sales and that the company is
having a more challenging time turning their accounts receivable
into cash. Either way, this movement of the balances means that
accounts receivable has “used” cash from the previous period.
If the accounts receivable balance went down to $50,000 (from
$100,000 the period before), then this could mean that more
accounts receivable has been successfully converted to cash and that
credit sales have gone down. In this case, the accounts receivable
balance has “generated” cash.
Each of the cash flow statement sections will reflect how cash
was “generated” or “used” in the business. Plus, you want to view
the cash flow statement as a “reconciliation” of the cash account on
the balance sheet. Thus, the beginning cash and the ending cash
balance should be the same number that can be found on the cash
balance of the balance sheet.

Topic 13: Operating, Financing, and Investing Activities

A cash flow statement shows you how the cash balance is changing
through three different activities that a business can engage in:
operations, investing, and financing. Another way you can think
about this statement is to reconcile the cash account on the balance
sheet by showing the additions and subtractions of cash and if those
additions and subtractions are associated with different general
ledger accounts categorized as operations, financing, and investing.

Cash Generated or Used from Operating Activities

In a company, cash is either being “generated” or “used.” Within the

operations activities of the business, you generate cash through
sales of products and services, and you use money by paying
bills. Therefore, a profit and loss statement can often be called a
“Statement of Operations.”
68 FIN A N CIA L IN T EL LI G EN C E

Now, one item that you will often see in this section of the cash
flow statement is an item called “depreciation and amortization.”
This line item is always “added back” into the cash. The reason it
is added back in is that any depreciation expense or amortization
expense, when deducted as an expense on the income statement, is
a NON-CASH expense. In other words, there is NO payment to a
vendor for this expense.
When we pay utilities, there is a transfer of money from the
company to the vendor. When we pay rent, there is a transfer of
funds from the company to the vendor, but there is no agency
or company that you are paying in the case of depreciation and
amortization. Thus, that money must be added BACK to the cash
balance because the money never left the bank account.
In addition, it is essential to note that your working capital
accounts will also be listed here on the balance sheet – accounts like
accounts receivable, inventory, and accounts payable. The reason for
this is because these accounts are considered to “operating” assets
and liabilities.
That makes sense if you think about it logically. Why do
accounts receivable exist in the first place? It exists because some-
times, when you have a revenue-generating event, you have not
received the cash yet from the customer. Or, if you have recog-
nized a bill you have to pay in accounts payable, you may not have
sent the bank transfer yet for the expense. Likewise, you can have
inventory sit on your books for quite a while before a sales transac-
tion occurs.
What you want to look for in this cash flow section is that more
cash is being generated by the business than cash that is being used
in the business. Operations is where most of the “generated” cash
flow will come from in a company. Or, at the very least, net cash
generation will hopefully be a consistent level.

Cash Generated or Used from Investing Activities

Another section you will find on cash flow statements is devoted to

investing activities. Investing for companies can be through areas
like investing in securities or the purchasing of equipment. Most
 C A SH F L O W S TAT EM EN T S 69

of the time, you will see net “uses” of cash here, but it can fluctuate
quite a bit depending on the company's decisions about where they
put their cash for returns.
These tend to be longer-term investments. For example, a com-
pany could buy bonds of other companies or municipalities to gen-
erate interest payments as other income sources or invest in treasury
bills. These are often “safer” investments that are not speculative in
nature but can provide a little more significant rate of return than
parking all the cash in a bank savings account.
This section also includes cash being generated or used by
investing in capital expenditures. Capital expenditures correlate to
the discussion of depreciation and amortization in the long-term
liabilities section of the book. The company may be using some
of its cash on hand to buy property, plant, equipment, purchase a
business, or invest in information technology. Those investments,
when capitalized, will be reflected in this section. Generally
speaking, you may see more “uses” of cash in this section of the cash
flow statement.

Cash Generated or Used from Financing Activities

Another section on the cash flow statement has to do with financ-

ing activities. Here a company can generate cash through bor-
rowing activities (think of loans), issuing their own bonds to the
public, or by issuing common stock to the public. Borrowing
money generates a debt obligation for the company (liability) while
issuing common stock is shareholder-focused (equity). Payment of
a dividend (a payment made of holders of stock) is a use of cash in
this section as well. Generally speaking, you may see more “uses”
of cash in this section of the cash flow statement.

Topic 14: How All Financial Statements Fit Together

The financial statements are related. However, as you have read

through the material so far and worked on various activities, you
may not have picked up on the connections. Here you will examine
how these financial statements are related.
70 FIN A N CIA L IN T EL LI G EN C E

Income Statement to Balance Sheet

Revenue to Assets Revenue events are the sales events of the business.
In some cases, you are obtaining cash when the sale happens, and in
other cases, you are setting up a receivable where your business will
be paid later. Either way, revenue equates to the assets section of the
balance sheet (see Figure 10 below).

Figure 10 Revenue to Assets

Expenses to Liabilities Expenses that are paid or recognized on the

profit and loss statement are paying for short-term and long-term
liabilities on the balance sheet. Thus, if an expense is recognized, it
may not have been paid yet. Therefore, this is why there is a
relationship between the expenses and the liabilities (see Figure 11
below).

Figure 11 Expenses to Liabilities

Net Income to Equity The income statement and the balance sheet are
related to how the accounting world manages the estimated profit
and loss every month. In accounting software, every month, the
income statement accounts are “swept” to the balance sheet. You do
not need to know how this happens; all you need to know is that it
DOES happen (see Figure 9 below). The more you see the interplay
 C A SH F L O W S TAT EM EN T S 71

of the accounts on the different financial statements, the higher

your financial intelligence will be! (Figure 12)

Figure 12 Net Income to Equity

Every account on the profit and loss statement is reduced to zero

at the end of an accounting period so that the new accounting period
can start with a zero balance for the profit and loss accounts. For
example, if you had $100K in revenue in Period One, that $100K
does NOT carry over to the next reporting period. Thus, every rev-
enue account, every expense account, “starts over” at the beginning
of the next accounting period.
Thus, all the accounts are reduced to zero, and the balances are
moved to the balance sheet. On the balance sheet, these amounts are
transferred to the retained earnings account in the equity section of
the balance sheet. Thus, the retained earnings account is a collection
of ALL the net profits and net losses over the business's life. Think
of it this way, if it helps: All the estimated profits and losses from
OPERATIONS go to the retained earnings.
An important observation is to be made here; as you can see in
the previous diagrams, the profit and loss statement and the bal-
ance sheet line up perfectly to one another in terms of the interplay
of the accounts represented on each financial statement. You may
be thinking, if revenue is related to assets, and expenses relate to
liabilities, then why would you have to transfer the not profit and
loss to the equity section of the balance sheet?
The answer to this is fairly simplified, but it may take a while to
dawn on you. But the answer boils down to the fact that the profit
and loss calculates a profit or loss. In addition, remember back to
Parts Two and Three of this book, where we discussed that a profit
and loss statement is prepared FOR a specific period of time; thus,
72 FIN A N CIA L IN T EL LI G EN C E

the balances do NOT accumulate, and the balance sheet accounts

ARE an accumulation over time. So, since the profit and loss state-
ment is a calculation of the net profit or loss, in order to start over for
the next reporting period, which calculated profit and loss has to be
moved by a journal entry to the equity section of the balance sheet.

Income Statement to Cash Flow Statement

Generally, the income statement is revenue minus expenses equal

to net profit or loss. However, if we examine the smaller details of
a profit and loss statement, we see some distinct sections. Each of
those sections relates to the cash flow statement in a direct way
(Figure 13).

Figure 13 Detailed Sections of Profit and Loss

In Figure 12, you see that revenue will have a corresponding cost
of goods sold (sometimes called cost of revenue) being subtracted.
These are the direct costs of producing your products or services.
The revenue minus cost of goods sold will then give you a calculated
gross profit. Then, you will have operating expenses subtracted from
gross profit, which will give you a calculated earnings before inter-
est, taxes, depreciation, and amortization (EBITDA)2. This can
also be called operating income.
Then, you have a section where depreciation and amortization
are being deducted, and then you have interest and taxes being
 C A SH F L O W S TAT EM EN T S 73

deducted. Not every single profit and loss statement will look exactly
like this, so you need to know how these different accounts translate
to the cash flow statement.
Therefore, you will want to refer to this figure for more detail on
the connect (Figure 14):

Figure 14 Income Statement to Cash Flow

Thus, when you look at the income statement, the revenue to

operating expenses represents activities generated within your
company's operations. These accounts directly translate to the
operations section of the cash flow statement. For example, since
revenue can generate accounts receivable, you will see changes in
the accounts receivable balance in the operations section of the cash
flow statement.
The depreciation and amortization expenses are related to invest-
ing activities. The reason for these accounts is that your company
could be investing in long-term assets like buildings, land, equip-
ment, expense computers, and technology infrastructure. All of
those assets can be depreciated or amortized to track the book value
of those assets. Thus, you are “investing” some of your cash reserves
into those assets.
Finally, when your company pays interest, it is because the com-
pany is paying interest on a bond issue. Those bonds are a debt to the
organization, and you must pay interest to the investors that invest
in those bonds. That is why this section of the income statement
74 FIN A N CIA L IN T EL LI G EN C E

relates to the “financing” section of the cash flow statement. Any

time you issue bonds, which is a financing, or debt, activity.

Balance Sheet to Cash Flow Statement

The balance sheet is a bit trickier when it comes to translating how

these accounts translate to the cash flow statement. However, we
will work with this figure to explain the connections (Figure 15):

Figure 15 Balance Sheet to Cash Flow Statement

The first thing to make sure you understand is the idea of “short-
term.” For example, a short-term liability account is Accounts
Payable. Because it is short-term in nature, meaning that payment
is due within 30 days, 90 days, or anything else shorter than a one-
year time frame, we are talking about the business's operations.
Short-term assets are things like cash, accounts receivable, and
inventory accounts. All of these accounts have to do with operating
the business in the short term. Thus, any account in the “short-term”
sections of the balance sheet (whether in assets or liabilities) will be
considered part of the business's operations and directly translate
to that section in the cash flow statement. The balance sheet will
categorize the short-term accounts and the long-term accounts, so
they should not be hard to find!
Long-Term assets are an investment a company makes that will
often be paid over terms that are much greater than a year. A Chief
Financial Officer (CFO) may have preferences about how much
cash versus how much money the company is willing to borrow to
acquire or build an asset.
 C A SH F L O W S TAT EM EN T S 75

Topic 15: Working Capital Management

Working capital management is a phrase you may hear from time

to time3. Working capital is about the cash generated and used in
the business in the short term. Another way to think about this is
that working capital management is how a company ensures that
they have the cash for operating activities4.
Working capital management is the strategy a company uses to
manage inventory and accounts receivable assets and the liability of
accounts payable. Each requires different strategies, but the focus is
to generate cash AS FAST as you can and HOLD ON to cash for
as long as possible.
While employees and investors may not be too concerned with
the day-to-day operational details of managing these functions,
you will most definitely be concerned as a business owner or entre-
preneur. Thus, we will go through a few strategies to watch out
for when you assess a company for acquisition or what you need to
think about as you build your own business from scratch.

Accounts Receivable

Management of accounts receivable is a crucial concern to generate

cash flow. One of the best ways to stay on top of accounts receivable
is to run reports on the “aging” of the invoices. Typically, the aging
of customer invoices will show you the open invoices in categories
of 30-day increments (Figure 16).

Figure 16 Example of A/R Aging Report

In the next section that describes ratios, the ratios that relate to
accounts receivable are the accounts receivable turnover rate and the
days sales outstanding, and the overall cash conversion cycle. Thus,
76 FIN A N CIA L IN T EL LI G EN C E

when you are assessing how the company is managing accounts receiv-
able as an element of working capital, those ratios help you determine
what is going on and if the cash is being managed efficiently.
Remember, too, accounts receivable, depending on how large a
company is, that ONE account line on the balance sheet can actu-
ally represent hundreds or thousands of customers. Thus, if you have
access to the underlying data, rather than just the 10-k or top-level
financial statements, you can also calculate customer groupings or
other categories of customers. Remember, that aging report can
tell you if the aging is mostly current or trending toward not being
current. Sometimes we cannot see the aging of the open accounts
receivable or do some of the calculations on categories of customers
or by regions of the company or states. There could be issues under-
neath these year-over-year comparisons, which is why you want to
see consistent performance over time.

Inventory

Inventory management is an important thing to pay attention to

because of the amount of money that can be tied up in your inventory
waiting to be sold. Plus, as mentioned previously, you may have
inventory that is not sold, so you want to make sure all inventories
are moving as quickly as possible and thus being turned into cash
as quickly as possible. If you do have the inventory, you do not sell,
and you just want to make sure that the inventory is being used.
Regardless of whether inventory is sold or used internally, here are
ways to ensure that you are maximizing the cash you have invested
in this asset.
Now, inventory can be large bucket money that is invested; how-
ever, not all inventory accounts are for resale. Thus, when we exam-
ine inventory, breaking out the different kinds of inventory can be
very useful. Even if an inventory account is NOT for resale, we
want to make sure the inventory is being used and not just tying up
our cash flow.
When we examine a company and its financial statements, we
will often only see that high-level, consolidated inventory value on
the balance sheet. If you are analyzing the company financials of a
 C A SH F L O W S TAT EM EN T S 77

business you work for, you should obtain a breakdown of the spe-
cific types of inventory. Do you have a raw materials inventory? Do
you have a finished goods inventory? Do you have a work-in-process
inventory? Do you have a maintenance inventory?
If we only have the high-level number for inventory, then we can
calculate and evaluate the inventory turnover ratio and days sales in
inventory ratios. Suppose we can obtain some detail on the inven-
tory accounts. In that case, we can calculate the second level of anal-
ysis on the inventory turnover ratio and the day's sales in inventory
ratio. Plus, if you are up to the challenge, you could prepare these
calculations for each specific product or product category. The detail
of your analysis can go that deep!
Remember, too, that many software packages today have some
of these calculations built into them. Thus, if you examine your
company or assess a company as an acquisition, you may want to
ask about the inventory management systems and see if a report
calculates this for you. However, even if that is not available, you
know how to calculate this now, and you can ask for information to
help you assess this data.
In the next section that describes ratios, the ratios that relate
to inventory are the inventory turnover rate and the days sales in
inventory, and the overall cash conversion cycle. Thus, when you are
assessing how the company is managing inventory as an element of
working capital, those ratios help you determine what is going on
and if the cash is being managed efficiently.

Accounts Payable

Accounts payable management is all about holding onto cash for

as long as possible. Of course, a company can delay the payment;
however, it is advised not to do that because it can impact your
credit rating over time as a company. But there are legitimate ways
to hold onto cash for as long as possible or maximize your suppliers'
payments.
One way to do this is to take advantage of discounts offered by
your suppliers. Since cash used for paying bills often does not earn
large amounts of interest these days, taking advantage of discounts
78 FIN A N CIA L IN T EL LI G EN C E

offered by your suppliers could be a better rate of return on your

money. Think of it this way, and if your supplier offers you a 2%
discount to pay your bill in 15 days, and your bank is only paying
you a fraction of a percentage point on your money at the bank, then
there is no reason to hold onto the money.
In addition, we, today, can transfer money by electronic means.
Thus, we have the luxury of waiting until the last day or two of our
credit terms to send money to a supplier. Thus, we can hold money
for as long as possible and still get a payment to the supplier within
the terms of our credit agreement. That way, if we are earning even
a small amount of interest on our money at the bank, then we can
hold onto the money to let it keep earning for us.
In the next section that describes ratios, the ratios that relate
to accounts payable are the accounts payable turnover rate and
the days payables outstanding, and the overall cash conversion
cycle. Thus, when you are assessing how the company is managing
accounts payable as an element of working capital, those ratios help
you determine what is going on and if the cash is being managed
efficiently.
Remember, too, accounts payable, depending on how large a
company is, that ONE account line on the balance sheet can repre-
sent hundreds or thousands of suppliers. Thus, if you have access to
the underlying data, rather than just the 10-k or top-level financial
statements, then you can also calculate data on customer group-
ings or other categories of suppliers. Remember, that aging report
can tell you if the aging is mostly current or trending toward not
being current. We can evaluate the aging overall or do some of the
calculations on categories of suppliers or by regions of the company
or states, so there could be issues underneath these year-over-year
comparisons, which is why you want to see consistent performance
over time.

Part Four: What to Watch Out For

• Cash flow statements show you how cash is generated and

used in the company.
 C A SH F L O W S TAT EM EN T S 79

• Cash can be generated and used through the operations of

the business.
• Cash can be generated and used through financing activities.
• Cash can be generated and used through the investing
activities of the business.

Part Four: Exercises, Practice, and Resources

Learning activities:
1. Over a five-year time frame, is the company showing solid
growth in cash being generated from operations?
2. What is included in the investing section? Is cash usually
being used or generated from that section of the cash flow
statement?
3. What is included in the financing section? Is cash usually
being used or generated from that section of the cash flow
statement?
4. It may take a few attempts to understand the changes in the
cash flow statement, so find a good accounting resource to
help explain it!
5. Always keep in mind working capital management when
looking at the operations section. How well is the company
managing its working capital (accounts receivable, inventory,
and accounts payable)?
6. Most often, you may be comparing year over year.
However, you can also compare quarter to quarter, or first
quarter to first quarter, or second quarter to second quar-
ter. Different ways of slicing the data can give you specific
insights!
7. Now that you have studied all three financial statements,
which one do you think gives you the best information
about the company? Which do you think gives you the best
information about financial performance?
8. At this juncture in your study, which company is performing
best? You can include the income statement, balance sheet,
and cash flow statement in your assessment overall.
80 FIN A N CIA L IN T EL LI G EN C E

Notes
1 Cash flow statement. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/accounting/cash-flow-statement%
E2%80%8B/
2 Everything you need to know about EBITDA (2021). Retrieved from
https://money.usnews.com/investing/investing-101/artic les/
everything-you-need-to-know-about-ebitda
3 Working capital management. Retrieved from https://corporatefinancein-
stitute.com/resources/knowledge/finance/working-capital-management/
4 Working Capital Management (n.d.). Retrieved from the CFA Institute
https://www.cfainstitute.org/sitecore/content/CFAI/Home/member-
ship/professional-development/refresher-readings/2020/working-
capital-management
 Part Five
The P ower of Finan cial
R ati os

Financial ratios can give you quite a bit of insight into a company.1
The key is to understand what you are looking for and how to interpret
the numbers. In this section, several different ratios will be explored
using the two companies as a source of information to illustrate the
power of these ratios. This knowledge serves two purposes. For one
purpose, you can see how this information is gathered and from what
sources, and the other purpose is to see how these ratios are applied.
In addition to this, you can then use this as a model for analyzing
a company you work for, or you can use this as a model for analysis
of a company you are considering purchasing or use this as a model
to determine if you want to invest in a specific company. You can
also use this as a model by which you study a company that you
invest in financially. These ratios can be used in all of these sce-
narios to help paint a picture of financial performance. Plus, if you
look at this data every month, every quarter, or every year, you will
gain insight into financial performance, and you will be training
your financial intelligence to where the hyperbole of any executive
will not sway you. Training your gut to be aware of the information
that the results of these ratios give you can prove invaluable.
Within this section of the book, you will be learning about ratios
that fall into four distinct categories. These categories are profit-
ability, solvency, liquidity, and activity ratios.2
The profitability ratios look at a company’s ability to consistently
generate or grow its gross margins and net profit margins. You are
aware that profit is an estimate, but you know that a business’s oper-
ations generate and use cash. Thus, even though you could be look-
ing at estimated numbers and know why they are estimated, you can
still see how easily cash is being generated and used in the company.

DOI: 10.1201/9781003110613-5 81
82 FIN A N CIA L IN T EL LI G EN C E

For the solvency ratios, you are looking at the company’s long-
term prospects – you will be able to assess if the company maybe
exist as a viable company in the foreseeable future. This analysis is an
important measure because the calculations include the ­company’s
long-term assets and long-term debt.
You will also examine and learn how to use liquidity ratios. These
ratios tell you how well the company can pay its bills in the short
term. These ratios show you the ability to turn current assets into
cash to cover those short-term or immediate debts (liabilities).
The last category of ratios is the activity ratios. These are another
way of looking at cash usage and generation of cash and how well
you are managing your working capital. You will assess how well
a company manages its cash by how well they manage accounts
receivable, accounts payable, and inventory.
Finally, you will also do some analysis on free cash flow and how
that ties to the earnings before interest, taxes, depreciation, and
amortization. It is important to keep it clear in your mind how to
handle the non-cash deductions, like depreciation and amortization,
and how those are handled when understanding cash flow.
Honestly, commit to analyzing these ratios for a company you
work for as a baseline of your learning journey. You will start to see
just how powerful these numbers are in understanding financial per-
formance. For instance, sometimes, it can be difficult to determine if
bad financial decisions are being made. Still, ratios can often point
to the possibility that bad financial decisions are being made.
For example, in 2009, General Motors filed for bankruptcy.3 If
you had been examining the financial statements up to that point,
the bankruptcy would not have been surprising to you. You may not
have predicted a bankruptcy was going to happen, but you would
have seen a financial performance that definitely headed in the
wrong direction. Suppose you can read the financial statements and
do some quick calculations and do this over a long period of time.
In that case, your instincts will tell you something is not right, and
then you can assess what you would like to do about the situation as
an employee or an investor.
The one thing you want to watch out for is just how similar the
business models are to any company you are comparing. No two
 T HE P O W ER O F FIN A N CIA L R ATI O S 83

companies are ever 100% alike. However, in this book, one of our
main analyses is comparing LogMeIn to Zoom. The reason for the
comparison is that both of these companies offer virtual meeting
technology. Any company you want to compare, you can Google
which competitors they are most customarily compared to finan-
cially. Or you can find sources on Google that tell you the industry
code for the company (this can also be in the 10-k), which can give
you a better idea of which companies to compare financially.
For our purposes, LogMeIn and Zoom have some similar
product lines, so there is some comfort in the comparisons even
though they are in different industries. If we were comparing Zoom
to Boeing, it would be a lot more difficult for comparison purposes.
There might not be a reason you have personally to compare their
financial performance to each other.

Topic 16: Profitability Ratios

When examining the profit and loss statement for a company, you
want to assess how profitable the company is and how that profit-
ability is trending over time. Thus, profitability ratios are a specific
way to assess how well a company uses its assets to generate profits.4
Since you now understand that profit is not the same thing as
cash, then you are looking for a consistency of earnings over time.
For instance, it should feel different if a company is showing
consistency and growth in their earnings versus a company with
huge variations in their earnings.
The gross profit margin is a profitability ratio that assesses gross
profit on the profit and loss statement.5 Here is the gross profit mar-
gin formula:

Gross Profit / Revenue

Do not be surprised by terminology. In most cases, revenue is the

first item on the profit and loss statement, but this can also be called
Gross Sales, Net Sales, Sales, Net Revenue, or Gross Revenue.
Plus, Gross Profit could be called Gross Margin. In addition, if you
84 FIN A N CIA L IN T EL LI G EN C E

are looking up videos or other web content, you could find that the
formula could be given to you as:

Revenue  Cost of Goods Sold  / Revenue

Revenue minus cost of goods sold is the same thing as gross profit
in the previous formula. In addition, if you use this rendition of the
formula, the cost of goods sold can also be called cost of revenue.

Gross Profit Margin

The gross profit margin for Zoom and LogMeIn are examined here.
From the 10-k reports, we have the following information for the two
companies (all numbers are in thousands per the 10-k) (Figure 17):

Figure 17 LOGM and ZM Revenue and Gross Profit Data

Then we plug these numbers into the gross profit margin for-
mula: Gross Profit/Revenue = Gross Profit Margin. Here are the
results of the calculations for both companies (Figure 18):

Figure 18 ZM and LOGM Gross Profit Margin Results

We are only examining two years here for illustration purposes.

Still, if you are studying your own company you work for or examining
 T HE P O W ER O F FIN A N CIA L R ATI O S 85

buying a business or an investor, you want to calculate many years to

establish a trend. Two years is not exactly a trend, but we see in these
numbers that both companies have a healthy gross profit. Why do I
say that? One way to think about this is that even though the gross
profit margin here is shown as a percentage, you can also think of it
as how many CENTS per ONE DOLLAR of revenue the com-
pany keeps. Thus, Zoom (ZM) keeps 81.5 cents of every dollar, and
LogMeIn (LOGM) keeps over 74 cents of every dollar of revenue.
The second reason you will learn is that the technology industry
tends to have good gross margins. Defining “good” is equal parts
art and science. The science is the calculation itself, but the art is
that over time you will get a “feel” for the gross profit margin in the
industry you are studying. The more you do these calculations and
establish a trend, the more you will see how well your industry or
company performs.
Another thing to consider is that no two companies are
EXACTLY alike. However, if anything ever looks odd or out of
place in any results, one good place to look for insight into the num-
bers is the 10-k report.
You could see (if there is something odd or out of place in results)
classified as an “extraordinary” item or something that only happens
irregularly. For example, there could be litigation that is resolved
where one party has to pay out a settlement on an income statement,
which would be an unusual circumstance (hopefully)! When you
see something like this, calculate the ratios with and without this
entry. You can see the impact of the extraordinary item and see if
performance is still in alignment without that effect.

Net Profit Margin

For the net profit margin, you are examining the bottom-line prof-
its.6 Gross margin examines the product line profitability, and the net
income looks at the overall profitability after all other expenses have
been accounted for in operations. The formula for net profit margin is:

Net Income / Revenue

86 FIN A N CIA L IN T EL LI G EN C E

Be aware that net income can be called net profit.

The net profit margin for Zoom and LogMeIn are examined
here. From the 10-k reports, we have the following information
for the two companies (all numbers are in thousands per the 10-k)
(Figure 19):

Figure 19 LOGM and ZM Revenue and Net Profit Data

Then we plug these numbers into the net profit margin formula:
Net Profit/Revenue = Net Profit Margin. Here are the results of the
calculations for both companies (Figure 20):

Figure 20 ZM and LOGM Net Profit Margin Results

Just like the gross profit margin, instead of looking at this as a

percentage, we can think of it as the CENTS leftover from EACH
dollar of revenue after ALL expenses have been recognized.
Therefore, for Zoom (ZM), the most recent year sees them keeping
four cents of every dollar they generate in revenue.
Now, four cents may not sound like a lot, but remember, Zoom
(ZM) generated $622,650,000 in revenue (because the number in
the table is THOUSANDS; thus, we have to add three zeros to it to
know the full revenue earned). Therefore, the net profit of $26,362
is $26 MILLION.
 T HE P O W ER O F FIN A N CIA L R ATI O S 87

Connecting Back to the 10-k

As you study the gross profit and net profit margins of a company,
keep in mind that you may start having questions about the results.
One way to find answers to your questions is to refer back to the 10-k
to find possible answers to questions. Thus, in the case of profitability,
you can search on various terms to find out more information that
might explain certain results you are seeing. You may want to search
on terms like revenue, profit, margin, or extraordinary expenses.
As you study different companies and build upon your financial
intelligence, you may have other search terms that you decide are
important. It is not intended to be an exhaustive list. You can also
take these search terms to Google or whichever Internet provider
platform you have and search on those terms to see what experts
may be saying about the company and their results.
For example, for Zoom and LogMeIn, the gross margins are very
healthy and pretty consistent for the two years that we have exam-
ined in the book. But the net profit margins for our small sample
of data have quite some variation. For Zoom, this may be because
they have had a boom in sales, making them more profitable and
boosting profitability. But what is happening with LogMeIn? 2019
is showing a net loss, and 2018 showed a net profit. One thing to
notice about this is that if you look in the 10-k and look specifi-
cally at the income statement on page 55 of the 2019 10-k, you
will notice a couple of accounts that are not consistent from year to
year. In 2019, there was a restructuring charge. If you search on the
word “restructuring,” you find a note explaining a reduction in force
(think layoffs).7 So, this is a one-time event and will not be happen-
ing every single year.
In addition, LogMeIn in 2018, there was an unusual item on
the income statement called a “gain on disposition of assets.” If you
search on the word “gain,” you will find a note on page 70 regarding
a divestiture (sale) of a business called Xively.8 This does not explain
all of the differences, but it gives us some insight into some unusual
situations each year. The other thing you will want to do is possibly
do a horizontal analysis to find the rest of the influences that make
the net profitability have so much variation for LogMeIn.
88 FIN A N CIA L IN T EL LI G EN C E

When you do have an unusual item like that, you can calculate the
ratios without that number in the calculations when it does not hap-
pen every year. You can then see how much the results align from year
to year without that unusual item in the totals. Take a look at results
compared to the totals having the gain on that disposition in the
numbers versus NOT having the gain in the numbers (Figure 21):

Figure 21 LogMeIn Results: Unusual Item

We can see here that the unusual activity of selling a business

unit inflated the net profit margin by a bit over 3%.

Topic 17: Solvency Ratios

Solvency is a way of examining a company’s balance sheet to get a

feel for how the company might exist beyond the short term.9 The
goal, of course, is that the company will continue to operate into the
foreseeable future and that the burden of liabilities will not impede
those operations. Think of these long-term liabilities as the long-
term debt, or financial leverage, of a company.
When you think about financial leverage in a company, you want
to examine and assess just how much debt financing, or borrowing,
a company is doing in the long term.
Companies can take out long-term loans, mortgage, or issue
bonds to the public to invest in that must eventually be paid back to
those investors. The financial statement that you want to examine
for long-term borrowing and liabilities is the balance sheet.

Debt to Assets

Another financial ratio that can be useful to you is to examine the

debt to assets ratio10. The result will let you know how much debt
 T HE P O W ER O F FIN A N CIA L R ATI O S 89

is financing your assets. Again, preferably, this result should be less

than 1, or the smaller, the better.
The formula for the debt to assets ratio is:

Total Debt / Total Assets

Equity to Assets

Another financial ratio that can be useful to you is to examine the

equity to assets ratio11. The result will let you know how much
equity is financing your assets. Again, preferably, this result should
hopefully be a bigger slice of the pie than debt. The
The formula for the equity to assets ratio is:

Total Equity / Total Assets

Debt to Equity

One ratio you can use to examine solvency is the debt to equity
ratio12. The formula works like this:

Total Liabilities / Total Shareholder Equity

A small result is what you are looking for in terms of financial

health.

Zoom Results

Here are selected items from the 10-k for Zoom (ZM) to calculate
these solvency ratios (Figure 22):

Figure 22 Zoom Solvency Data

90 FIN A N CIA L IN T EL LI G EN C E

Note here that the 10-k information did not show a correct num-
ber for the total equity. The total equity number had left out the
amount for convertible preferred stock. The reason the error was
caught is because of the accounting equation. The assets have to
equal the liabilities plus the equity. When these numbers did not
add up, the difference was the amount in the convertible preferred
stock account; thus, that number was added back in to arrive at the
total equity in 2019 is $152,113 rather than the negative $7,439 that
is showing in the 10-k report.
Once we plug in all the numbers, we get the following results for
Zoom (ZM) (Figure 23):

Figure 23 Zoom Solvency Ratios

In 2019, we can see from these numbers, the equity was 42.9% of
the total assets and liabilities (debt) was 57.1% of assets. This data, if
we think of assets as the total pie, can be split up in terms of equity
and liabilities as shown here (Figure 24):

Figure 24 Zoom 2019 Split of Debt and Equity to Assets

 T HE P O W ER O F FIN A N CIA L R ATI O S 91

For 2019, 42.9% of the assets were financed by equity, and 57.1%
were financed by debt (liabilities). Another way to say it is that
42.9% plus the 57.1% = 100% of assets on the balance sheet.
For 2020, debt was reduced, as seen in this graphic (Figure 25):

Figure 25 Zoom 2020 Split of Debt and Equity to Assets

For 2020, the debt was reduced from 57.1% in 2019 to 35.3%.
Most companies will carry some debt, but just like with individuals,
we do not want to have more debt than equity (think the net worth
of an individual).
These results help explain the debt to equity ratio. For example,
in 2019, the Zoom debt to equity ratio was 133.1%, meaning that
the company had a much larger debt than it did equity, but that
turned around significantly in 2020. By 2020, the debt was only
about half of the equity, which is a much better position!

LogMeIn Results

Here are selected items from the 10-k for Zoom (ZM) to calculate
these solvency ratios (Figure 26):

Figure 26 LogMeIn Solvency Data

92 FIN A N CIA L IN T EL LI G EN C E

For LogMeIn (LOGM), when the numbers are input into the
formulas, we obtain the following results (Figure 27):

Figure 27 LogMeIn Solvency Ratios

For LogMeIn, in 2018, 24.4% of assets were financed by debt, and

75.6% of assets were financed by equity. The 24.4% debt to assets
ratio plus the 75.6% equity to assets ratio equals 100%. Compared
to Zoom. LogMeIn carries less debt than they do; however, the
debt as a percentage of equity is on the rise, but it is still lower than
Zoom’s result.

Connecting Back to the 10-k

First, before referring back to the 10-k for these two companies,
think about what high levels of debt feel like in your personal life.
For instance, if you keep track of your net worth (i.e., balance sheet)
and have $500,000 worth of assets. How would you feel if you had
$20,000 in long-term debt? How would you feel if you had $100,000
in long-term debt? Or how would you feel if you have $450,000 in
long-term debt? As the debt increases, your net worth decreases,
or as your debt decreases, your net worth increases. When you are
locked into servicing large amounts of debt, your choices go down
about what you can do with your assets.
Thus, the same situation exists for a company. Carrying larger
and larger amounts of long-term debt can cause problems down the
road, especially if you encounter economic conditions where you are
not generating as much cash as you used to in your operations.
Both of these companies have a good balance between equity
(i.e., think net worth) and long-term debt. You generally want to
 T HE P O W ER O F FIN A N CIA L R ATI O S 93

see, as a general guideline, that your debt is a fraction of the total

assets. Many companies can last a long time with debt levels at 60%,
maybe even 70%, but that is when economic conditions are good.
What happens when economic conditions go wrong as they did
with COVID-19? A good financial officer will try to keep long-
term debt to a minimum. It might even be a good idea to talk with
a Chief Financial Officer about how they manage these numbers!
For both LogMeIn and Zoom, if you search through the 10-k’s
using search terms like “debt” or “financing,” you will find a few
notes. Many of the notes are in the highlighted risks to the busi-
ness. Those can be interesting to read through to get a sense of what
each business is concerned with when it comes to debt. Amazingly
enough, if you search on the term “solvency,” neither 10-k report
says anything about that! You can always go to the web and look
for information about analysts’ opinions about these companies and
building the ratios for more years backward so that you can see a
clear trend. Looking at only two years is a very short window for
comparing these numbers.
However, as you do these calculations more and more and build
upon your financial intelligence, you will get a “feel” for a company
and its performance. For instance, I have worked for Starbucks as
an accountant and in information technology groups. Because I also
teach this subject, I have used Starbucks financials in many classes
to discuss these concepts.

More about Developing a “Gut Feel”

I have studied Starbucks’ financial statements for over a decade,

and usually, when I calculated debt to assets, Starbucks was around
50-60% for many years. However, in January 2020, I was teaching
a graduate class. I calculated the debt to assets ratio, and the result
came out to over 100% (which means that the equity went negative
for the first time since I had been studying the company).
As we discussed the results, we searched in the 10-k and on the
web to explain this enormous change in results. What we found was
an article by Cannivet (2019) that discussed the financial decisions
Starbucks had made to increase their debt to such levels.13 I stated in
94 FIN A N CIA L IN T EL LI G EN C E

the class that IF there were to be a major economic event that would
cause Starbucks, a former employer to have a challenge generating
sales, this is potentially not a good position to be in and little did we
know that the COVID-19 outbreak in the world was coming that
March/April. Now, this performance does not in any way indicate
that Starbucks was going to go out of business, BUT the decisions
could give you a pause.
What Starbucks was doing, as many companies were doing, was
going into DEBT to buy back stock and to pay out shareholder
dividends. There is an idea in personal investing called “good debt”
versus “bad debt.”14 The article examines what these terms may
mean, but going into debt to build a manufacturing facility that
will directly lead to more sales is what I would classify as good debt.
However, to pay dividends or to invest in stock buybacks, those
activities do not generally lead to future cash flow, and thus, it did
not feel like a great financial decision.
It was useful information for me on whether or not I wanted to
continue investing in buying stock in the company. I have bought
and sold a lot of Starbucks stock over the years. I change my invest-
ing strategy for Starbucks during the COVID-19 period to watch
how that situation played out. This analytical approach and con-
nection is the ability you can cultivate in yourself to determine your
own choices.
One other note about this “gut feel.” In 2007, Starbucks stock
was falling like a rock. I remember several internal conversa-
tions about the company stock price and leadership. I was not
convinced that it was an operational problem. Due to that belief,
Starbucks stores shut down in early 2008 for training.15 At the
time, I had a conversation with someone where I stated that I did
not believe that the company’s operations were “off.” I believed
there was something else happening. Not too long after that con-
versation, we found out the economic reality that caused the drop
in the stock.
See, buying a cup of coffee is not generally an “essential” purchase
for people. Thus, one of Starbucks’ metrics to share in their finan-
cials each quarter was a “foot traffic” number. Well, this foot traffic
metric had been falling. In hindsight, the reason was that people
 T HE P O W ER O F FIN A N CIA L R ATI O S 95

were feeling the tight wallet due to the financial collapse coming in
the real estate market. When the financial collapse started to occur,
it made sense that foot traffic would have been falling for a little
while because a company like Starbucks is likely a leading indicator
of what may be happening in the economy. In other words, people
were being affected by losing their homes, and when that happens,
they focus only on essential purchases.
As you study a company you work for, you will develop this
same sense of the truth about financial performance. As you gain
confidence in your ability to do this, you will feel very comfortable
assessing a company for acquisition if you want to buy a business as
an entrepreneur!

Topic 18: Liquidity Ratios

Liquidity ratios are assessing the short-term financial health of an

organization. These ratios let you know if the company can pay its
bills or obligations in a time frame of a year or less.

Current Ratio

The current ratio is a very common ratio for assessing a company’s

ability to pay short-term debts.16 This ratio is calculated using the
following formula:

Current Assets / Current Liabilities

Once the result is calculated, you are expecting to see a result greater
than 1. Anything higher than a result of 1 is very healthy.

Quick Ratio

Another ratio, very similar to the current ratio, is called the quick
ratio. Another name for this is the acid test ratio. In this ratio, the
calculation will be as follows:

 Current Liabilities  Inventory  / Current Liabilities

96 FIN A N CIA L IN T EL LI G EN C E

As you can see, the only difference here is that you are taking
OUT the effect of the inventory. For some companies or industries,
inventory can sit for a long time. In other words, sometimes, you
want to see how inventory impacts your ability to pay bills in the
short term.

Zoom Results

Here is a graphic of the data for Zoom from the 10-k to input into
the current ratio and the quick ratio (Figure 28):

Figure 28 Zoom Liquidity Ratio Data Input

One thing to notice here is that Zoom does not carry any inven-
tory. Thus, the results of the current ratio and the quick ratio will be
the same. Once we input the data into the current ration formula,
we obtain these results (Figure 29):

Figure 29 Zoom Current Ratio and Quick Ratio

For Zoom, the results have improved quite a bit. For the year
2019, the quick ratio was good, and the results got even better in
2020. What this shows is that Zoom has plenty of current assets to
pay for their current liabilities as they come due. We look for this
ratio to be one (1) or better, and for these two years, Zoom exceeds
that benchmark.
 T HE P O W ER O F FIN A N CIA L R ATI O S 97

LogMeIn Results

Here is a graphic of the data for Zoom that was used from the 10-k
to input into the current ratio and the quick ratio (Figure 30):

Figure 30 LogMeIn Liquidity Ratio Data Input

LogMeIn also does not carry any inventory. Therefore, their

current ratio and quick ratio will have the same results. Once we
input the data into the ratio calculation, we see the following results
(Figure 31):

Figure 31 LogMeIn Current and Quick Ratio Results

LogMeIn is not having good results like Zoom. Since the results
are less than 1, this means that LogMeIn has more current liabili-
ties that need to be paid than they have current assets.

Connecting Back to the 10-k

As a search term in the 10-k’s for LogMeIn and Zoom, inventory

does not get any hits (the same is mentioned in the book’s activity
ratios section) because of the inventory turnover rate and the days
sales in inventory calculation.
Since LogMeIn and Zoom create digital products, an insig-
nificant amount of materials are needed to produce the software
products. When installing software on a computer from a disc in
the early days of software development, companies had to carry
98 FIN A N CIA L IN T EL LI G EN C E

installation documents, disc cases, discs, and packaging materi-

als to ship the product worldwide. Today, digital products cost
a fraction of those costs and you do not have to sink money in
inventory.

Topic 19: Efficiency or Activity Ratios

Efficiency, or activity, ratios are measuring how well a company is

managing working capital17. A company’s working capital means
how well a company manages accounts receivable, inventory, and
accounts payable. In other words, this is a measure of how a com-
pany manages its current assets and current liabilities. A company
must ensure they are managing their cash in a way to ensure opera-
tions run smoothly.18

Inventory Turnover Ratio

The inventory turnover ratio will tell you how many times a year
that inventory turns into cash.19 One way of calculating inventory
turnover is to use the following formula:

Cost of Goods Sold / Inventory

Another formula that you can find is the following:


Cost of Goods Sold /  Inventory Current Period
 Inventory Previous Period  /  
Sometimes, if the inventory has a lot of variation in it (extreme
movements from one comparative period to another), you may want
to smooth out the effect of that variation.
One thing to watch out for: Many companies may NOT have
any inventory that they sell. Thus, calculating an inventory turnover
rate may be impossible. This situation is not an issue at all. It just
means that they do not have inventory and an inventory turnover
rate, and you cannot calculate a days in inventory ratio.
 T HE P O W ER O F FIN A N CIA L R ATI O S 99

Days Sales in Inventory

Once you have calculated the inventory turnover rate, you can then
calculate the days sales in inventory ratio. This ratio tells you how
many days it takes to turn inventory into cash.20 The following for-
mula calculates this ratio:
 days / Inventory Turnover Rate

Zoom and LogMeIn do not have any inventory, so calculating an

inventory turnover ratio and days sales in inventory is impossible.

Accounts Receivable Turnover

The accounts receivable turnover ratio will tell you how many
times a year accounts receivable is turned into cash 21. Here is how
the accounts receivable turnover rate is calculated:

Revenue / Accounts Receivable

You will need to pull the revenue amount from the profit and loss
statement, and you will need the accounts receivable balance from
the balance sheet. The equation will look like this:


Revenue /  accounts receivable current period
 accounts receivable previous period  /  
You may want to use the average of two periods because of large
fluctuations in the accounts receivable balance. Here is the data that
will be used for the calculation:
For Zoom, we have the following input data for the accounts
receivable turnover calculation (Figure 32):

Figure 32 Zoom Input Data for A/R Turnover

10 0 FIN A N CIA L IN T EL LI G EN C E

For Zoom, you will plug the numbers into the formula (Figure 33):

Figure 33 Zoom Accounts Receivable Turnover

For Zoom, this number tells us that the company turns their
accounts receivable into cash almost seven times a year.
For LogMeIn, we have the following input data for the accounts
receivable turnover calculation (Figure 34):

Figure 34 LogMeIn Input Data for A/R Turnover

For LogMeIn, you will plug the numbers into the formula
(Figure 35):

Figure 35 LogMeIn A/R Turnover Calculation

For LogMeIn, this number tells us that the company turns their
accounts receivable into cash almost 13 times a year.
One thing to watch out for: When you are possibly looking at
this for a small business, you might have a much quicker turn-
around. For example, I work with a client that is a technology
company. They sell a software product, and 99% of their sales
come through credit card sales. Thus, essentially it is a cash
business because a credit card sale settles quickly. Thus, the only
time delay is however long it takes for the business to obtain
access to their money which is likely just in a matter of a few
days or less.
 T HE P O W ER O F FIN A N CIA L R ATI O S 101

Days Sales Outstanding

Using the accounts receivable turnover, you can calculate the days
sales outstanding by using this formula 22:
 days / Accounts Receivable Turnover

Then, we can calculate how many days it takes to turn their

receivables into cash by using this calculation (Figure 36):

Figure 36 Zoom Days Sales Outstanding

Thus, it takes almost 2 months, 53.94 days, to turn accounts

receivable into cash.
Then, we can calculate how many days it takes to turn their
receivables into cash by using this calculation (Figure 37):

Figure 37 LogMeIn Days Sales Outstanding

It takes LogMeIn on 30 days to turn its receivables into cash. In

terms of this calculation, Zoom turns their accounts receivable into
cash at a slower rate than LogMeIn.

Accounts Payable Turnover

The accounts payable turnover ratio will tell you how many times
in a period that accounts payable uses cash.23 One of the calcula-
tions you may see is the following:
Total Purchases /Accounts Payable

In addition, just like previous activity ratios, you can average

accounts payable over two periods (the current period and previous
period). In addition, there is no such account called “Total Purchases”
on any financial statement. Thus, to come up with that number,
10 2 FIN A N CIA L IN T EL LI G EN C E

you can take Cost of Goods Sold + Inventory Current Period –

Inventory from Previous Period without being an employee for the
company. In using this approach and using average inventory, you
would have the following formula:

 Cost of Goods Sold  Inventory Current Period

 Inventory from Previous Period 
/   Accounts Payable Current Period
 Accounts Payable Previous Period  /  

For Zoom, here is the input data for the A/P turnover calculation
(Figure 38):

Figure 38 Zoom Input Data for A/P Turnover

Now, take this information and input the numbers into the for-
mula (Figure 39):

Figure 39 Zoom A/P Turnover Calculation

This means that Zoom uses cash to pay its bills around 35 times
a year.
For LogMeIn, here is the input data for the A/P turnover calcu-
lation (Figure 40):

Figure 40 LogMeIn Input Data for A/P Turnover

 T HE P O W ER O F FIN A N CIA L R ATI O S 10 3

Now, take this information and input the numbers into the for-
mula (Figure 41):

Figure 41 LogMeIn A/P Turnover Calculation

This result means that LogMeIn uses cash to pay its bills around
seven times a year.
One thing to note: Some small businesses may not have a typical
invoice processing department that handles invoices from suppli-
ers. Many businesses could have credit cards charged for purchasing
products or services. Thus, the timing difference may be minimal
when someone orders to when the money leaves the business. It
becomes important to ask the business questions about how invoices
are paid – or at least know the split between invoices charged by
credit card or debit card and what is handled by the traditional
invoice processing methodology.

Days Payable Outstanding

Once you have the accounts payable turnover, you can calculate
the days payable outstanding.24 This information will tell you how
many days it takes to use cash for accounts payable.
For Zoom, the A/P turnover is 35.19 times a year. Thus, when
you input this information into the days payable outstanding for-
mula, then we get this result (Figure 42):

Figure 42 Zoom Days Payables Outstanding

Thus, Zoom uses cash to pay its accounts payable every ten days.
For LogMeIn, the A/P turnover is 7.39 times a year. Thus, when
you input this information into the days payable outstanding for-
mula, then we get this result (Figure 43):
10 4 FIN A N CIA L IN T EL LI G EN C E

Figure 43 LogMeIn Days Payables Outstanding

Thus, it takes LogMeIn almost two months to use cash for its
short-term bills.

Cash Conversion Cycle

Once you have calculated the days sales outstanding, days sales in
inventory, and days payables outstanding you can then calculate the
cash conversion cycle.25 The cash conversion cycle shows the net
numbers of days it takes to generate and use cash in the working cap-
ital accounts of accounts receivable, inventory, and accounts payable.
The formula will work like this:

 Days Sales Outstanding

 Days Sales in Inventory
 Days Payables Outtstanding
 Cash Conversion Cycle

For Zoom, the cash conversion cycle is (Figure 44):

Figure 44 Zoom Cash Conversion Cycle

And for LogMeIn, their cash conversion cycle is (Figure 45):

Figure 45 LogMeIn Cash Conversion Cycle

 T HE P O W ER O F FIN A N CIA L R ATI O S 10 5

A negative cash conversion cycle is a good thing. What it means

is that that cash is USED at a slower pace than generating cash.
For Zoom, their cash conversion cycle will need to be assessed as a
trend, looking at several years, to see if that is improving or if this
is the usual performance.
One thing to note: As described in previous information on this
topic, the day’s sales in inventory may not exist in a business, or the
day’s sales outstanding and days payable outstanding may be much
smaller. The closer you get to the ZERO days of the cash conver-
sion cycle, the more you can consider the business a cash business
in their working capital – even if they are using accrual accounting.

Connecting Back to the 10-k

Inventory, as a search term in 10-k’s for both LogMeIn and Zoom

does not get any hits. The same is noted in the liquidity section of
the book regarding the calculation of the quick ratio.

Ties to Cash Flow and Working Capital Management

The activity ratios and the cash conversion cycle, along with the
cash flow statement and working capital management are all tied
together. For instance, if you are a technology business and all your
sales are on credit cards, you turn sales into cash quickly. Thus, you
have access to cash very quickly, and you do not have to have a lot
of cash on hand for paying bills in the short term as compared to a
technology business where you are dependent on the customer pay-
ing their invoices based on credit terms. If you have to wait 30 days
for the cash to come in, you still have bills to pay during that period.
The basic essence of working capital management and cash flow
means the same thing – how well are you managing money com-
ing in and out of the business? For technology businesses, cash flow
models are usually the better models in the business community.
Suppose you think about some of the largest and most success-
ful technology companies today, like Amazon, Microsoft, Apple,
Google, etc. In that case, they are rewarded on Wall Street largely
because of their cash flow abilities.
10 6 FIN A N CIA L IN T EL LI G EN C E

Remember, a negative cash conversion cycle is a GOOD thing. It

means that you are GENERATING cash, bringing money IN……
BEFORE you have to pay your creditors (cash going OUT).26 For
Amazon, they do so by using a structure where, yes, they have their
warehouses. Still, they also are a marketplace for consumers and
businesses where Amazon does not always have to house the prod-
ucts in their warehouses. For example, you could have a product
that you sell, and you have your inventory, but you show your prod-
ucts on the Amazon marketplace and source the items from your
store. Thus, Amazon is taking advantage of a subscription to this
service for companies to be on their platform and they may take a
cut of the revenue generated.
The future of technology may bring a lot of innovative ideas about
how to make and generate revenue for a lot of different companies,
the only restriction is how creative you can be in how you envision
using technology as a platform. The key is understanding how your
creative idea can generate cash flow very quickly while not paying
out cash as quickly. As an industry, this performance has been the
success of technology so far and you can learn to create your cash
flow driven technology platform.

Topic 20: Other Financial Formulas of Interest

There are two other formulas to introduce, the EBITDA and free
cash flow.

EBITDA

EBITDA stands for “Earnings Before Income Tax and Depreciation/

Amortization.” You will need the income statement and the cash
flow statement to figure this out.
First, the “Earnings Before Income Taxes” is what you may see as
“Operating Profit” on the income statement.27 Whatever a company
may call it, it is the earnings BEFORE the income tax line.
Second, on the cash flow statement, you will be looking for depre-
ciation and amortization amounts. Adding these BACK INTO the
profit is because amortization and depreciation are ways of handling
 T HE P O W ER O F FIN A N CIA L R ATI O S 10 7

capital investments’ expenses. Thus these deductions are not actual

cash expenditures for the company.

Free Cash Flow

Free cash flow is the cash on hand that a company can use as they
desire.28 This concept equates to individual discretionary funds. For
example, a company can use the free cash flow to invest in infra-
structure and equipment. The company can invest some of the
money into securities with a safe return and quickly turn back into
cash if the company needs the money. This concept is the same idea
as individuals who can use our discretionary funds by investing in
something that is not risky but has a good return. Hence, we have
the money for a rainy day or invest it in mutual funds, homes, or
other assets.
For example, if you know the stock symbol of any technology
company, you can go to finance.yahoo.com, enter the stock symbol
in the search bar, click on financials, and then click on the cash flow
statement. For example, if we use Amazon, stock symbol AMZN,
at the bottom of the cash flow statement, the free cash flow is cal-
culated for you. In 2019, the free cash flow was $21,653,000,000.
Sometimes it may be hard to fathom a number as big as that, but
remember, these numbers are relative.
For instance, a person might have a few thousand dollars on
hand, so a company with billions of dollars on hand could be hard
to comprehend. However, one way to normalize this number is to
look at how long they could stay in business – the same idea as an
individual having an emergency fund.
Thus, when you examine free cash flow – how long would that
money last if a company encountered a time of extremely reduced or
no sales? COVID-19 was a great example of this type of scenario.
Thus, for Amazon, how long could they last with no sales?
We assess this by also pulling the total operating expenses on the
profit and loss statement. We can look in the same place in finance.
yahoo.com and click on the profit and loss statement. Annually,
in 2019, Amazon had operating expenses of $60,213,000,000.
Remember back when we talked about the time frames of a profit
10 8 FIN A N CIA L IN T EL LI G EN C E

and loss statement? This number represents the total operating

expenses for the entire year. Since we do not have access to the
12 individual reporting periods for Amazon’s income statement,
then we take this number and divide it by 12 to obtain the average
monthly operating expenses.
Thus, doing that calculation, we get a result of $60,213,000,000/12
= $4=5,017,750,000. Remember, operating expenses occur EVEN
IF there are no sales. Thus, if we have $21,653,000,000 of cash
on hand, and we have $5,017,750,000 in operating expenses every
month, then Amazon can only last a little over four months with no
sales (calculated by taking $21,653,000,000/$5,017,750,000 = 4.32
months).
Just like an individual with a cushion of a certain amount of
dollars as an emergency fund, the same principle applies here, and
this exercise can certainly give you a much better picture of free
cash flow than just the number itself. The sale is different, but the
approach is the same!
NOTE: Calculating the number of months the free cash flow can
last is not a formal business ratio analysis. However, it is a way of
examining personal finance (i.e., in personal finance, this is a way of
assessing how long an emergency fund would last). Thus, since there
is no formal ratio found on this topic in the literature, an appropriate
terminology could be times free cash flow – which means how long
can free cash flow last without sales personally speaking, this means
how long cash will last without personal income.

Horizontal Analysis

You do not always have to do a horizontal analysis. Sometimes, if

you run into unusual results, it might be easy to pick out unusual
items on a financial statement (like our discussion about LogMeIn’s
net profit margins). However, we could not see all the issues at play
with the variation in net profits from 2018 to 2019. Thus, one of the
ways you can analyze these results further is to conduct a horizontal
analysis.
Horizontal analysis is something where you are comparing one
year to another year for a specific financial account.29 For instance,
 T HE P O W ER O F FIN A N CIA L R ATI O S 10 9

you may want to see how much the 2019 revenue increased or
decreased compared to 2018. This, to do this comparison for
LogMeIn, for the revenue account on the income statement, we
start first with calculating the dollar change from the BASE year to
the COMPARISON year:

Dollar Change  Comparison year  Base year

For LogMeIn, for the data we have for profitability, 2019 is the
most recent year. Thus it is our comparison year. We are compar-
ing 2019 to the base year of 2018. We want to see how much 2019
changed compared to the base year.
Revenue for LogMeIn in 2019 (comparison year) was $1,260,385
and the base year (2018) has a revenue number of $1,203,992. Thus,
the dollar change for revenue for LogMeIn, comparing 2019 to
2018, is:

$1, 260,385 − $1, 203,992 = $56,393

Then, to calculate the percentage change, we take do the follow-

ing calculation:

 Dollar Change / Base Year  

Plugging the numbers into the formula, we obtain the following

results:

$56,393 / 1, 203,992 = 4.68%

Using this approach, we will take the items in the income state-
ment for LogMeIn. We will do a full horizontal analysis to deter-
mine what line items are driving the change and variability in net
profits from 2018 to 2019.
Here is the data for the horizontal analysis for the income
statement for LogMeIn for the income statement (Figure 46):
110 FIN A N CIA L IN T EL LI G EN C E

Figure 46 LogMeIn Horizontal Analysis P&L

A few things jump out here. In 2018, the net profit was $74,371.
Thus, we are looking for the accounts that will explain a swing from
$74,371 to a negative $14,555 for a total swing of $88,926.
We see that cost of goods sold has increased by 15%, and revenue
only increased by about 5%. Thus, the increase in direct costs is
contributing to this swing. In the 10-k, if we search on the cost of
revenue, we find one section that gives us a definition of how the
cost of goods sold is derived, and then another section tells us that
this section increased because of the costs of acquired assets.
Another section contributing to this swing is sales and marketing
expenses have grown by over 20%. By searching the 10-k regard-
ing using sales and marketing as the search phrase, we find that the
company is recognizing a high commission expense because of a
new accounting rule. Now, you may have to grab an accountant to
dig into the complexities of acquiring assets or what this account-
ing rule is, but what we are looking for right now is, does this make
sense? Even though we may not know all the finer details of this,
if you talk to an accountant, you would find out that acquiring new
assets can increase the cost of goods sold, and a new accounting rule
can impact how expenses are recognized. This topic would require
a bit more digging for the questions to be answered. Part of the
 T HE P O W ER O F FIN A N CIA L R ATI O S 111

learning is knowing no book will ever cover all the questions you
may want to ask, but you will know your resources on where to find
more information!

Part Five: What to Watch Out For

• When using financial ratios to assess a company and their

financial performance, be sure to look at several years in a
row to establish a trend.
• Profitability ratios examine the gross profit and the net
profit of a company.
• Liquidity ratios assess the ability of a company to pay its
bills in the short term.
• Solvency ratios assess the long-term leverage and if they heav-
ily finance through debt or equity. This ratio is a good indica-
tion of the long-term viability of the company over time.
• Activity ratios help you to assess the ability of the company
to manage its working capital.
• The cash conversion cycle helps to assess the timing of how
a company generates and uses cash.
• Free cash flow is similar to the emergency fund that an
individual builds in his or her personal life.

Part Five: Exercises, Practice, and Resources

Learning activities:
1. Obtain the financial statements or the 10-k, or any other
financial notes you can get your hands on for your analysis.
Gather a few years’ worth of data if you can, perhaps at least
five years if you can.
2. Obtain competitor information (if possible) or at least look
at a publicly traded competitor. It is important to compare!
3. For each year, calculate:
a. Profitability ratios
i. Gross profit margin
ii. Net profit margin
112 FIN A N CIA L IN T EL LI G EN C E

iii. What trends are you seeing over time?

b. Solvency ratios
i. Debt to assets ratio
ii. Equity to assets ratio
iii. Debt to equity ratio
iv. What trends are you seeing over time?
c. Liquidity ratios
i. Current ratio
ii. Quick ratio
iii. What trends are you seeing over time?
d. Activity ratios
i. Inventory turnover ratio
ii. Days sales in inventory
iii. Accounts receivable turnover
iv. Days sales outstanding
v. Accounts payable turnover
vi. Days payables outstanding
vii. Cash conversion cycle
viii. What trends are you seeing over time?
e. Calculate the EBITDA, compare the net income to
EBITDA. How much money is going to non-cash
transactions?
f. Calculate free cash flow, or if publicly traded you can go
to finance.yahoo.com and look up your company. Once
you enter the company stock symbol in the search, you
will see a tab for financial statements, and you will look
up the cash flow statement. At the bottom, yahoo has
calculated the free cash flow for you!
g. Calculate the times free cash flow numbers to see how
long the cash balance would last if there is a economic
catastrophe. What is your reaction to this result? How
many months would they be able to cover those expenses
without revenue and cash flow generation?
h. If you see unusual results or variations/swings in any
ratios, can you explain why those variations occurred?
Part of the answers may be in the calculations of the hori-
zontal analysis.
 T HE P O W ER O F FIN A N CIA L R ATI O S 113

4. At this juncture in your study, which company is performing

best? You can include the income statement, balance sheet,
cash flow statement, horizontal analysis, AND your ratio
calculations in your assessment overall.

Notes
1 Financial ratios (2020). Retrieved from https://www.inc.com/encyclope-
dia/financial-ratios.html
2 Five types of financial ratios for analyzing stocks (2020). Retrieved from
https://www.thebalance.com/types-of-financial-ratios-2637034
3 TIMELINE: Key Dates in General Motors’ History. Retrieved from
h t t p s : / / w w w. r e u t e r s . c o m / a r t i c l e / u s - g m - c h r o n o l o g y - s b /
timeline-key-dates-in-general-motors-history-idINTRE5500ES20090601
4 Profitability Ratios: Measures of a Company’s Earning Power. Retrieved
from Corporate Finance Institute at https://corporatefinanceinstitute.
com/resources/knowledge/finance/profitability-ratios/
5 What is the gross profit margin (2020). Retrieved from https://www.the-
balancesmb.com/what-is-the-gross-profit-margin-393201
6 Net profit margin. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/finance/net-profit-margin-formula/
7 LogMeIn 2019 10-k. Retrieved from https://www.sec.gov/Archives/
edgar/data/1420302/000156459020004769/logm-10k_20191231.htm
8 LogMeIn 2019 10-k. Retrieved from https://www.sec.gov/Archives/
edgar/data/1420302/000156459020004769/logm-10k_20191231.htm
9 Solvency. Retrieved from https://corporatefinanceinstitute.com/resources/
knowledge/finance/solvency/
10 Debt to assets ratio. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/finance/debt-to-asset-ratio/
11 Equity ratio. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/finance/equity-ratio/
12 Debt equity ratio. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/finance/debt-to-equity-ratio-formula/
13 Cannivet, M. (2019) Starbucks’ Big Stock Buybacks Limits Future
Upside. Retrieved from https://www.forbes.com/sites/michael-
cannivet/2019/08/29/starbucks-big-stock-buyback-limits-future-
upside/?sh=12cd8ead7047
14 Alvarez, J. Good debt vs. bad debt: Why what you’ve been told is proba-
bly wrong. Retrieved from https://www.cnbc.com/2020/07/20/good-
debt-vs-bad-debt-why-what-youve-been-told-is-probably-wrong.
html#:~:text=%22Good%22%20debt%20is%20defined%20as,to%20
improve%20your%20financial%20outcome.
15 Raedle, J. (2008). Starbucks to close all U.S. stores for training. Retrieved
from https://www.nbcnews.com/id/wbna23351151
114 FIN A N CIA L IN T EL LI G EN C E

16 Current ratio formula. Retrieved from https://corporatefinanceinstitute.

com/resources/knowledge/finance/current-ratio-formula/
17 Efficiency ratios. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/finance/efficiency-ratios/
18 Working capital management. Retrieved from CFA Institute at https://
www.cfainstitute.org/sitecore/content/CFAI/Home/membership/pro-
fessional-development/refresher-readings/2020/working-capital-
management
19 Inventory turnover ratio. Retrieved from https://corporatefinanceinsti-
tute.com/resources/knowledge/finance/inventory-turnover-ratio/
20 Days sales in inventory. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/modeling/days-sales-in-inventory/
21 Accounts receivable turnover ratio. Retrieved from https://corporatefi-
nanceinstitute.com/resources/knowledge/accounting/accounts-
receivable-turnover-ratio/
22 Days sales outstanding. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/accounting/days-sales-outstanding/
23 Accounts payable turnover ratio. Retrieved from https://corporatefinan-
ceinstitute.com/resources/knowledge/accounting/accounts-payable-
turnover-ratio/
24 Days payable outstanding. Retrieved from https://www.myaccounting-
course.com/financial-ratios/days-payable-outstanding-dpo
25 Cash conversion cycle. Retrieved from https://www.myaccountingcourse.
com/financial-ratios/cash-conversion-cycle
26 Four Week MBA (n. d.). Amazon Cash Conversion in a Nutshell. Retrieved
from https://fourweekmba.com/cash-conversion-cycle-amazon/
27 EBIT Guide. Retrieved from https://corporatefinanceinstitute.com/
resources/knowledge/finance/ebit/
28 Free cash flow (FCF) formula. Retrieved from https://corporatefinancein-
stitute.com/resources/knowledge/valuation/fcf-formula-free-cash-flow/
29 Horizontal analysis. Retrieved from https://corporatefinanceinstitute.
com/resources/knowledge/finance/horizontal-analysis/
 Part Six
S pecial Topi c s

There are a few other topics that are essential to your financial edu-
cation. Many employees in a company, or entrepreneurs, tend to
think about how to protect assets or that these concepts in account-
ing and finance impact them. In this chapter, you will be exploring
some of the common controls that you may or may not be aware of
in a company. The goal is to increase your awareness, and if you work
in a company with accounting and finance resources, they can help
you understand the financial concerns your company can address.
One control area is Excel. Some people are familiar with this
tool, and some do not use it much, but financial information can be
housed in Excel. How can you ensure that the data and informa-
tion are protected? How can you ensure that the data has not been
compromised or is inaccurate? The Sarbanes Oxley (SOX) legisla-
tion of 2003 put into law that Excel must be treated as a financial
asset when using it to house any information that could impact your
financial statements.
In addition, budgeting and variance analysis may be something
you have familiarity with already. Still, if you plan a business, you
will need to understand some basic information regarding building
budgets. This will include how you calculate variances on this data
and how to explain those variances.
All businesses may have to answer using contractor labor ver-
sus employee labor, but it is a MUST conversation for a technol-
ogy company or a technology department. Many companies and
departments can have inconsistent or wildly varying work needs
over time, and contractors can easily fill these needs. You will want
to make sure that you can think through these types of scenarios
and build out a decision process for yourself and what the decision
means in cash.

DOI: 10.1201/9781003110613-6 115

116 FIN A N CIA L IN T EL LI G EN C E

Finally, the rest of the book addresses issues in small businesses

and things you want to look out for in working with, or assess-
ing, a small business. The concepts covered in that topic are var-
ied. Depending on which lens you are looking at a small business
through, any or all ideas could be beneficial – especially as a bud-
ding entrepreneur.

Topic 21: Internal Controls

When you examine financial statements through ratio analysis, one

of the hardest things to do is to try and identify fraud or if someone
is “cooking the books.” Ratios will give you an idea of how consis-
tent company financial performance is. However, internal controls
will be a great way to assess for issues that are potentially hidden in
the numbers. The important thing to learn here is not ONLY the
internal control technique but how to go about asking questions
about the technique as it is used in businesses1.

Segregation of Duties

The idea behind segregation of duties is that no ONE person is

responsible for an entire process in a company2. Thus, if you desire
to be an entrepreneur, you do not want to have only one person who
buys your supplies, receives them into inventory, and pays the supplier.
The same idea for an information technology department is pres-
ent when you have only one person buying computer spare parts,
or any assets, receiving them, paying for them, and counting them.
While you may trust someone with these responsibilities, theft in
businesses can start to occur when there are few or little control
around assets of value (especially with cash and your inventory).
Even in a small business, where you may have very few employees
or contractors on-site, you will want to ensure that there are places in
processes that touch cash or other assets. This strategy includes mul-
tiple eyes are involved to ensure no one is mishandling these assets.
It is important, as well, to have standard operating procedures,
even for a small business, where expectations for how the process
should work are described and articulates what evidence is required
 S P ECIA L T O PI C S 117

of the process to ensure that the process or procedure is working

according to the expectations.

Asset and System Access Controls

Asset controls and system access controls are applied in distinct

ways. For example, you might have to supply employees with com-
puters and other peripherals (like a mouse, extra monitors, etc.), and
these assets must be tracked. Thus, one of the controls over a com-
puter is that the asset might have an asset tag applied. These asset
tags are often glued to the computer with a strong adhesive and are
very hard to remove. This way, the information technology depart-
ment can conduct an inventory of the assets to ensure that the items
purchased remain in control of the company.
In addition, assets could be locked away for different reasons. For
instance, you might have very expensive replacement parts, or you
may have products that you sell that are very expensive. Because of
the price tag, you may determine that the items need to have extra
protection from theft, and thus they may be locked up in some way,
and very few people would have the keys to unlock the items.
Products do not have to be expensive to require lock up for safe-
keeping. For instance, if you have a retail presence in your business
and you give away coupons for free merchandise, those coupons may
have value on the street. Thus, to keep employees from stealing them
and selling them you may need to keep those under lock and key.
Furthermore, your financial information is something of value to
you as a business. Thus, any software systems or Excel files should
have password protection on the data. Of course, you can certainly
teach your employees financial intelligence – that is encouraged.
But your financial information, your bank accounts, your credit
debit cards must be protected as much as you can.

Physical Counts of Assets

Your assets must be counted to ensure that your books say your
value of the assets is accurate. Plus, it helps you to start assessing if
there is any theft of your assets.
118 FIN A N CIA L IN T EL LI G EN C E

In the following section on reconciliations, which is closely related

to this topic, you would want to count your cash and count any inven-
tory you have on hand. If you have a large inventory, you may want to
rotate your counting of inventory by using a cycle counting strategy.

Cycle Counting

Cycle counting is a strategy that focuses on counting more regularly

the subset of inventory that moves the most. You can also think of
this in terms of the Pareto principle – that only 20% of your inven-
tory drives 80% of your sales, so you want to count those assets a lot
more often3.
Thus, you would split up your inventory into three categories, A,
B, and C. The “A” category would be those items you have identified
as high value and high turnover. These items you would likely count
every single month at a minimum.
The “B” category could be items that are HIGH value and
LIMITED turnover or LOW value with HIGH turnover. These
you might decide to count at least four times a year.
Finally, category “C” items are LOW value items and have LOW
turnover rates. These you may not count but once a year.
This strategy can be important for a couple of reasons. If you are
assessing an acquisition business, as an entrepreneur, you will want
to know how inventory is counted and make sure this procedure is
documented. If you are doing the inventory turnover calculations,
you may want to see this data broken out by these different catego-
ries or other product categories.
Another important consideration here is that if you assess a busi-
ness, you may want to consider hiring an accountant or a certified
public accountant (CPA) to conduct an audit of the business’ finan-
cial controls, inventory practices, and other control documentation.

Reconciliations

Part of a procedure, especially around asset accounts, is to do a rec-

onciliation. For example, assume you build computers for a living
in a small business. You will have to consider where you will keep
 S P ECIA L T O PI C S 119

your inventory (the physical location) and how you will store this
information financially (the digital record).
A reconciliation matches these two “record” locations to ensure
that what is represented electronically and what is reported physi-
cally are in alignment, and that differences can be explained. You
see this in a lot of different areas in business.
Cash register: If you have a retail store as part of your busi-
ness, you will most definitely do a cash reconciliation on your cash
register.
Inventory: If you carry an inventory of merchandise that you sell
or inventory of supplies, you will want to establish reconciliation
procedures.
Assets: If you have expensive computer equipment and printers
or anything else with a significant value, you will want to keep a log
of these items with a tracking number and reconcile a computer list
of the items with an actual physical count.
In addition, an important concept here is that anytime you use
forms for any process, you will want to have numbered forms. This
works like check numbers. Think about reconciling your bank
checking account (even though we likely use way fewer checks
today) it is easy to reconcile a bank statement because of the check
numbers. Plus, a nice safeguard on reconciling a bank statement is
when you see a missing check number, you then have a signal to
question that issue – especially if you are having someone else pay
your bills for you. Even without check numbers, it will be easy to see
if a transaction is missing in the books.
When looking at a business to purchase, be sure that you are
looking at reconciliations on each asset and liability account. This
will tell you if you must be suspicious of the valuations on the
­balance sheet.

Approval Authority

Another important control is the approval authority. This pertains

to WHO in your company has the authority to purchase items, sign
checks, and to what level of authority (in terms of dollar value) you
will allow them to sign off on for the company’s behalf.
12 0 FIN A N CIA L IN T EL LI G EN C E

For example, if you buy computer parts and have someone who
buys the parts for you, will you allow them to make purchases up to
$500 without your signature? $1,000? What about $500,000? Some
procedures will require that a second signature be obtained for any
purchase over a certain amount or MULTIPLE signatures for any
purchase over a certain amount.

Procedures and Audits

Ultimately, every single idea here, in this topic rea of internal con-
trols, should be documented into formal procedures. Of course,
when you are just starting as a sole proprietor, you may not need
formal procedures because you are acutely aware of all the transac-
tions in your business.
However, as you grow and hire other people or utilize contrac-
tors, what will you allow them to do? How will they be expected
to handle the responsibilities you give them? A great way to for-
malize those expectations are within formal standard operating
procedures.
On top of that, you could then hire a CPA firm on a random
basis to audit your procedures. This is what the larger corporations
do. That way, you can determine if your employees and contractors
follow the rules and if any procedure needs to be adjusted.
The bottom line is this: the more you deal with this upfront,
sooner rather than later; you will run LESS risk of having theft or
some other type of fraud occur within your company.

Topic 22: Protecting Financial Information in Excel

Financial and accounting software often will not take care of every-
thing that has a financial impact on the business. For instance, you
could be working for a large IT business or department and all your
assets may not be tracked in financial systems.
It is possible that you could work for a company, or think about
acquiring a company, and have financial information in Excel. One
of the issues that came out of the Enron Corporation collapse and
other financial issues is that Excel information must be protected
 S P ECIA L T O PI C S 121

and safeguarded IF the file contains information that could be a

part of the company’s financial picture.
In this topic, you will learn ways to protect financial information
contained in Excel spreadsheets. This is very important because this
is now directed by legislation. Back in 2003, when the SOX legisla-
tion was passed in response to the collapse of Enron, Excel controls
were included as part of the legislation4. You would be amazed at how
much financial information can be housed in Excel. For instance, in
a technology department, you may manage your computer assets in
an Excel spreadsheet. You can do that, but you will want to be sure
you understand the risks and how to mitigate those risks. This sec-
tion will teach you what to look for and how to fix any issues!
The first thing to do is to assemble an inventory of any Excel
spreadsheet that could have a material impact on your financial
statements if something happens to be inaccurate. For example, if
you have an inventory of computers in Excel, if any information in
that file was inaccurate by $100, $1,000, or $10,000, how would you
feel about that? If there was an issue with the file that had an impact
of $100,000? Accountants would call this “materiality.” Would it
surprise you to know that sometimes a company may not consider
$100 to be a material error? Frankly, for some businesses, $50,000
might not be a material amount.
The amount of material impact will depend on the value of the
computers or other equipment that you are tracking. If the value is
$25,000, then will you be concerned about $100? Will you be con-
cerned about $1,000? These are the kinds of decisions you would
have to make with your organization’s accounting and finance
department.
This situation matters because the value of an inventory can be on
the balance sheet as an account in property, plant, and equipment.
Thus, if a computer were lost, or stolen, would the amount you have
to write off be significant to you? Or, if someone deleted a line out
of your inventory in Excel be a concern for you? If it is a concern,
then you will have to consider different strategies.

Problem 1: Accessing File Content You have probably experienced

having a central place where your team shares files (Microsoft Word,
12 2 FIN A N CIA L IN T EL LI G EN C E

PowerPoint, and Excel documents). These files can be on a hard

drive, or these files can be shared on a cloud service like DropBox or
Google and Microsoft cloud drives. Either way, the issue is always
the same – what if someone can get into a file and they should not
have access to the file and its contents?
There are a couple of ways you may want to handle this in terms
of file access. In other words, who can access the contents of an
Excel file is one of the first considerations. For Excel, you can set a
password that allows a person to see the contents of a file and make
changes to the file if the password is known to the individual. If
the person does not know the password, you can set it to where the
contents cannot be seen or that the contents can be seen but not
changed (view-only access). Here is a video resource to help: https://
www.youtube.com/watch?v=VJqbCpVD-jU
Now, Excel will change over time as new versions come out.
Thus, in the future, to look for resources, just go to Google and
search for “how to set a password on an Excel file,” and you will
find many resources. Plus, if you are within the Excel application,
use the F1 key on your keyboard, and you can search with the same
information and find multiple resources to help you!

Problem 2: Erasing Content in a Cell One of the issues with Excel or

Google Sheets is that contents (data or formula) in a cell can easily
be erased – either on purpose or by accident. Would you be able to
detect that this had happened? Most of us may not be confident that
we would notice that, so the goal is to minimize this possibility from
our files getting data corrupted in this way. But how do we do it?
As you are designing (or redesigning) a spreadsheet, you will
want to think about formulas, specifically, and not allowing some-
one to erase those. The best way to do this is through two comple-
mentary strategies.
Strategy One: Have formulas that ONLY have cell references or
references to functions. In other words, there should be NO hard-coded
numbers in the formulas. Take, for example, the following formula:

 SUM  A  : A  .

 S P ECIA L T O PI C S 12 3

In this formula, cells from A2 to A16 are added up for a sum

and then multiplying it by a rate of a 2% increase. Thus, unless you
remember that this hard-coded number exists in this formula, this
could turn out to be generating data that has errors over the years.
Thus, if this “1.02” represents a 2% increase that you are budgeting
for this year ONLY, will you remember to change it next year? Or
the year after that?
What you want to do instead is have a tab (or multiple tabs)
devoted to INPUT data. Thus, if the “1.02” is a rate entered every
year, then you want to have a tab that prompts a user to enter that
RATE, something like this:

Enter the current year’s budget rate :>>>>> 1.02

Then whatever that cell is that houses this number, 1.02,

every formula that NEEDS that rate can reference that ONE
cell. So, if you only have one formula that needs it or has a
thousand formulas that need it, the formula will look at this cell
for the data every time. Then, all you have to remember is this
input tab and not trying to inventory a thousand cells that need
to be updated.
Strategy Two: Once you have designed, or redesigned, for-
mulas in this way, then you can LOCK the cells so that NO
ONE can change, alter, or delete the formulas. Here is a video
resource to aid you in how this is done: https://www.youtube.com/
watch?v=obB7-mKW2OU
Using this approach, you would ensure that certain tabs have for-
mulas only and no hard-coded information in the formulas. Then
you can lock those cells down, or the entire tab can be locked if it
is full of formulas. One word of caution is to keep track of your
passwords because if you forget, you will have to start this process
of Excel worksheet development all over again!

Problem 3: Consistency in Data Entry Another cool feature in Excel is

the ability to set up drop-down lists for data entry. This way, if you
want a product name always to be entered in a certain way, or you
12 4 FIN A N CIA L IN T EL LI G EN C E

have part numbers and descriptions to be consistent, you can set up

the list as a drop-down list to choose from on data entry.

Think of it this way, here is an address:

Route 1 Box 10, Columbia Alabama 35432

Someone as: could enter this address as:

R1Bx10,
R1 Box10
R1 BOX 10

And various other combinations of ways, including misspellings!

Thus, if you want to have consistency in certain data, you can make
sure that data is “picked” rather than “entered. Here is a video on how
this is done: https://www.youtube.com/watch?v=fq-HmPps_V0

Problem 4: Audit and Informational Tabs In any Excel file, an

information tab can be very useful. For example, you could have
information about WHY the file has been developed, who developed
it, when it was developed, and generally how the file operates. This
tab can be the files documentation tab, or it can link to a Microsoft
Word file that explains how the file works. This tab may also contain
change management information (or you may need to make a
separate tab for that).
In a change management tab, you could have a table where every
change made in the file is tracked. This approach is a form of version
control. If you have a version control process, or if version control is
turned on if you are using SharePoint, this tab will track all of the
changes that have been made over time.
In Excel spreadsheets that have a fiscal impact, an audit tab can
be very helpful to users. If your company uses internal or external
auditors, then this tab would be for audit testing. For example, if
you indicate that a file has a master tab for input data, an auditor
can then use that information to ensure that this rule has not been
broken. Thus, this tab could have auditing “tests” listed and keep
track of every time the file is tested by an auditor and their results
notes or link to test documents.
 S P ECIA L T O PI C S 12 5

Problem 5: Embedded Calculation Factors Another issue that can be

found in Excel files is embedded factors that are in calculations. For
example, you may have a budget file that assumes a certain income
tax rate. Suppose that you assume that any sale has a 5% sales tax
applied to the transaction. However, you have just learned that the
sales tax rate is going up to 5.5% in a few months. What if that 5%
tax rate is embedded in cell calculations? If it is embedded in one
calculation, so you know where that calculation is located in the file?
However, what if the 5% sales tax rate is a factor that is embedded
in ten cell calculations? What if it is in 50 cell calculations? What if
it is in 100 embedded calculations? You can see how quickly this
becomes a problem!
One of the best ways to deal with this is to develop Excel spread-
sheets by using an input, processing, and output modeling method-
ology. Thus, you would have input parameters, like a tax rate, to be
on an input tab. The idea here is that you want a tab of input data
where you will once, and only once, enter a tax rate. Then, you can
have multiple tabs and multiple formulas that point to that ONE
input cell. The point is you do NOT want to have a formula with
embedded rates or numbers in them. The best practice is to make
formulas always refer to cells that have numbers input into them.
Thus, the need for tabs to be designated as input, processing, and
output tabs. Here is a resource to refer to about this design approach:
https://www.youtube.com/watch?v=qxjPKy_Xv10. Remember, you
can have multiple input tabs, multiple processing tabs, and multiple
output tabs.

Input tabs: One way to use an input tab is to have a tab for
those hard-coded rates. Thus, if you have tax rates, any
kind of factors like a growth rate in your spreadsheet, or
if you have data that you copy and paste out of reports. For
instance, many software packages today allow you have
reporting come out as an Excel file with rows of data that
can be copied and pasted into an Excel tab. For example,
if your company uses SAP or Oracle, you can get report-
ing out of the system in an Excel or csv format that Excel
recognizes. The good thing is that some of these reports,
12 6 FIN A N CIA L IN T EL LI G EN C E

depending on the size of your organization can have hun-

dreds of not thousands of data lines. You can be grateful that
Excel can handle a million or more rows of data in one tab!
Processing tabs: Processing tabs are devoted to the transfor-
mation of the data in the data tabs. An example of a pro-
cessing tab is a tab devoted to a pivot table or multiple pivot
tables. As an example, you may have an input tab that has
thousands of rows of sales data. You may need to have this
data consolidated into a monthly total of sales. A way to do
that quickly is by using a pivot table5.
Another way of using a processing tab is when you have
to do a lot of calculations. This approach can also include
pivot tables for processing and consolidating information
from other tabs in the Excel file.
Output tabs: An output tab should be used for printing pur-
poses. Your output tab may have formulas in it where you
are pulling data from other spreadsheet tables. Still, the
important distinction is that the information is formatted
for formal reporting and printing.
This tab can be a great place to have a “dashboard.” For
instance, you might have charts that are pointing at data in
other tabs. These tabs may have header information suitable
for printing.
Closing thoughts: The idea here is that you have a solid
strategy for developing spreadsheets that help you to
reduce errors and ensure the integrity of the data you
are using in financial statements. Many companies with
Excel spreadsheets drive journal entries or contain other
financial information, and you want to be sure the data is
accurate.
You can have many of the input tabs, processing tabs,
and output tabs that you want. In some files, you may use
one type of tab more than others – it is entirely up to you
and the particular situation of the spreadsheet. But if you
have a methodology that everyone is taught how to use,
then everyone can be on the same page on how to protect
company financial information!
 S P ECIA L T O PI C S 12 7

Topic 23: Budgeting and Variances

Budgeting and variance analysis are important to any business. You

will learn the basics of budgeting and variance analysis and will
likely rely on an accountant or bookkeeper with the details. Still,
you should also know what these professionals are doing for you to
stay on top of their work and ask good questions!

Budgeting

Budgeting can be simple, and it can be complex. The complexity

comes in building your modeling for this important exercise and
what information you are trying to track. This task requires us to
determine the best way to forecast line items on the profit and loss
statement, which is the most common form of budgeting for a small
business6.
In a larger business, there will be MANY different kinds of bud-
gets. The budgeting process would begin with the strategic plan –
what are the big goals of the organization? How much does the
organization target revenue growth? Generally, a company may
look five years forward and budget for the most current or upcom-
ing year. Essentially, many large businesses start with a master bud-
get that reflects the organization’s overall goals. Then the budgets
start cascading down into supporting budgets – like sales budgets,
department budgets, expense budgets, capital budgets, and many
other types of budgets7.
The key to budgets is determining HOW to forecast budget
line items. There are numerous ways to do this, but a few different
approaches will be outlined here to get you started. Your task is to
know that learning to budget and doing it well requires practice
and attention to detail. Think of budgets as a learning process that
teaches you about your business!
As an entrepreneur, budgeting comes down to how you fore-
cast your startup or how you forecast and budget for opera-
tions if you acquire a business. Otherwise, as an employee of a
company, you may very well be involved at some point in your
career, having to develop and monitor budgets for a department
12 8 FIN A N CIA L IN T EL LI G EN C E

or other subgroup within an organization. As an investor, you

would not likely look at this in assessing a company’s financial
performance.

Historical Averages

Suppose we have four years’ worth of call data that come into a sup-
port center for the information technology department. This data
could be data that is pulled from a ticketing system.
One way to get an idea of averages is to look at this by calculating
the historical average of just the January data each year. Then get
an average for the data for just the February months and so on. The
reason you may want to do this is to avoid seasonality issues that
can mess with averages over a year. Consider the following support
center call data (Figure 47):

Figure 47 Call Center Data Forecasting Example

If you are looking at this data and you are desiring to forecast,
or budget, what 2018 would look like, we can first examine what
would January 2018 look like if we only calculated an average of
the January 2014, January 2015, January 2016, and January 2017
data by doing the following calculation (or function) in Excel or on
a calculator:

        /    ROUNDED 

Now, take a look at this data if we were to graph the data out year
over year (Figure 48):
 S P ECIA L T O PI C S 12 9

Figure 48 Support Center Data for Forecasting Chart

Here, we can see that each year does follow a bit of a pattern.
This helps us a great deal to come up with a budget/forecast. This
helps us confirm that doing a monthly average of January, February,
March, etc., can be a valid way to forecast the year of 2018.
Another way to approach this might be to calculate the difference
between each data point per month, to get an average “increase.”
For example, for the month of January we have the following data:

Month/Year Amount Inc/Dec

January 2014 3023
January 2015 3024 +1
January 2016 3327 +303
January 2017 3723 +396

Then, if we take the average of the increases or decreases, we

have:

       /     ROUNDED 

Finally, our January 2018 forecast would then be:

    

13 0 FIN A N CIA L IN T EL LI G EN C E

These calculations could be done the same way for the rest of the
months of 2014 through 2017.

Trendline Analysis

There are two ways to think about trendline analysis. A trendline

analysis looks at if there is a pattern that can be seen in the data.
Maybe, every year in September, inventory levels increase because
you are a retail organization, and you are getting ready for the sales
season around the holidays.
You can look at the data for trends from year to year, or you can
look at trends from month to month. For instance, let’s say that you
look at data over a period of months (Figure 49).

Figure 49 Assessing Patterns in Ten Years of Sales Data

Looking carefully at these months of sales data over several years,

you can see a pattern emerge. Sales in March are usually the highest
month as well as July and August. This data also shows that each
year is generally increasing in sales, following the same pattern.

Cost Drivers

Another way of establishing a budget is to consider cost drivers. A

cost driver is an activity that drives costs up or down. For example,
 S P ECIA L T O PI C S 131

when hiring employees, there are all kinds of costs in a budget that
can be impacted8.
Thus, a budget line may be directly impacted by the hiring of
new people. Thus, a budget line would need input data elements of
how many staff currently exist, possible attrition rates if you have a
historical perspective of what to expect in turnover, and how much
hiring you will do over the budget time frame.
Thus, hiring a new person means that you ADD on a Microsoft
365 subscription, which is an easy expense to forecast based on your
expected headcount (i.e., number of employees you project to hire.

Variance Analysis When a company budgets (think about this as a

forecast for financial activities), you will eventually compare the
budget, or forecast, to actual performance. This sequence is how
variances are calculated; variances are the difference between
budgets and actual performance9.
For example, assume that you have budgeted for travel expenses
in a particular month for $20,000 based on a historical average.
If the actual costs come in at $28,000, you may have to explain
why this line item went over budget by $8,000 (a negative variance).
There could be several reasons…maybe the travel costs have gone
up. Maybe some extra trips needed to happen because of some sort
of emergency that was not anticipated, or maybe more people trav-
eled this month than you had expected.
It is also true that positive variances should also be explained.
For instance, if that budget of $20,000 for travel came in as $8,000
actual costs, it is important to explain why there is a $12,000 posi-
tive difference. For instance, after COVID-19 occurred, many busi-
nesses probably had very positive travel budget line items in terms
of planned travel getting curtailed because of an external event that
happened to the company.
It is important to determine what is a material variance that
MUST be explained. Different companies may see different toler-
ances for variances or different managers for different accounting
departments. For some people, anything more than 10% variance
one way or the other requires an explanation. For some, they may set
tolerances based on dollar figures. The numbers can be surprising.
13 2 FIN A N CIA L IN T EL LI G EN C E

Would it surprise you to know that I have worked in departments

where a $5,000 or less variance does not have to be explained, and I
have also worked in an environment where a $250,000 variance or
less did not have to be explained.
Why is it important to explain these variances? You want to
think of variances as learning opportunities. For instance, you may
find that a system or procedure is not working correctly. It allows
you to fix a broken process. Or you may find that you need to build
the budget in a different way, where you examine some of the cost
drivers. For instance, if you have built the budget based on a his-
torical average, MAYBE the budget would be better defined if you
determined WHY people may be traveling that month and build
a budget around individuals and those assumptions. Over time, as
you learn more about the budget, what drives the budget, etc., then
the more accurate you can become on predicting expenses and other
costs (or even revenue).
In addition, companies are moving to models where they review
and adjust budgets sometimes twice a year. Budget assumptions
can be way off. For example, during 2020, when COVID-19
impacted the marketplace, a company may have budgets for sales
that just did not materialize. Thus, if you kept the same budget
without adjusting it, it would not make sense to explain variance
when COVID-19 is impacting the numbers so heavily. It does not
mean that you do not want to explain the variances; it just means
that you want to adjust the budget, so you take out as much of the
COVID-19 impact as possible, so you are dealing with other issues
in the variances.
The most common budget for a company is a static budget. A
static budget is usually just one version of a budget based on your
best assumptions and models. As COVID-19 showed, a static bud-
get may not be the best approach to budgeting.
Sometimes, a company has various budget versions, such as a
worst-case scenario, a likely scenario, and a super best-case scenario.
As you get into the production year, you can decide that the year
appears to be following either one of the forecasted models and go
with that model for the rest of the year. This model is what is called
a flexible budget10.
 S P ECIA L T O PI C S 13 3

Topic 24: Contractor or Full-Time Employee?

The world of an information technology department is a com-

bination of support services and project-based work. An infor-
mation technology company will encompass more than that.
Still, the concept of outsourcing or hiring contractors to do work
versus employees is an important discussion when it comes to
information technology departments and companies alike. It is
important to develop your approach to making these decisions
within your department or company. This section discusses dif-
ferent things to consider as well as suggested approaches in anal-
ysis models.

Reasons for Contracting Labor

Many small businesses outsource various activities. For example,

consider a legal department. In a large company, having a legal team
that you hire onto the payroll could make sense. However, when
you start in a small business, you may employ or contract with a
law firm to do certain things for you WHEN you need them to
be done. For instance, small businesses may need a non-disclosure
agreement or some other type of contract. It is much easier and
much less expensive to obtain that through a vendor than hiring a
full-time legal counsel.
In addition, the same scenario may apply when it comes to ser-
vices like accounting and bookkeeping or human resources. These
are departments you may not hire full-time until you are a large
enough business to call for hiring people to the payroll for these
functions. Thus, finding part-time contractors can be the way to go
before having to hire anyone full-time.
In larger businesses, using contractors can be a solid strategy.
For example, from a legal department point of view, you could
have a full-time lawyer on your payroll that coordinates all legal
activity. However, they may then contract out for legal aid when
necessary.
The same strategy can hold for accounting and finance depart-
ments as well as technology departments. For example, in
13 4 FIN A N CIA L IN T EL LI G EN C E

accounting departments, the most significant flurry of activities

is around month-end. In addition, technology departments have a
certain level of support activities they handle for the business, but
technology projects can ebb and flow with the business. Thus, it is
important to staff yourself for the day-to-day support activities, but
when time demands ramp up, you can easily, and sometimes more
cheaply, hire contractors to fill out the need.
Another important area for a contractor can be when a specific
knowledge base is required. For instance, your company may have
grown to the point where you need to implement an enterprise-
wide solution to have one database of information on all activi-
ties that comprise your sales to cash cycle and your purchase to
cash cycle. You decide to purchase Oracle or SAP to process those
activities. However, you may not have anyone in your full-time
technology professionals who have any experience implementing
those systems.
Thus, one primary reason to hire contract professionals is for the
specific knowledge they have. You want to utilize these professional
contractors to help implement the solution, but you are also hiring
them for a knowledge transfer to your full-time staff.

Modeling Analysis

When you have a situation where you do not have the in-house
expertise, it is a simple decision to look for contracting help. The
challenge then becomes finding the best resource. You can decide
to use good interviewing techniques and a good referral community
to obtain referrals for the expertise you need.
However, if you are in a situation where you are considering that
you neither need to hire a full-time resource, how do you assess
whether you directly employ a person to your payroll or if you want
to go the contractor-for-hire route? Part of this decision will have
to do with the fiscal impact of your decision. Another part of the
decision will have to do with the harder to quantify variables. In a
large company, you have in-house resources to help you build finan-
cial models, either on your team or in the finance or accounting
department.
 S P ECIA L T O PI C S 13 5

One of the possible reasons you may need this kind of help as an
entrepreneur is to build a product or service profitability analysis,
build a commission schedule, or build a breakeven analysis, among
other possible needs.

Topic 25: Small Business

You can learn much about a company you want to start by working
at a company similar to the one you want to open. However, there
are a few things to consider in starting a business that are different
than the rest of the topics in the book. You can certainly use these
resources regardless of starting a business, but most of the time,
these approaches will be things that an entrepreneur needs to think
about in starting a business.
This section is geared more toward the entrepreneur. This
section will discuss various items, at a high level, of what you
need to consider as you are starting as an entrepreneur or look-
ing to expand in terms of your business’s financial condition and
expectations.

Overall Business Resources

As an employee of a technology-oriented company, whether it is

publicly traded or not, you would have easy access to accounting
and finance professionals. Even as an investor, the accounting, and
finance professionals in companies you work for may have years of
investing experience; thus, they can be a great resource to you in
learning about this specialized area of business and how it applies
to your goals.
Thus, if you are reading this book and desiring to strike out on
your own in a business, you may not want your current company’s
accounting and finance staff to know that you want to spread your
wings. However, there are resources out there and things to think
about in starting an entrepreneurial venture.
The best place to start, especially if you are in the conceptual
phase of thinking about starting a business, utilizes the SBA (Small
Business Administration). The SBA has many great free resources
13 6 FIN A N CIA L IN T EL LI G EN C E

as a public service to the community – such as webinars, work-

shops, and probably their most significant SCORE (Service Corps
of Retired Executives). Suppose you are just starting to think about
putting together a business plan or thinking about buying a busi-
ness. In that case, these retired executives can teach you about
marketing, production, product development, and other areas of a
business and the financial considerations you must think about to
be successful.
As you start to firm up your plans, you will decide at some point
to have assistance from a financial professional. As a small busi-
ness, you do not necessarily have to hire a full-time accounting or
financial professional. Still, you will likely need one or two of these
professionals at some point. While there are options out there for
financial software, QuickBooks offers a listing of pro advisors. Even
if you are not necessarily using QuickBooks for your accounting
software, you could find that you need to find an accountant that is
familiar with your chosen industry. A QuickBooks pro advisor can
serve in that role as a paid professional, while a SCORE mentor is
a free resource.

Reports

A few years ago, I interviewed a local entrepreneur for a book on

entrepreneurship. As we talked, one of the important things he said
to me was that financial information he considered to be an ASSET
of his company.
Think about that. It stands to reason that customer files would be
an asset of a company, or the vendor files, or his inventory, but HE
considered his financial INFORMATION to be an asset. Thus,
when it comes to time for him to sell his business to someone else
potentially, a person looking to acquire his business would walk into
a solid financial information system.
What this means is that the financial information contained in
your records is valuable to the company. What this boils down to are
the reports and documents. Can financial reports be run for every
year, every quarter, or every month? Can information from period
to period be explained with backup and proof? Do they even look
 S P ECIA L T O PI C S 13 7

at reports and know what they mean? When considering buying a

business, you may want to watch how financially intelligent the cur-
rent owner is with the business. Your questions will help you assess
this essential element of your assessment.

QuickBooks and Software

When you assess a small business, you will want to be familiar with
typical processes in the business that have a monetary impact. Just
about everything in a business – business decisions about prod-
ucts, clients, expenses, personnel – all of those decisions flow to the
financial statements.
Thus, many businesses may use accounting software, and one of
them that is very popular is QuickBooks. QuickBooks can be used
as a desktop version or an online version. There are other software
options out there; however, QuickBooks has a bigger market share,
which might provide you a certain amount of comfort in starting a
business. QuickBooks (Intuit is the company name, QuickBooks is
the product) has pro advisors that you can utilize to identify profes-
sionals who are well-versed in the software’s abilities for your indus-
try. You can search by industry and other criteria. Here is the link
to the Pro Advisors search page: https://quickbooks.intuit.com/
find-an-accountant/
One thing to note about QuickBooks is that it is set up perfectly
to map accounts to tax items on the 1040 tax form. Thus, once you
set up your account and start processing transactions into the soft-
ware, tax reporting becomes much easier.
However, that is not the end of the kinds of decisions you might
want to make on how you set up your books. For instance, the soft-
ware comes preloaded with a revenue account that represents all of
your sales. Suppose you want to report on different sales categories
or examine the profitability of different products and services. In
that case, you will need more setup in your books. This situation
could be a reason why you hire a professional.
QuickBooks has various ways to track information about your
business, but you may need a professional to help you figure out
the best way to do extra tracking. For instance, you can set up a
13 8 FIN A N CIA L IN T EL LI G EN C E

PRODUCT revenue account and a SERVICE revenue account. If

you have multiple products and services, you can set up different
product or service identifiers that map to different accounts.
Plus, QuickBooks features other features that allow you to
track project revenue and expenses or classify transactions into
CLASSES or by TAGS. Then your accountant can build reporting
that breaks out the different classes or tags or projects so that you
can see if your products and services are earning adequate gross
profits or margins. Not every business needs this level of detail,
but it would be good to move in this direction if you have multiple
products and services.
In addition to classifying transactions appropriately, this also
applies to direct and indirect costs of manufacturing and deliv-
ering your products and services. Direct costs are those costs that
can be traced directly to your product or service. For example,
suppose you are an information technology services company. For
instance, you may provide consultants to companies as project
managers in information technology departments. Thus, if you
have a client, and they are paying you $5,000 a week for a project
manager to run a project, then you know that the project manager
you are supplying to that project is a direct cost of servicing that
client.
Therefore, if the project manager you supply to the client is paid
$3,000 a week, you can add this cost to the project or classify the
transaction with the appropriate class or tag to see these costs and
revenue together to assess this profitability client.
Indirect costs are the costs we know to go to servicing clients or
manufacturing products, but it is harder to trace these costs directly
to the client or product. For example, a consultant may service more
than one client. Suppose you have two clients that ONE consul-
tant is supporting in project management. Now, the direct HOURS
spent on a client is easily tracked by the timesheet of a consultant.
However, would you allocate the benefits of the employee against
these two clients?
An allocation is a methodology that a company uses to split
indirect costs by hours, production units, or other cost drivers.
For example, back to the idea that the MORE people we hire, the
 S P ECIA L T O PI C S 13 9

higher a cost moves, we can then evaluate certain costs on activ-

ity or volume levels and costs. Thus, if we expected that we would
HIRE ten people but only hired eight, that impacts the costs of a
budget line item just as much as the cost going up for the line item
in general.

Financial Data Analysis

When you are building reporting in QuickBooks (and this can be a

similar approach by other software companies like Xero) you want
to be aware of “extra” fields or tools that can help you dive deeper
into your financial data. Within QuickBooks, there are a few tools
that can help you with being able to analyze financial data in dif-
ferent buckets.
For example, when speaking of buckets, we are essentially “catego-
ries” of data. For instance, transactions can be looked at by sequence,
or by date, through the bank transaction detail in QuickBooks, or
you can look at transactions by vendor or by customer. There are
other ways to classify data into other types of categories.
One of the ways to classify transactional information is by using
a CLASS within QuickBooks. For example, one way this could be
used is geographic location or as a store identifier. See, many times,
businesses will get this level of detail by creating many more general
ledger accounts. With QuickBooks and other software, you may
have limits on the number of general ledger accounts depending on
your subscription level with the software. A QuickBooks accoun-
tant can assist in understanding these nuances and helping you to
develop a strategy11.
Think about using things like classes as a way of analyzing finan-
cial data in your business. All of these tools available can give you
reporting that enables you to dig into customers or other data pieces
to understand your business to a level where you can make action-
able decisions.
For instance, assume that you are starting a business doing tech-
nical support to small businesses. Some of your clients may use
your services hourly, and other clients may pay you a fixed amount
each month for your services. In addition, you may have individuals
14 0 FIN A N CIA L IN T EL LI G EN C E

working with you that service these clients when they have issues or
need new technology platforms installed.
How will you know if each client is profitable? How will you
know if you are chagrining service fees appropriately to ensure prof-
itability? The way that you know is to identify the client on your
payroll records or contractor pay records. That way, every month,
you can take your revenue and cost of goods sold and break it out by
the customer. This analysis is what I call a “margin analysis” report.
Here is a sample of what this could look like (Figure 50):

Figure 50 Sample Gross Margin Analysis

This report can be very informative to the business. For example,

maybe this business owner is targeting a 50% gross margin on all
customers. Overall, the business owner is not too far off from that
goal. Customer 3 has a very nice gross margin of 60%. Thus, it
is expected the business owner would then be thinking: Why are
we achieving 60% with that customer? Can that performance be
replicated with the other customers? The answer will depend – the
types of product support could drive the performance achieved on
customer three (3) they receive from your business, or you might be
using cheaper labor to support that business.
On top of that, what is happening with customer 2? Why is the
gross margin so far off from the target? The answer might lie in
the labor supporting the client, but it could also be that the client
had more problems during this reporting period that required some
extra effort to support them during the month.
This analysis is similar to variance analysis. Because you have
target goals of gross margin percentages, if you set up the books
correctly, you can dive into the data to discover where you can tweak
your services and support to achieve your desired financial goals.
 S P ECIA L T O PI C S 141

This information is how financial data can assist you as a business

owner to ensure the viability of your business.

Pricing Products and Services

If you study an existing business, the pricing of products and ser-

vices should have already been done. However, when assessing an
existing business, dig into questions about how products and ser-
vices are priced. Ask the current business owner how they arrived
at pricing and ask them about what specifically are included in the
costs of producing the products and services.
It will be important to identify appropriate costs of a product or
service to establish solid pricing. For instance, if you are starting
a technology consulting company where you provide information
technology project managers to companies that need this expertise
on their teams.
One of your first questions will be how much would you be pay-
ing a consultant by the hour? One great way to establish this num-
ber is to look at job postings online for project managers and look
for salary information on those job postings or at a website like
glassdoor.com.
For example, suppose you find that, on average, a project man-
ager in your area makes $90,000 a year in base salary. If you want
to get at an hourly rate, you will take that number and divide by, say
2,000 hours (which is 50 weeks of the year, working 40 hours per
week), and you will arrive at $45 per hour. The 2,000 hours assume
that the person would be working except for two weeks out of the
year (the allowed vacation time you may build into your model).
However, there are other costs to consider when determining
your pricing to your customer. For instance, do you pay for any ben-
efits for the consultants on your staff? Since your labor force is the
direct cost of servicing a client, you may also want to include health
insurance costs. Arguments can be made one way or the other on
what you include, but for the sake of argument, consider if you are
paying $1,500 a month for health insurance for the employee.
If you take the $1,500 times 12 months in a year, then the total
cost for that one employee is $18,000. If you then divide that by
14 2 FIN A N CIA L IN T EL LI G EN C E

the expected workload of 2,000 hours of billable time, you have an

additional $9 per hour of costs. Thus, add the $45 per hour to the $9
for a total cost of the consultant being $54.
As you can see, adding on benefits to the resource can increase
the costs you are attempting to cover in the rates that you charge
to the client that needs project management services. So, what does
that mean? Think of it this way…suppose that you are going to
charge the client $100 an hour. That seems reasonable, but we need
to examine that a little further.
For example, if you bill your client $100 per hour, for the con-
sultant that costs you $54 per hour, you make a $46 gross profit
(we arrive at that by taking $100 minus $54). This represents a 46%
gross profit (that result is arrived at by taking $46 divided by $100).
How does that sound to you? For some reading this book, your
honest answer may be, “I have no idea.” That is fair. You want to
start with what is a typical amount of gross profit for technology-
based consulting services? One source, Macrotrends, says that it is
around 40%12. Other sources might say something different, but
this is a good way to try and validate your rates.
However, if you add any more direct costs for the consultants,
you start eating into that gross margin. Another way to look at this
is to determine how many hours you think your one consultant
will work in any given year. If you assume, they will work a full 50
weeks, then the total gross margin for that consultant to your busi-
ness is 2000 hours times $46 equals $92,000. Now you can evaluate
that amount of gross profit and think about will this amount cover
your operating expenses? Will this cover any rent you are paying?
Will this cover a salary that you will want to pay yourself? If this
amount is falling short, what will you do to make the model work?
Add on more consultants to contribute to the gross margin or try to
trim operating costs? Or will you work to increase your hourly rate
charged to your clients?
Another way of thinking about this is to think about the rate per
hour you are charging your client and then compare that to others
costs to service that client. For instance, say that you are charging
a client $80 an hour to provide technical support. Would that be
enough to have good gross margins?
 S P ECIA L T O PI C S 14 3

Suppose that you have a resource that is supporting that client

that is paid $50 per hour. Just based on the labor payroll cost alone,
that is a gross margin of only $30 per hour, or 37.5% ($30 divided by
$80). This does not include employer-related payroll taxes nor ben-
efits. In addition, suppose you are assisting the client in obtaining
Microsoft Office subscriptions – do you include that in the cost, or
is that a separate, reimbursable amount charged to the client? Plus,
can you support that client virtually? Or do you have to go to their
office and pay for any mileage reimbursement for the associate sup-
porting the client at their site?
As you think through a typical day in the life of client support,
you will be thinking of the resources and support you are giving
your associates and the related costs of that support. If you do not
think about it upfront, you can price yourself right out of the market.

Business Plans

Business plans are not always needed to start a business. So many

businesses start as a side hustle, as a side gig to make a little extra
income. However, at some point, you may have any number of rea-
sons you want to grow your business or make it a more formal ven-
ture. Business plans can serve two purposes: 1) to vet out your idea
so that it makes sense to you, and 2) to obtain funding from inves-
tors or other sources. A business plan is a document that lays out
all of the plans for your business13.
The key is a combination of the type of idea you have and your
business evolution. For example, many businesses start as a hobby –
like building computers in your garage. You think it is fun, and you
do it for friends and family, and then you realize, well, you could
do this on the side and make a little bit of extra cash. Or maybe
you like to do computer repair, and you will offer those services to
people because you are getting a lot of referrals from your family
and friends. Or perhaps you would like to support small businesses
in their technology needs since many small businesses cannot hire a
full-time technology person to their staff.
When you start this way, you may not form a formal business
structure, and you would report your revenue and expenses on the
14 4 FIN A N CIA L IN T EL LI G EN C E

Schedule C of the 1040 tax form every year because you are consid-
ered a sole proprietor. A sole proprietor is the simplest and easiest
form of a business to create14. You are so small that you do not need
any capital from a bank loan or anything. You just do it on the side
when you have the cash to buy parts. Thus, no urgent need to have a
business plan since business plans serve the purpose of helping you
get funding.
Maybe you perform this little side gig or hobby for a few years,
and you do not perform any formal advertising, but your small little
business steadily gains clients from referrals. One day you realize,
hey, this business could work. Clients are happy, I am providing
good value to my clients, so I think it is time to become much more
formal in my business. You then decide to place a more formal
structure on your business, start a web presence, and advertise.
At this juncture, you may want to take on a different legal struc-
ture, such as becoming a limited liability corporation (LLC) to
limit your exposure to liability as you decide to grow the busi-
ness15. As you decide to grow, you may need to invest in a larger
amount of inventory, and you do not have the cash on hand to
make a large investment. Thus, you may want to find investment
capital through friends, family, or go to a funding source like a
bank. When you do that, you will need to have a business plan to
talk an investor or creditor through your business model, how you
make money, etc.
Now, even though you may not need investment capital, prepar-
ing a business plan has merit, even if it will not be shared with
others. A business plan allows you to think through the pricing
and costs of your business and gives you an idea of how profitable
you could be with the business model you are choosing to employ.
Going through the exercise can help you determine if you need any
capital, when you may want to hire others, etc.
There are many resources on the web for business planning tem-
plates and what you may want to include in a business plan for any
type of business. As a technology-driven business, you could start
with the Small Business Administration and its SCORE (Service
Core of Retired Executives) volunteers. They may have a resource
that is very familiar with your business model!
 S P ECIA L T O PI C S 14 5

Business versus Personal

One of the most important things in building a business is to have a

separate business banking account (savings and checking). Keeping
your personal expenses out of the business is extremely important
and having separate bank accounts helps keep the lines clean.
Now, this does not mean you cannot take money out of your
small business. You can. But it does mean that if you are paying
your cable bill or paying for other personal expenses, you are doing
so with your personal money. You may take a draw from your busi-
ness or a salary from your business, but then that money goes into
your personal checking account and you can pay for any personal
expenses you want to from that account.

Receipts and Documentation

Another important thing to examine in examining a business to

purchase is to see what kind of documentation backs up transac-
tions on the financial statements. For instance, if you are looking at
a particular expense, can you find invoices or receipts for the trans-
actions? It is important to trace that documentation. NOT 100%
of the transactions will likely be documented, but you want to see a
clear pattern of information and documentation being saved to back
up the financial statements. Some of this may be digital or in paper
form, and either way is fine.
At the same time, should you do all of the work? Maybe not. You
can hire an accountant to help you assess all of these and to see just
how well everything is documented. For instance, here are some
things that you, or an accountant you hire, should be examining
when it comes to documentation:

1.  Check to see if receipts or copies of invoices are attached

to transactions in the financial software (i.e., QuickBooks)
2.  Do all of the vendors have invoice copies on their trans-
actions? These can be digital copies OR paper copies in a
filing cabinet.
14 6 FIN A N CIA L IN T EL LI G EN C E

3.  Do all vendors have complete vendor records, includ-

ing W-9 forms, to identify 1099 vendors for reporting to
the IRS easily? These forms could be in digital format and
attached to vendor records in QuickBooks.
4.  Does the company have inventory? If yes, does the com-
pany have an inventory counting policy?
5.  Does the company have bank statement reconciliations
available, either digitally or in paper form?
6.  If the company has a retail presence, what are the com-
pany’s policies on managing the cash register?
7.  Have all tax payments been made on time – you can see
this in QuickBooks in the payroll section or in the vendor
section (or a combination of looking in both places).

Taxes

Every company will have various demands in taxes at the local,

state, and government levels. For an existing company, there will
be accounts in the income statement that correspond to these items.
Still, an entrepreneur has to be familiar with the particular demands
of your business.
Thus, you will need to explore the taxing authorities in starting
a business or buying a business. This situation can also be a perfect
reason why you hire a bookkeeper/accountant for their expertise in
this area.
To consider here, if you have chosen a LLC legal structure, you
can ALSO elect to be treated by the Internal Revenue Service
(IRS) as an S-Corporation16. This treatment is currently advan-
tageous to you in terms of saving money on Social Security and
Medicare taxes.

Social Security and Medicare For example, assume that your business
has a net income in any given year of $50,000. As an LLC, this net
income would “pass-through” to you and your partners as business
income when you file taxes. Thus, you would be paying Social
Security and Medicare taxes on that amount. However, IF you
decide to elect the S-Corporation treatment with the IRS, you
 S P ECIA L T O PI C S 147

might pay yourself a salary of $30,000. Then the $50,000 that would
normally pass through to you would drop down to $20,000, but
since you are already taxed, through payroll, for a salary, the IRS will
NOT tax additionally the $20,000 that is passed through to your tax
filing. Thus, you will save the Social Security and Medicare taxes on
the $20,000.
Now, that may not sound like a lot, but what if your net income
after salary deductions was $100,000 or even $1,000,000? You can
see how quickly the savings add up! Because, a business is respon-
sible for the full Social Security and Medicare taxes, which together
add up to 15.3% (that is 6.2% for employee Social Security tax,
+ 6.2% employer Social Security tax, + 1.45% employee Medicare
tax, + 1.45% employer Medicare tax). Thus, if you multiple $20,000
times 15.3%, you are saving $3,060. This result is why you will find
that LLCs will elect to go the route of electing the S Corporation
treatment with the IRS, and all you need to file to obtain this elec-
tion is IRS form 2553.
Now, remember, too, if you are building a financial model to
model out what this can do for you in terms of tax savings, there
is a limit to these taxes and you will want to factor that into your
model. For example, the IRS will publish the base salary limits for
Social Security taxes on any given tax year. For example, in 2021,
this base salary limit is $142,80017. This means that if your salary/
income goes BEYOND $142,800, you will not be taxed on any
amounts over that base salary for Social Security. There is also an
additional Medicare tax on any salary that goes beyond $200,000.
When you build out this model, you want to build into it all of
these nuances to have a solid idea of how you are saving money
using these elections.
Consider the following scenario: You are a small business. You
have been operating as a sole proprietor and just taking out money
and using it personally when you need it. This payment is what is
called a draw, rather than paying yourself a salary through payroll18.
Your business has generated a net profit at approximately $20K to
$30K a year. We will split the difference here and assume your busi-
ness will clear a net profit of $25,000. We will also be assuming
that your business net profits added to your regular earnings from
14 8 FIN A N CIA L IN T EL LI G EN C E

other jobs will still be under the maximum social security salary
level of $142,800 (2021 rates). Thus, your total income is UNDER
that amount.
The IRS will assess the FULL EMPLOYEE and FULL
EMPLOYER tax on your net profits as a sole proprietor. Thus, you
will have to pay the IRS on your 1040 the following amounts:

Employee Social Security 6.2%

Employer Social Security 6.2%
Employee Medicare 1.45%
Employer Medicare 1.45%
Total 15.3%19

If your salary from a job, or multiple jobs, is $50,000 and we add

the net income of $25,000 to that, then the IRS is looking for social
security and Medicare taxes to be assessed on a total of a $75,000
salary. In your job, a payroll check will deduct these amounts, but if
you are a sole proprietor that does not use payroll, then your tax bill
on 1040 will assess 15.3% on the $25,000 earnings for a tax bill of
$3,825 (without taking any other factors into account).
However, if you set yourself up as an LLC, and you set up pay-
roll, you pay yourself a modest salary of $20,000 for the year AND
you still net $25,000 that passes through to your 1040 income.
You will be assessed the social security and Medicare taxes on the
salary you pay yourself, BUT the pass-through income will NOT
be assessed the extra taxes. The key for the IRS is that you are pay-
ing yourself something reasonable for your business. When you
first start your business, the salary will be based on what you can
pay yourself, and as you grow, you want your salary to eventually
match what a professional would be paid on the market of your
profession.

Payroll Taxes Payroll taxes can be handled through a monthly

subscription through QuickBooks, but there are other ways to handle
payroll as well. As an entrepreneur, if you work through a QuickBooks
Online Accountant, at least when this book is published, if you create
 S P ECIA L T O PI C S 14 9

a NEW subscription through the Accountant version, you can get a

possible discount on the cost of the subscription for the life of your
subscription. That can be substantial savings.
Even so, some entrepreneurs may look at payroll being handled by
QuickBooks and think, well, maybe I can do it cheaper on my own.
Processing payroll manually is a lot of time you would have to con-
sider and make sure all of the different payments are made on time.
At least through QuickBooks or a similar service, much of the pro-
cess can be automated, which will save you money in the long run.
Learning how to leverage your time is the key to entrepreneurship!

Other Tax Demands Other taxes can also apply to your business. You
may need to pay sales taxes, excise taxes, and licensing fees. For
example, in some states, there is no income tax – however, state and
local governments may have sales taxes or other types of taxes that
need to be paid. Thus, having good records on these taxes and paying
them is an important part of assessing a business for acquisition.

Financial Human Resources

Many small business owners do not know what financial resources

they may need – in terms of financial advisors and contractors.
Depending on where you are in the business will determine the
types of individuals you may need to tap to help you.
In the world of finance and accounting, you may need a CPA,
a bookkeeper or managerial accountant, a chief financial officer
(CFO), or a personal finance advisor (or wealth manager). Wow,
that is a lot of people, so how do you know which one you need and
when?

Bookkeeper/Accountant A bookkeeper or accountant will often be the

person that is involved in your business the most. They can combine
any number of tasks for you, such as processing transactions, bank
reconciliations, bill clients, pay bills, pay taxes, run payroll, prepare
reports, and do other kinds of analysis for you on the business. Some
bookkeepers may just want to process transactions for you, but
15 0 FIN A N CIA L IN T EL LI G EN C E

sometimes you need an operational partner. Someone who can know

your business, help you examine profitability, make sure products
and services are profitable, etc. So, be clear on the expectations of
what you need. Typically, a CPA will prefer NOT keeping your
books for you – they may even have a referral they can make to a
good bookkeeper.

CPA A CPA is your tax strategy specialist – helping you not only
with the overall business tax liabilities you may have but also in
terms of your overall personal tax strategy. Depending on the size of
your business, you may want to meet with them a couple of times a
year or at least quarterly20.

CFO A CFO for hire comes in handy as you grow and expand. A
CFO would work with your accountant if you were looking to
expand by acquiring other businesses21. Or a CFO is a great resource
if you are thinking about selling your business.

Personal Finance/Wealth Advisor A personal wealth advisor may be

another individual you want to engage, especially when selling your
business. When you are selling your business, you could be receiving
a windfall of cash and that might be overwhelming if you have not
had that much cash before in your personal life.

Bank Reconciliations

If you are examining a business as your initial entry into becoming

an entrepreneur or deciding to examine a business as an acquisition,
expand. As you enter into this assessment, one of the things you are
doing is to assess financial statements. Still, your examination of the
business may need to go further than that exercise.
While it is important to get a sense of the financial statements,
you also want to make sure sound business practices have been
occurring around the financial information. One of these important
tasks are bank reconciliations.
 S P ECIA L T O PI C S 151

Why is this important? It is a critical piece of information that lets

you know that the company pays attention to the financial informa-
tion. If you cannot get your hands on the last years’ worth, or two
years’ worth, of bank statement reconciliations, then how can you
trust the information in the financial statements? A bank statement
reconciliation shows the bank balances and all of the deposits and
payments, and there should be nothing outstanding that does not
get cleared by the next period. It is a possible red flag if the recon-
ciliations have not been completed.

Contractor Payments

Contractors are paid through a separate process than payroll. There

is a payment of contractors at least within QuickBooks (other soft-
ware may work a little differently). Thus, when you pay contractors.
You are paying them a total amount of money, and the contractor is
responsible for the taxes.
You want to make sure that you obtain a W-9 form from each
person or company for contractors. A fillable W-9 can easily
be obtained by googling “IRS fillable form W-9,” and you can
obtain a link to the PDF document. Send that to your contrac-
tor for them to fill out, and then you can update the vendor
record with the W-9 and attach the form to the record. Within
QuickBooks, you also can send a link to the contractor to have
them fill out all of the information in the online form. The con-
tractor can also set up their payment details if you are paying
them by direct deposit.
In January of every year, your business would then need to file
1099s. The IRS sometimes has two different types of 1099 forms,
sometimes just one form. However, if you are using a software
system like QuickBooks, they will remind you of these important
elements! Right now, you have two 1099 form options. One is for
“non-employee compensation,” or the 1099 NEC. The other form is
for other types of specific payments, like royalties, and the form is
called 1099 MISC22.
As an entrepreneur, if you are looking to acquire a business for
expansion or just starting, you want to review if 1099s are up to
15 2 FIN A N CIA L IN T EL LI G EN C E

date and that all of the documentation is secured. Ensure all of the
W-9’s for all vendors are available and that you can access them
either through a documentation system in the accounting software
vendor section.

Funding

Not every business will need funding. However, you may need
funding upfront for developing a product or need working capital. It
will depend on the business idea, your connections to resources, and
how the business model will work. Entrepreneurs can get started by
generating cash to continue building the business as they go, so you
may not need a funding source. But when you do, what should you
think about in planning for the funding request? What are funding
sources looking for when they review your business and financial
information?

Clarity of the Business Model One area that will be on lenders’ minds
is how well you can communicate your business model. In terms of
the market, industry, products, and services you will offer, how this
translates into the business’s cash flow and money management. The
lender will want to see that you know how the product is manufactured
or assembled, what it costs to produce the product, and any other
economic risks you face in the industry.
If you are providing a service, the key elements to review with
lenders how you duplicate YOU. Often, as a business owner pro-
viding a service it is a reflection of your personality and approach.
Thus, how you hire will be important and ensure that your customer
service approach will be replicated with new employees.
Importance will be placed on building your financial models and
budgets, including ensuring that you forecast your sales, purchases,
and document your assumptions on how your cash flow will work.
Now, this might be easier to do because you may have been in busi-
ness for a little while and already have a very solid idea of how the
business model will work. You can have a pretty good track record
of sales and sales growth and then flow the numbers through to the
 S P ECIA L T O PI C S 15 3

business’s profit and loss and balance sheet. It is an Excel model-

ing exercise and will require a good deal of documentation on your
assumptions.
It might be a good idea to go into the business as you start, with
financial projections so that you can assess how well you can fore-
cast and budget. If you can do it well, with small variances over
time, then your confidence level should be very high that you know
what you are doing. If you have to obtain funding before you start
your operations, it could be harder to make good assumptions ini-
tially. As a result, people often start their businesses as home-based
businesses to work out the business challenges as you go, and then
when you need funding, you are in a much better position to know
exactly what you need.
This will be an appropriate time to obtain a good Excel resource
and a good financial resource to build these financial projections.
Your job is to be clear on how many products you anticipate you can
sell, or how many clients you can obtain in what periods of time,
know how many resources are needed to support the production of
products and services, and the costs of any materials.

Do the Numbers Make Sense? The financial statements that you are
presenting will have to make sense. So, what does this mean? As a
lender is reading the verbiage of the business and they start to look
at the financial projections or past financial statements, they will be
looking at a few things.
First, does the business have the cost of goods sold represented
on the income statement? Any time you produce or assemble prod-
ucts OR even if you are providing services, direct expenses exist
because of the revenue or sale. If you sell computers, there are com-
ponent parts that went into building that computer. Suppose you
are servicing clients with technology services. In that case, it takes a
certain amount of client service from your technicians, or your tech-
nology infrastructure may need to be recognized as costs of goods
sold or cost of revenue.
For instance, one time I had a client come to me that ran into
this issue. They were a construction company, and they had over
$3M in revenue but practically no cost of goods sold. It stands to
15 4 FIN A N CIA L IN T EL LI G EN C E

reason that a construction company would have labor in the field,

they would have materials they are using in the field, so it did not
make any sense that they had over a 90% gross margin. A lender will
notice that immediately and have instant reservations about lending
money.
Second, do the accounts on the financial statements make
sense? One of the things a lender will look at on ANY financial
statement is that the account names are appropriate. For instance,
does the tax accounts say “Tax Expenses” or “Tax Liability.” If the
account says “Tax Liability,” then the account must be on the bal-
ance sheet. If the account name is “Tax Expenses,” then the account
must be on the income statement.
Seeing a tax liability account on the income statement will cause
a lender to pause and question the information. Now, it could be
that the account is truly a tax liability account, OR it is possible that
the account could be misnamed or mislabeled.
In the construction company example, there were quite a few
accounts like this that had been miscategorized. The fix was simple
– a good accountant can go into the chart of accounts and reclassify
the account so that it shows up on the appropriate financial state-
ment. In one case, the account was on the right financial statement,
so the name was changed not to confuse a lender.
Third, are there accounts that have negative balances? This
concept gets a little tricky. Any time we talk about negative and
positive balances in accounting, we must understand what this
means by definition. Here again, is the math problem people often
think is the issue in accounting.
If you look at an income statement in QuickBooks, it would
not be obvious to you that REVENUE accounts have credit bal-
ances (or what those in math circles would equate to as “nega-
tive” balances)….because they look like a positive number on the
financial statement. However, when a revenue account is defined,
the underlying balance should be a credit or negative number;
however, the number will look POSITIVE when you look at the
income statement. Confused yet?
I bet you are. Thus, if you looked at an income statement in
QuickBooks and the revenue section looked like this:
 S P ECIA L T O PI C S 15 5

Figure 51 Sample - Correct Balance

Figure 51 shows exactly how revenue would be represented, even

though behind the scenes, this represents a credit balance. However,
take a look at this example:
In Figure 52, the minus sign is your indication that there is a
problem here. This analysis works the same way with expense
accounts or asset accounts, or liability accounts. Any minus sign
could potentially be an issue.

Figure 52 Sample - Incorrect Balance

In the construction company case, they had several accounts

that had minus signs in front of the balances. In some cases, it was
because the accounts were not defined correctly, but some of it sig-
nified other major issues.
A large issue was the fact that wages were being reported and
recorded incorrectly. That issue took some time to unravel, and that
is where an accounting professional can help you make sure every-
thing is corrected and works going forward.
Fourth, any accounts that appear personal. In the section on
“Business versus Personal,” you learned that personal and business
accounts must be separated. Thus, you can have a business credit
card, and you can have a personal credit card, but you should not
have a credit card that serves both areas of your life.
Thus, several accounts had been identified as personal in the nam-
ing convention on the construction company’s financial statements.
15 6 FIN A N CIA L IN T EL LI G EN C E

Upon questioning, it was confirmed they were personal. Thus, those

balances needed to be written off.
Does this mean you can never use a personal card? No….
it just means that regularly, you show excellent business judg-
ment and place business expense on a business credit card only.
A mistake can happen….and suppose it does, on your personal
credit card. In that case, you can have the pay from account be
your business checking account. It is highly recommended that
you make one payment for the one charge so that when it comes
through your bank account as a payment, you can appropriately
assign the correct vendor to the transaction and post the purchase
documentation.
Finally, do your ratio analysis. As you learned in ratio analysis,
this can tell you if you are overweight in liabilities and other issues.
Run your ratio analysis as much as you can before going to a lender.
You want to be prepared for the numbers they may examine, and
that can give you a great idea of your financial position and any
potential risks the lender may be concerned about in how the busi-
ness works.

Part Six: Exercises, Practice, and Resources Learning activities:

1.  As an entrepreneur, or if you want to be an entrepreneur,

check out the Small Business Administration site. Find out
what resources they have available and take one of their
courses!
2.  As an entrepreneur, or budding entrepreneur, start reach-
ing out to SCORE in the Small Business Administration.
Those executives could help you for many reasons – they can
help you with marketing, product and service development,
finance, and many other topics!
3.  As an employee, make sure you are clear on reporting in
the business. Are you educated on the purpose of different
reports? Of course, today, this can be digital reports, not just
paper reports, so educate yourself on the reporting that is
crucial to what you do.
 S P ECIA L T O PI C S 15 7

4.  If you are acquiring a business, does the business have

years of financial reports for you to review for trends? Make
sure they have an income statement and balance sheet, and
the cash flow statement can be important if you are assessing
a business that has timing delays in the generation of cash
flow. Also, look for aging reports on payables and receivables
and as much data detail on product profitability and other
important business measures. This is where SCORE execu-
tives can assist.
5.  For your own business, make sure that reporting and data
are being tracked for your business. Have access, easily, to
financial reports and other financial and performance data
on your business and ensure you have someone who can
build that reporting for you.
6.  Does the business have backup documents for transac-
tions? This may not be 100% documented, but it is impor-
tant to check. This documentation can be emails, it can be
invoices, and other documents.
7.  Interview a small business accountant if you are on the
entrepreneur path. Find out what the accountant can do
for you using this book as your basis for developing your
questions.
8.  Interview different accountants in the business you work
for as an employee. Find out what they do and specifically,
ask them how their role helps your department or ask them
to give you ideas on what to watch out for around internal
controls or problem solving on issues that come up around
the financial data they care about from your department.
9.  As an entrepreneur, work with your QuickBooks accoun-
tant, or other software, to find out how you can track more
detail in your profit and loss/income statement. How might
you utilize project tracking, or classes, in your reporting to
identify product, service, or client profitability?
10.  As an employee, ask a cost accountant or another accoun-
tant who may know your products or services’ direct and
indirect costs. What goes into these costs?
15 8 FIN A N CIA L IN T EL LI G EN C E

11.  As an entrepreneur, find a SCORE executive or an

accountant that can help you to determine the direct and
indirect costs of your products and services. This activity
could help you to revise pricing structures or help you find
other opportunities.
12.  As an entrepreneur, do you have a business plan? Even if
the purpose is to vet out the idea in your mind, a business
plan can be very useful. It becomes even more important if
you need a funding source!
13.  Have you separated your business expenses from your
personal expenses? As you formalize a company, have a sep-
arate bank account and credit cards for your business.
14.  As an entrepreneur, keep good records of transactions –
including backup documentation (i.e., receipts).
15.  If you are looking to buy a business, do they have good
backup records of their transactions? Can you find receipts?
Can you find invoices? Do they file things by paper copy or
digitally?
16.  If you are assessing a business to acquire, are the ven-
dor and customer records up to date? Are 1099s current?
Are tax payments current? Have bank reconciliations been
completed? Are process and procedures done? Do they pay
attention to internal controls? Are payroll taxes current?
17.  As an entrepreneur, find a good accountant. You can find
one through QuickBooks or ask around for a referral.
18.  If you are acquiring a business, you may need the help of
a CFO – someone who can help you assess the business. You
can google for a CFO for hire, or a virtual CFO, and your
accountant may know someone to refer.
19.  Are you looking to sell your business? If so, a CFO and a
wealth advisor can come in handy in helping you with the
details of that transaction as well as how you will handle
perhaps a large windfall of cash.
20.  Interview an entrepreneur or two. Ask them about any of
the questions and activities in this book. See what they have
to say about the topics that interest you!
 S P ECIA L T O PI C S 15 9

21.  For a company you work for, many of these topics in this
section can be great questions to ask about the company’s
accounting resources!

Notes
1 Internal control definition. Retrieved from https://www.accountingtools.
com/articles/internal-control.html
2 Segregation of duties definition. Retrieved from https://www.accoun-
tingtools.com/articles/segregation-of-duties.html
3 (2018). ABC Analysis & Cycle Counting in Inventory Control. Retrieved
from https://gpmate.com/mate-pcs/abc-analysis-and-cycle-counting-
in-inventory-control/
4 Martin, A. (n.d.). Implement Best Practices for Spreadsheet
Use. Retrieved from http://www.s-ox.com/dsp_getFeaturesDetails.
cfm?CID=2388
5 Microsoft (n. d.). Create a pivot table to analyze worksheet data. Retrieved
from https://support.microsoft.com/en-us/office/create-a-pivottable-
to-analyze-worksheet-data-a9a84538-bfe9-40a9-a8e9-f99134456576
6 Budget. Retrieved from https://www.investopedia.com/terms/b/budget.
asp
7 Master budget (2020). What is it? Retrieved from https://www.thebal-
ancesmb.com/budgeting-what-is-a-master-budget-393049
8 Cost driver definition. Retrieved from https://www.accountingtools.
com/articles/2017/5/4/cost-driver
9 Variance analysis definition. Retrieved from https://www.accounting-
tools.com/articles/what-is-variance-analysis.html
10 Flexible budget definition. Retrieved from https://www.accountingtools.
com/articles/what-is-a-flexible-budget.html
11 Lang, B. (n.d.) How to use class tracking in QuickBooks. Retrieved from
https://quickbooks.intuit.com/blog/whats-new/how-to-use-class-
tracking-in-quickbooks/
12 (n.d.). Information Services Profit Margin 2007–2020. Retrieved from
https://www.macrotrends.net/stocks/charts/III/information-services/
profit-margins
13 Write your business plan. Retrieved from https://www.sba.gov/business-
guide/plan-your-business/write-your-business-plan
14 Sole proprietorships. Retrieved from https://www.irs.gov/businesses/
small-businesses-self-employed/sole-proprietorships
15 Limited liability corporation (LLC). Retrieved from https://www.irs.
gov/businesses/small-businesses-self-employed/limited-liability-
company-llc
16 S corporations. Retrieved from https://www.irs.gov/businesses/small-
businesses-self-employed/s-corporations
16 0 FIN A N CIA L IN T EL LI G EN C E

17 IRS (n.d.). Topic no. 751 Social Security and Medicare Withholding
Rates. Retrieved from https://www.irs.gov/taxtopics/tc751
18 Owners draw vs. salary: How to pay yourself (2020). Retrieved from
https://bench.co/blog/accounting/owners-draw/
19 Self-employment tax (Social Security and Medicare taxes). Retrieved
from https://www.irs.gov/businesses/small-businesses-self-employed/
self-employment-tax-social-security-and-medicare-taxes
20 What does a CPA do? Retrieved from https://www.picpa.org/consum-
ers/cpa-locator/what-does-a-cpa-do
21 What does a CFO do? Retrieved from https://corporatefinanceinstitute.
com/resources/careers/jobs/what-does-a-cfo-do/
22 IRS (n.d.). Instructions for Forms 1099-MISC and 1099-NEC (2020).
Retrieved from https://www.irs.gov/instructions/i1099msc
Appendices

Appendix A – Ratio Analysis Recap

Gross Profit Margin

Revenue  Cost of Goods Sold  / Revenue

Net Profit Margin

Net Income / Revenue

161
16 2 A P P EN D I C E S

Solvency Ratios

Debt to Assets : Total Debt / Total Assets

Equity to Assets : Total Equity / Total Assets

Debt to Equity : Total Liabilities / Total Shareholder Equity

Current Ratio : Current Assets / Current Liabilities

Quick Ratio :  Current Liabilities  Inventory 

/ Current Liabilities

Inventory Turnover Ratio : Cost of Goods Sold / Inventory

or


Cost of Goods Sold /  Inventory Current Period
 Inventory Previous Period  /  
Days Sales in Inventory :  days / Inventory Turnover Rate
 A P P EN D I C E S 16 3

Accounts Receivable Turnover : Revenue / Accounts Receivable


Revenue /  accounts receivable current period
 accounts receivable previous period  /  
Zoom

LogMeIn

Days Sales Outstanding :  days / Accounts Receivable Turnover

Zoom

LogMeIn

Accounts Payable Turnover : Total Purchases /Accounts Payable

 Cost of Goods Sold  Inventory Current Period  Inventory Previous Period 

/   Accounts Payable Current Period  Accounts Payable Previous Period  /  

Zoom

LogMeIn

Days Payable Outstanding

Zoom
16 4 A P P EN D I C E S

LogMeIn

Cash Conversion Cycle :

 Days Sales Outstanding
 Days Sales in Inventory
 Days Payables Outstanding
 Cash Conversion Cycle

Appendix B – Learning Plan

Use this information and Appendix F (Starting and Managing a

Book Group) to learn the book’s material.

Part One: Why Being Financially Savvy Matters

Part One should be of interest to investors, entrepreneurs, and employees. It is a chapter that
builds the arguments for developing your financial competence.
Part One Completed __________
Part Two: Revenue and Expense – The Basics of Income Statements
Part Two examines the foundational elements of the Income Statement. Entrepreneurs,
employees, and investors will find value in reviewing this part of the book.
Profit and Cash Completed __________
Revenue Completed __________
Cost of Goods Sold Completed __________
Gross Margin Completed __________
Operating Expenses Completed __________
Operating Income Completed __________
Net Profit Completed __________
 A P P EN D I C E S 16 5

Timing Issues Completed __________

Part Two Completed __________
Part Three: Assets, Liabilities and Equity – Understanding the Balance Sheet
Part Three is all about the balance sheet and exploring all of the parts and accounts of this
financial statement. As an entrepreneur, investor, or employee, it is important to have a solid
understanding of the information contained in this report.
Short Term vs Long Term Completed __________
Cash Completed __________
Accounts Receivable Completed __________
Inventory Completed __________
PP&E Completed __________
Accounts Payable Completed __________
Long-Term Liabilities Completed __________
Stock/Retained Earnings Completed __________
Part Three Completed __________
Part Four: Cash Flow Statements
Profit/Cash Relationship Completed __________
Operating Activities Completed __________
Investing Activities Completed __________
Financing Activities Completed __________
Fitting Them Together Completed __________
Working Capital Completed __________
Part Four Completed __________
Part Five: The Power of Ratios
Ratios help you build upon the conceptual framework of the financial statements from the
previous topics in the book. Now, you are utilizing your baseline understanding of financial
statements and starting to interpret performance. This is a crucial learning exercise for
employees, investors, and entrepreneurs.
Profitability Ratios Completed __________
Gross Profit Margin
Net Profit Margin
Solvency Ratios Completed __________
Liquidity Ratios Completed __________
Current Ratio
Quick Ratio
Activity Ratios Completed __________
Inventory Turnover
A/R Turnover
A/P Turnover
Cash Conversion Cycle
Other Ratios Completed __________
EBITDA
Free Cash Flow
Horizontal Analysis
Part Five Completed __________
Part Six: Special Topics
This section of the book contains various topics that touch your lives as an employee or an
entrepreneur. As an investor, you may not touch on these much at all – however, internal
controls are always a concern, even as an investor, and you will expect businesses to keep
control over their financial assets.
16 6 A P P EN D I C E S

Internal Controls Completed __________

Excel Controls Completed __________
Budgeting Completed __________
Variance Analysis Completed __________
Contractors’ vs Employees Completed __________
Small Business Completed __________
Part Six Completed __________

Appendix C – Nomenclature Table

Throughout the book, certain terms have other terms by which they
are known. This table is intended to be a quick reference as you are
studying the presented material and analysis strategies.

WORD OR PHRASE OTHER NAMES

Profit and loss statement Income statement
Statement of operations
Consolidated profit and loss
Consolidated income statement
Consolidated statement of operations
Balance sheet Consolidated balance sheet
Cash flow statement Consolidated statement of cash flow(s)
Revenue Sales
Net sales
Accounts receivable Accounts receivable, net
Cost of goods sold COGS
Cost of revenue
Cost of sales
Net profit Net income

In addition, sometimes, you may look up a ratio on Google or other

web inquiry tool like Bing or Chrome. I have had many students
look up a ratio for a company to check their work, and the number
is a little bit different. Presented throughout the book are formulas
for common ratios, but you may find a slightly different variation
online. So how do you assess that?
For one, the difference in the calculation may be the author’s pref-
erence about how THAT PERSON likes to calculate the formula.
The reasoning could be valid, so be on the lookout as to WHY the
person calculates it in a slightly different way.
 A P P EN D I C E S 16 7

Another reason may be that if you work FOR a company, you

may have access to more precise data. Rather than the data, we may
have an investor or an entrepreneur, which is especially true when
calculating the accounts payable turnover. Internal calculations of
this number are much more accurate because you can get your hands
on more precise accounts payable data on purchases.
Finally, the ratio formula may be another interpretation of the
information contained in the formula. For example, let us examine
variations of the gross profit ratio.
You are learning that the formula is Gross Margin/Revenue.
You could also see this as Gross Margin/Sales. Or you could see it
represented as Revenue – Cost of Goods Sold/Revenue. But now,
you KNOW that “revenue minus cost of goods sold” is equivalent
to how “gross margin” is calculated, and thus you can conclude it is
the same formula just presented in a different way.

Appendix D – Personal and Corporate Finance

PERSONAL Finance CORPORATE FINANCE

We have discretionary income A company generates a net income or estimated net
income
We are building net worth A company is building equity
We have an emergency fund A company has free cash flow
We have INCOME A company generates sales or revenue
We have expenses A company has expenses
Households generally do not have a company does have costs of goods sold or costs of
costs of good sold revenues
We have assets A company has assets
We have liabilities A company has liabilities
We have cash flow A company has cash flow
We are on a cash basis of Companies, if publicly traded, use accrual accounting
accounting Otherwise, companies use the cash basis of accounting

Appendix E – Utilizing a Book Group

One of the best ways to handle learning this material is to have a

few people study. Suppose you are an employee of a company. In
that case, this can easily be accomplished by having your depart-
ment learn together, or you have like-minded colleagues that want
16 8 A P P EN D I C E S

to leverage their knowledge of financial information for business

and promotional opportunities.
As an investor, you may not be able to get your entire department
interested in the information, but you may have friends or colleagues
that have similar interests in building your financial intelligence.
As a budding entrepreneur, you may have friends or family that
are interested in learning how to understand financial information
about possible business investments. Plus, there are meet-up groups
that could be interested in learning this material together, or you
could start your own virtual meet-up!
Regardless of the reason you want to learn this material, here are
various components of a learning group that you want to consider:

Facilitation

As you are learning the material, you may want to consider hav-
ing accountants join in the conversation – for their expertise and
the fact that they can help translate information if anyone struggles
with the conceptual framework. It may be easy to find someone who
works in a company that does a good job explaining information
about the accounting world in a company.
Not everyone has access to individuals who can explain account-
ing information well. You can always look up SCORE executive
through the Small Business Administration, especially if you are
desiring to start a business. However, be aware that they may not be
willing to be educators.
One other option is that you can utilize my expertise. Contact
me at [email protected] to discuss what you would like to do,
and we can set up the structure!

Company Selections

One thing to do is decide on at least a couple of companies that your

group wants to study. If you are employees of a particular company,
then you can choose the company you work for PLUS a competi-
tor. The competitor should be a company where you can access their
financial information, or it is a company that is publicly-traded that
 A P P EN D I C E S 16 9

is similar to your company. Since you have a lot of intimate knowl-

edge about your company, as you learn about different concepts in
the financial world, you will have a much easier time connecting the
information to your experience.
As an investor, you can choose any industry you are interested
in and the companies within that industry. One good way to think
about this is you may want to consider companies that you fre-
quent as a customer. For instance, here where I live, I am a cus-
tomer of Costco, Amazon, Starbucks, Microsoft, Alaska Airlines,
and T-Mobile. Plus, I have worked for Weyerhaeuser, Starbucks,
Boeing, and other areas. All of them would be great candidates to
study for investments.
As a budding entrepreneur, you would want to study a company
similar to the one that you want to start or purchase. Now, one
thing to note, in terms of technology companies, some of the big
companies out there like Google, Facebook, Microsoft, or Amazon
are very complex with lots of divisions, departments, products, and
services. Thus, building a small business is not an exact 100% com-
parison, but you can learn a lot by studying the larger companies and
their financial statements and financial information. The entire pur-
pose of studying these companies is to start understanding financial
information with a company that INTERESTS you because you
will give up learning the material with that interest.

Organizing the Sessions

As you can see, there is a lot of material to cover in this book. So,
you have to have some strategies to think about in conducting ses-
sions. Here are some ideas to get you started!
Option 1 – One option is to follow the questions and exercises
in each section. Each section could take one to three ses-
sions if you have an hour each session. Facilitating a study
group in this applied manner may take several sessions until
you get used to the material.
Option 2 – Another option is to follow a ten week schedule
like a course I teach to graduate students.
Index

A accrual accounting, 22, 24–25, 37, 105,

167
accountant(s), 5–7, 16, 18–19, 38, 47, accrual based accounting, 65
49, 54, 56, 59, 61, 93, 110, accrual basis of accounting, XXIII,
118, 121, 127, 136–139, 23–25, 38, 65
145–146, 148–150, 154, 168 accumulated depreciation, 56
accounting, XXIII, 1–2, 4–6, 8–13, 16, acid test ratio, 95
19–27, 29, 32, 37–38, 51–52, acquisition, 6, 25, 38, 75, 77, 81, 95, 118,
55–56, 58, 61, 65, 70–71, 105, 149–150
110, 115, 120, 131, 133–137, activity ratios, XXIV, 81–82, 97–98, 101,
149, 152, 154–155, 167–168 105, 111, 165
equation, XXIII, 47, 50, 90 aging, 52, 61, 75–76, 78
and finance, XVII–XX, 1–2, 6, 8–12, allocation, XXIV, 138
16–17, 115, 121, 133, 135 Amazon, XVIII, 105–108, 169
period(s), 27, 61, 71 amortization, XXIV, 40, 57, 68–69,
software, 19, 51–52, 61, 70, 120, 72–73, 82, 106
136–137, 152 amortized, XXIV, 40, 57, 73
accounts payable, XXIII, 6, 35, 50, approval authority, XXIV, 119
58–59, 61, 68, 74–75, 78, 82, as of, 48
98, 101–104, 163, 165, 167 assembling, 31, 53
accounts payable turnover, 35, 78, 103, asset, XXIV, 40–41, 48–52, 55–57, 61,
163, 167 68, 70–71, 73–76, 82–83,
ratio, XXIII, 101 87–93, 95–98, 107, 110,
accounts receivable, XXIII, 6, 26, 29–30, 115–121, 136, 155, 162,
35–36, 49, 51–52, 61, 67–68, 165, 167
73–76, 82, 98, 100–101, 104, controls, 117
163, 165–166 tags, 117
aging, 52 auditing, 6, 124
accounts receivable turnover, 99–101, 163 audit(s), XXIV, 118, 120, 124
ratio, 99

171
17 2 IN D E X

B certified public accountant (CPA),

55–56, 118, 120, 149–150
bad debt, 94 CFO, see chief financial officer
balance sheet, XXIV, 7, 14–15, 29–30, change management tab, 124
36, 40, 47–51, 55–56, 58–61, check number, 119
65–68, 70–72, 74, 76, 78, 88, chief financial officer (CFO), 6, 74, 93,
91–92, 99, 119, 121, 153–154, 149–150, 158
165–166 classes, 8, 10, 36, 93, 136, 139
bank reconciliations, 149–150 common stock, XXV, 47, 60–61, 69
bankruptcy, 2–3, 82 comparison year, 109
bank statement, 119, 151 conceptual framework, 9, 11, 165, 168
reconciliation, 151 of accounting and finance, 9
base year, 109 consistency, 83, 123–124
Boeing, 83, 169 contractor, XXV, 58, 115–116, 120,
bond, 33, 49–50, 60, 69, 73–74, 88 133–134, 140, 149, 151, 166
bookkeeper, 59, 127, 146, 149–150 contract professionals, 134
bookkeeping, 19, 133 cost of goods sold, XXV, 31–34, 38–42,
book value, 56, 73 54, 57, 66, 72, 84, 98, 102,
budget, 8, 13–14, 58–59, 115, 123, 125, 110, 140, 153, 161–164,
127–132, 139, 152–153 166–167
budgeting, XXIV, 6, 8, 59, 115, 123, 127, cost of revenue, 31, 40–41, 72, 84, 110,
166 153, 166
business plan, 136, 143–144 cost(s), 19, 31–35, 38–40, 53, 58, 98,
110, 130–132, 138–139,
141–144, 152–153, 167
C driver, XXV, 130, 132, 138
capital, 61, 68, 75–78, 82, 98, 104–105, coupons, 117
111, 144, 152, 165 CPA, see certified public accountant
budgets, 8, 127 credit card, 29, 52, 59, 100, 103, 105,
expenditures, 69 155–156
investments, 107 transactions, 29, 52, 59
projects, 23, 57 current asset(s), 51–52, 61, 82, 95–98, 162
capital budgeting, 6 current liabilities, XXV, 58, 60–61,
cash, 21–23, 29–30, 33, 35, 41, 48–55, 95–98, 162
60–61, 66–70, 74–79, 81–83, current ratio, XXV, 95–97, 165
92, 98–108, 111, 115–116, customer, 22, 25, 29–30, 35–37, 49–53,
118, 134, 143–144, 150, 152, 55, 59, 68, 75–76, 78, 105,
164–165 136, 139–141, 152, 169
accounting, 22 cycle counting, XXV, 118
equivalents, 51, 61
generation, 66, 69, 101 D
for operating activities, 113
register, 119 dashboard, 126
reserves, 23, 73 day(s) payable outstanding, XXV, 78,
cash basis, 24, 26, 38, 41 103–105, 163–164
of accounting, XXIV, 22–25, 29, 38, days sales in inventory, XXV, 77, 97, 99,
65, 167 104, 162
cash conversion cycle, XXIV, 25, 35, 75, ratio, 77, 99
77–78, 104–106, 111, 164 days sales outstanding, XXV, 36, 53,
cash flow, 7, 22, 34–35, 65–66, 68, 75–76, 101, 104, 163–164
75–76, 82, 94, 105–108, 111, debits and credits, 6, 9
152, 165–167 debt(s), 50, 60, 69, 73–74, 82, 88–94,
statement, XXIV, 2, 35, 65, 67–69, 111, 162
72–74, 78, 105–107, 165 financing, 88
 IN D E X 173

debt to assets, 88, 93 extraordinary expenses, 87

ratio, XXVI, 88–89, 92–93 extraordinary items, 28, 42
debt to equity ratio, XXVI, 89, 91
deferred revenue, XXVI, 30, 37, 42
department budgets, 127 F
depreciation, XXVI, 40, 55–57, 68–69, financed, 91–92
72–73, 82, 106 finance(s), XVII–XVIII, XXVI, 1–2, 4,
expense, 56 6, 8–14, 16–17, 21–23,
direct cost, XXVI, 33, 39–40, 72, 110, 107–108, 111, 115, 149, 167
138, 141–142 department, 121, 133–134
discretionary income, XXVI, 14–15, professionals, 135
22, 167 financial asset(s), 115, 166
dividends, 23, 94 financial collapse, 95
documentation, 118, 124, 145, 152–153, financial control(s), 118
156 financial distress, 3
draw, XXVI, 145, 147 financial education, 115
financial intelligence, 28, 71, 81, 87, 93,
E 117, 168
financial leverage, 88
Earnings Before Income Tax and financial literacy, 5, 7, 19
Depreciation Amortization financial performance, 3, 5, 7–8, 12, 16,
(EBITDA), XXI, XXVI, 72, 28, 81–83, 95, 111, 116, 128
106, 165 financial projections, 153
Earnings Before Income Taxes, 106 financial statements, 4, 6–7, 13,
EBITDA, see Earnings Before Income 18–19, 22–26, 41, 47–48,
Tax and Depreciation 55, 66, 69, 71, 76, 78, 82, 93,
Amortization 115–116, 121, 126, 137,
efficiency ratios, 35 145, 150–151, 153–155,
emergency fund, 107–108, 111, 167 165, 169
employee(s), XXVI, 2–3, 16–18, 57–58, financing, 33, 65, 67, 69, 74, 88–89, 93,
75, 82, 102, 115–117, 120, 165
127, 131, 133, 135, 138, 141, activities, XXVI, 69, 79, 165
147–148, 151–152, finished good, 53–54
164–168 inventory, XXVII, 77
Enron Corporation, 3, 120 fiscal year, XXVII, 26–28, 41
entrepreneur(s), XVIII, 7, 16–17, 23, 38, fixed assets, XXVII, 50, 55–56
75, 95, 115–116, 118, 127, flexible budget, XXVII, 132
135–136, 146, 148–152, forecast, 127–129, 131–132, 152–153
164–165, 167–169 for the period, 27, 29, 32, 48
entrepreneurship, 136, 149 fraud, 116, 120
equity, XXVI, 15, 47, 49–51, 60–61, 66, free cash flow, XXVII, 82, 106–108, 111,
69–72, 89–93, 111, 162, 165, 165, 167
167
Excel, 115, 117, 120–126, 128, G
153, 166
excise taxes, 149 GAAP, see Generally Accepted
expense(s), XXVI, 8, 22, 28, 32–33, 42, Accounting Principles
55–59, 61, 65–66, 68, 70–73, Generally Accepted Accounting
85–87, 107–108, 110, 127, Principles (GAAP), XXI,
131–132, 137–138, 142–143, 13
145, 153–156, 164, 167 General Motors, 2, 82
account, 33, 58, 61, 65–66, 71, 155 general operating costs, 39
budgets, 127 gift cards, 22, 29–30, 36
management, 8 good debt, 94
174 IN D E X

gross margin, XXVII, 5, 32–35, 42, 81, investing, 1, 4, 8, 23, 55, 65, 67–69, 73,
83, 85, 87, 140, 142–143, 154, 79, 94, 107, 135, 165
164, 167 activities, XXVIII, 67–68, 73
gross profit(s), 32–34, 66, 72, 83–85, 87, investor(s), 16–17, 23, 25, 60, 73, 75, 82,
111, 138, 142, 167 85, 88, 128, 135, 143–144,
margin, XXVII, 83–86, 111, 165 164–169
gross revenue, 83 invoice(s), 24–26, 29–30, 35, 49–52, 59,
gross sales, 83 75, 103, 105, 145
guidelines, 11, 16 invoicing, 29
IRS form 2553, 147

H
J
hard money, 57
headcount, XXVII, 131 journal entries, 6, 9, 26, 126
historical average, XXVII, 128, 131–132
horizontal analysis, XXVII, 87, L
108–110, 165
human resources, XVII, 57, 133, 149 labor, 31, 33, 39, 53, 115, 140–141, 143,
154
leverage, 2, 6–7, 19, 35, 42, 88, 111, 149,
I 168
IFRS, see International Financial liabilities, XXVIII, 37, 47, 49–51, 58,
Reporting Standards 60–61, 66, 68–71, 74, 82,
income, XXVII, 14–15, 22–23, 28, 33, 88–91, 95–98, 150, 156, 162,
69, 72, 85–86, 143, 146–148, 165, 167
161, 166–167 liability, 24, 30, 36, 48, 50, 58, 60–61,
statement, XXVIII, 7, 14–15, 21, 23, 74–75, 119, 144, 154–155
28, 32, 40–41, 45, 56–57, 61, licensing fees, 149
66, 68, 70, 72–73, 85, 87, 106, Limited Liability Corporation (LLC),
108–109, 146, 153–154, 164, XXVIII, 144, 146–148
166 liquid, 49, 51, 81
tax, 106, 125, 149 liquidity ratios, XXVIII, 82, 95–97, 105,
indirect costs, XXVIII, 39–40, 138 111, 165
input, processing, and output modeling, LogMeIn, 17–18, 26, 37, 40, 83–88,
125 91–93, 97, 99–105, 108–110,
input tab(s), 123, 125–126 163–164
interest, 72–73, 77–78, 82 long-term, 47
expense, 33 assets, XXVIII, 48, 50, 55, 73–74, 82
internal control(s), XXVIII, 116, 120, debt, 60, 82, 92
165–166 liabilities, XXIX, 48, 60–61, 69–70,
Internal Revenue Service, 146 88, 165
International Financial Reporting loans, 60, 88
Standards (IFRS), XXI, 13
interpretation, 11, 21, 167 M
inventory, XXVIII, 26–27, 31, 40, 48,
52–54, 61, 68, 74–77, 82, machinery, 50, 55–56
95–98, 102, 104–106, maintenance inventory, 77
116–119, 121, 123, 130, 136, managerial accountant, 149
144, 162–163, 165 manufacture, 32, 53
inventory turnover, 35, 55, 118 manufacturing, 23, 31, 33, 53, 55,
rate, 77, 97–99, 162 94, 138
ratio, 77, 98–99 margin analysis, 140
 IN D E X 17 5

master budget, XXIX, 127 personal finance(s), 13, 22, 108,

materiality, 121 149–150, 167
material variance, 131 personal financial information, 13
math, 9–11, 34, 154 personal wealth advisor, 150
Medicare, 146–148 pivot table, 126
mergers and acquisitions, 6 pricing, 34, 141, 144
Microsoft, 27, 105, 121–122, 131, pro advisors, 19, 136–137
143, 169 procedure(s), XXX, 38, 55, 57, 116–120,
mortgages, 49 132
processing tab(s), 125–126
procurement to payment cycle, XXX,
N 24–25
naming convention, 15, 21–23, 155 production, 34–35, 39–40, 50, 53, 55,
net income, XXIX, 14–15, 22–23, 28, 136, 153
70–71, 85–86, 146–148, year, 132
166–167 product(s), 5, 8, 19, 22, 24–25, 29–32,
net profit, 28, 33, 66, 71–72, 81, 86–87, 34–40, 42, 50, 52–55, 58–59,
108–111, 147–148, 165–166 66–67, 72, 77, 83, 85, 97–98,
margin, 85–88, 108 100, 103, 106, 117–118, 123,
net revenue, 29, 41, 83 135–138, 140–141, 150,
net sales, 29, 41, 83, 166 152–153, 169
net worth, 15, 48–49, 60, 91–92, 167 profitability, 81, 83, 86–87, 109, 135,
statement, XXIX, 48 137–138, 140, 144, 150
nomenclature, 60, 166 ratios, XXX, 81, 83, 111, 165, 167
non-cash, 66, 68 profit and loss, 23, 61, 71–72, 153
non-disclosure agreement, 133 statement, XXX, 13–14, 24, 26–29,
normalize, 107 31–36, 41, 47, 59–60, 67,
numbered forms, 119 70–73, 83, 99, 107, 166
profit(s), 21, 23, 26, 28, 33–35, 41, 47,
66, 72, 81, 84–88, 106,
O 108–111, 138, 142, 147–148,
obsolete inventory, XXIX, 55 165–166
operating activities, XXIX does not equal cash, 23, 35
operating expenses, XXIX, 32–33, 42, is an estimate, 81
66, 72–73, 107–108, 142, 164 property, plant and equipment, XXX,
operating income, XXIX, 33, 72, 164 50, 55, 121
operating profit, 106 publicly-traded, 168
operations, 23, 28, 33, 41, 51, 54, 65, purchase order(s), 24–25, 58–59
67–68, 71, 73–74, 79, 81, 85,
88, 92, 94, 98, 127, 153 Q
order to cash cycle, XXX, 25–26
original purchase price, 56 QuickBooks, XXX, 19, 47, 65, 135,
output tab, 125–126 137–139, 148–149,
151, 154
quick ratio, XXX, 95–97, 105, 162, 165
P
Pareto Principle, 118 R
password, 117, 122–123
pattern(s), 3, 16, 37, 129–130, 145 ratios, XXX, 28, 35–36, 75–78, 81–82,
payroll, 133–134, 140, 147–149, 151 85, 88, 93, 95, 97, 111, 116,
taxes, 143, 148 165–166
personal expenses, 145 analysis, 3, 5, 36, 108, 116, 156, 161
17 6 IN D E X

raw materials, 53 small business(es), 52, 59, 65, 100, 103,

inventory, XXX, 53, 77 116, 118, 127, 133, 135–137,
reconcile(d), 31, 65, 67, 119 139, 143, 145, 147, 149,
reconciliation(s), XXXI, 6, 65, 67, 166, 169
118–119, 149–151 social security, 146–148
reporting period(s), 22, 26–27, 37, 41, soft money, 57
61, 66–67, 71, 108, 140 sole proprietor, XXXI, 120, 144,
retained earnings, XXXI, 61, 66, 71, 165 147–148
revenue, XXXI, 13, 22, 28–38, 40–41, solvency, 81, 88–89, 93
59, 61, 65–66, 70–73, 83–87, ratios, XXXI, 82, 88–92, 111,
99, 106, 109–110, 127, 132, 162, 165
137–138, 140, 143, 146, source document, 59
153–155, 161, 163–164, spare parts, 116
166–167 inventory, 53
to assets, 70 standard operating procedures, 116,
recognition, XXXI, 13, 35, 37 120
Starbucks, 28, 93–95, 169
statement of operations, 23, 28, 67, 166
S static budget, XXXI, 132
stealing, 117
sales, 13, 21–22, 25, 29, 32–34, 36, stock buybacks, 94
41–42, 51, 53, 59, 67–68, 70, subscription(s), 22, 37–38, 41, 52, 106,
75, 77, 83, 87, 94, 97, 99–101, 131, 139, 143, 148–149
104–105, 107–108, 110, 118, supplier(s), 24, 49–50, 58, 77–78, 103,
126, 130, 132, 134, 137, 152, 116
162–164, 166–167 supplies, 116, 119
budgets, 127
tax(es), 125, 149
Sales and General Administration, 32 T
Sarbanes Oxley (SOX), 115, 121
tags, 117, 138
Schedule C, 144
taxes, 72, 82, 106, 143, 146–149, 151
S Corporation, 146–147
the teacher matters, 10
Securities and Exchange Commission
10-k, XXIII, 17–18, 37, 40, 65, 76, 78,
(SEC), XXI, 17
83–87, 89–93, 96–97, 105,
segregation of duties, XXXI, 116
110
Service Corps of Retired Executives
theft, 116–117, 120
(SCORE), XXI, 136, 144,
1099, 151
156, 168
1099-MISC, 151
service(s), 5, 8, 19, 22, 24–25, 29, 31–35,
1099-NEC, 151
37–39, 42, 58–59, 66–67, 72,
time frame(s), 26–27, 47, 49–50, 74, 95,
103, 106, 122, 133,
107
135–143, 149–150,
times free cash flow, 108
152–153, 169
timing issues, 22, 29, 35, 165
short-term, XXXI, 47, 49–50, 58, 60, 70,
trendline analysis, XXXI, 130
74–75, 82, 88, 95–96,
trend(s)(ing), 29, 76, 78, 83, 85, 93, 105,
104–105, 111, 165
111, 130
assets, 49–50, 74
liability, 50, 60, 74
signature(s), 120 U
Small Business Administration (SBA),
XXI, 19, 135, 144, 168 U. S. government, 51, 66, 146
 IN D E X 17 7

V work in process, 53
inventory, XXXI, 53, 77
variance(s), 115, 127, 131–132, 153
analysis, XXXI, 115, 127, 131,
140, 166
vendor(s), 47, 49, 58, 68, 133, 136, 139, X
151–152, 156 Xero, 139

W
Z
W-9(s), 151–152
working capital, XXXI, 61, 68, 75–78, Zoom (Communications), 17–18, 26,
82, 98, 104–105, 111, 152, 165 37, 40, 83–87, 89–93, 96–97,
management, XXXI, 75, 105 99–105, 163