For starters, we want to emphasize that this book is different from other finance books. It doesn’t presuppose any financial knowledge. But neither is it another version of Accounting for Dummies. We will never mention debits and credits. We won’t ever refer to the general ledger or trial balances. This book is about financial intelligence, or, as the subtitle says, what you really need to know about the numbers. It’s written not for would be accountants but for everyone in information technology.
IT professionals sometimesmaybe even many timesget a bum rap. They focus on technology for technology’s sake, so it is said, rather than on what will strategically support the business. That’s a bum rap because the business needs technology to continue operating and to move ahead. Still, it may be true that IT folks tend to shy away from discussions and decisions that involve finance, if only because it can be difficult to quantify the costs and benefits of various technology implementations. That hurts the company, because senior management may miss out on the IT perspective. But it also hurts IT people themselves. Why? The fact is, business will always be a game of numbers, and the real players are the people who understand what the numbers mean. If you want to be seen as an integral part of your company’s success, if you want your department to be seated at the strategic table, if you want to be a true business partner, then you need to be financially intelligent.
We propose to teach you to understand what is happening in your company from a financial perspective. We’ll show you how to use that information to work and manage more effectively. You’ll learn how to read the financial statements and how to use the information they contain to do your job better. You’ll learn how to calculate ratios. You’ll learn about ROI and working capital management, two concepts that you can use to improve your decision-making skills and boost your impact on the organization. You’ll see pretty quickly that it isn’t hardthe concepts are straightforward, the calculations simple.
A few years ago, the directors in a sample of Fortune 500 companies took a simple financial-literacy testand got an average of 32 percent of the questions right. If you read this book, you should get 100 percent.
THE BENEFITS OF FINANCIAL LITERACY
But it isn’t just a matter of scoring well on a test; financial literacy brings with it a host of practical benefits. Here’s a short list of the advantages you’ll gain.
The Ability to Move IT From a Service to a Strategic Organization
Historically, people from IT have not been included in strategic discussions. Some senior managers thought that IT was simply a function that supported business processes. IT people often took that message to heart and focused on technology rather than on strategic needs, so their proposals weren’t always aligned with the organization’s strategy. Financially literate proposals, however, will get senior managers’ attention. They’ll show that you understand where the organization’s priorities lie. Maybe IT can give up its role as “the department that just wants to spend lots of money” and start being “the department that allows us to meet our strategic objectives.”
The Ability to Evaluate Your Company Critically
Maybe you’ve had nightmares in which you worked at Enron, Global Crossing, or Sunbeam. Many of the people at these troubled companiesincluding the IT people who continued to propose projects and spend capitalhad no inkling of their precarious situation.
Suppose, for instance, you worked at the big telecommunications company WorldCom (later known as MCI) during the late 1990s. WorldCom’s strategy was to grow through acquisition. Trouble was, the company wasn’t generating enough cash for the acquisitions it wanted to make. So it used stock as currency and paid for the companies it acquired partly with WorldCom shares. That meant it had to keep its share price high; otherwise, the acquisitions would be too expensive. It also meant keeping profits high so that Wall Street would give it a high valuation. WorldCom paid for the acquisitions through borrowing. A company doing a lot of borrowing has to keep its profits up, or the banks will stop lending it money. So on two fronts WorldCom was under severe pressure to report high profits.
That, of course, was the source of the fraud that was ultimately uncovered. The company artificially boosted profits “with a variety of accounting tricks, including understating expenses and treating operating costs as capital expenditures,” as BusinessWeek summarized the Justice Department’s indictment. When we all learned that WorldCom was not as profitable as it had claimed, the house of cards came tumbling down. But even if there hadn’t been fraud, WorldCom’s ability to generate cash was out of step with its growth-by-acquisitions strategy. It could live on borrowing and stock for a while, but not forever.
Or look at Tyco International. For all the news stories about Dennis Kozlowski’s elaborate birthday party and zillion-dollar umbrella stand, there is another story that wasn’t widely reported. During the 1990s, Tyco also was a big acquirer of companies. In fact, it bought some six hundred companies in just two years, or more than one every working day. With all those acquisitions, the goodwill number on Tyco’s balance sheet grew to the point where bankers began to get nervous. Bankers and investors don’t like to see too much goodwill on a balance sheet; they prefer assets that you can touch (and in a pinch, sell off). So when word spread that there might be some accounting irregularities at Tyco, the capital markets effectively shut Tyco off from further acquisitions. Today Tyco is focusing on organic growth and operational excellence rather than on acquisitions; its financial picture matches its strategy. A strategy of organic growth and operational excellence can mean a high level of strategic involvement on the part of IT. Companies such as today’s Tyco may present great opportunities for financially intelligent IT professionals.
Now, we’re not arguing that every financially intelligent IT manager would have been able to spot WorldCom’s or Tyco’s precarious situation. Plenty of seemingly savvy Wall Street types were fooled by the two companies. Still, a little more knowledge will give you the tools to watch trends at your company and understand more of the stories behind the numbers. While you might not have all the answers, you should know what questions to ask when you don’t. It’s always worth your while to assess your company’s performance and prospects. You’ll learn to gauge how it’s doing and to figure out how you can best support those goals and be successful yourself.
Goodwill comes into play when one company acquires another company. It is the difference between the net assets acquired (that is, the fair market value of the assets less the assumed liabilities) and the amount of money the acquiring company pays for them. For example, if a company’s net assets are valued at $1 million and the acquirer pays $3 million, then goodwill of $2 million goes onto the acquirer’s balance sheet. That $2 million represents all the value that is not reflected in the acquiree’s tangible assetsfor example, its name, its reputation, its customer lists, and so on.
The Ability to Understand the Business
Peter G. W. Keen, chairman of Keen Innovations, makes a couple of telling observations in the foreword of the book The IT Payoff by Sarv Devaraj and Rajiv Kohli: “Historically, to be an IT ‘professional’ meant having training and experience in systems development and project management...There was very little attention paid to what should have been a priority: the financial responsibility of true professionals to ensure effective use of the firm’s capital investment in IT.” He continues: “In the 1980s, the focus of IT education did shift from development to IT-and-competitive-advantage (an almost breathless single word), but the focus was on market share, growth, and new product and service development. Here again, the financial responsibility was ignored. The implicit assumption was that growth would generate return and that competitive advantage ends up on the bottom line.”
Think about it. You are working in a business. How can you be effective if you don’t know how the company makes money? Or what the numbers mean? Or how the company decides what to invest in? Imagine if you started your own business. How long would it be successful if you yourself didn’t work toward ensuring that it earned a profit? If your current employer is to succeed, it will need your help.
The balance sheet reflects the assets, liabilities, and owners’ equity at a point in time. In other words, it shows, on a specific day, what the company owned, what it owed, and how much it was worth. The balance sheet is called such because it balancesassets always must equal liabilities plus owners’ equity. A financially savvy manager knows that all the financial statements ultimately flow to the balance sheet. We’ll explain all these notions in part 3.
The Ability to Understand the Bias in the Numbers
We’ve already discussed the bias that is built into many numbers. But so what? What will understanding the bias do for you? One very big thing: it will give you the knowledge and the confidencethe financial intelligenceto challenge the data provided by your finance and accounting department. You will be able to identify the hard data, the assumptions, and the estimates. These assumptions and estimates often affect IT recommendations and decisions. For instance, IT professionals need to know the assumptions and estimates that underlie a decision to cut budgets so that they can play an effective role in the conversation. You will knowand others will, toowhen your decisions and actions are on solid ground.
And it isn’t just cost-cutting decisions that are at stake. Let’s say you are proposing a new system that takes your company’s customer-service function to the level everyone has been clamoring for. Your boss says he’ll listen, but he wants you to justify the purchase. That means digging up data from accounting and finance, including cash flow analysis, working capital requirements, and depreciation schedules. All these numberssurprise!are based on assumptions and estimates. If you know what they are, you can examine them to see whether they make sense. If they don’t, you can change the assumptions, modify the estimates, and put together an analysis that is realistic and that (hopefully) supports your proposal. Joe, for example, likes to tell audiences that he’s a veteran finance professional and could easily come up with an analysis to show why his company should buy him a $5,000 computer. He would assume that he could save an hour a day because of the new computer’s features and processing speed; he would calculate the value of an hour per day of his time over a year; and presto, he would show that buying the computer is a no-brainer. A financially intelligent boss, however, would take a look at those assumptions and posit some alternatives, such as that Joe might actually lose an hour a day of work because it is now so easy for him to surf the Web and download music.
It’s amazing, in fact, how easily a financially knowledgeable manager can change the terms of discussions so that better decisions are made. When he worked for Ford Motor Company, Joe had an experience that underlined just that lesson. He and several other finance folks were presenting financial results to a senior marketing director. After they sat down, the director looked straight at them and said, “Before I open these finance reports, I need to know ...for how long and at what temperature?” Joe and the others had no idea what he was talking about. Then the light went on and Joe replied, “Yes, sir, they were in for two hours at 350°.” The director said, “OK, now that I know how long you cooked ’em, let’s begin.” He was telling the finance people that he knew there were assumptions and estimates in the numbers and that he was going to ask questions. When he asked in the meeting how solid a given number was, the financial people were comfortable explaining where the number came from and the assumptions, if any, they had made. The director could then take the numbers and use them to make decisions he was comfortable with.
Absent such knowledge, what happens? It’s simple: the people from accounting and finance control the decisions. We use the word control because when decisions are made based on numbers, and when the numbers are based on accountants’ assumptions and estimates, then the accountants and finance folks have effective control (even if they aren’t trying to control anything). That’s why you need to know what questions to ask.
The Ability to Form Stronger Relationships With Finance
The chief information officer (CIO) in many companies reports to the CFO. It can be a rocky relationship because CIOs may think that CFOs don’t understand the strategic importance of technology and CFOs may think that CIOs don’t manage their budgets effectively and always want more money. So what if IT took the high road and learned the language of the CFO? We’ve already talked about the importance of everyone in an organization speaking the language of business. If the department you are in actually reports to the CFO, then it is essential that you speak the CFO’s language. Imagine the conversations you could have with your colleagues if you were able to discuss budget variance, ROI analysis, and cash flow. Andy James, vice president of MIS at Saucony Inc., was quoted on cfo.com as saying, “Managerial training and financial literacy are the keys to solving business problems...Some people in IT don’t get that.”
The Ability to Use Numbers and Financial Tools to Make and Analyze Decisions
What is the ROI of that project? Why can’t we spend money when our company is profitable? Why do I have to understand accounts receivable when I am in IT, not the accounting department? You ask yourself these and other questions every day (or someone else asks themand assumes you know the answers!). You are expected to use financial knowledge to make decisions, to direct your subordinates, and to plan the future of your department. We will show you how to do this, give you examples, and discuss what to do with the results. In the process, we’ll try to use as little financial jargon as possible.
For example, let’s look at why the finance department might tell you not to spend any money even though the company is profitable.
We’ll start with the basic fact that cash and profit are different. In chapter 15 we’ll explain why, but right now let’s just focus on the basics. Profit is based on revenue. Revenue, remember, is recognized when a product or service is delivered, not when the bill is paid. So the top line of the income statement, the line from which we subtract expenses to determine profit, is often no more than a promise. Customers have not paid yet, so the revenue number does not reflect real money and neither does the profit line at the bottom. If everything goes well, the company will eventually collect its receivables and bank the cash that corresponds to that profit. In the meantime, it doesn’t have that money.
Now suppose you’re working for a fast-growing business-services company. The company is selling a lot of services at a good price, so its revenues and profits are high. IT is busy developing systems to support the growth, and of course, all that work has to be paid for. But all the profit that the systems are helping generate won’t turn into cash until thirty daysor maybe sixty daysafter the work is billed out. That’s one reason why even the CFO of a highly profitable company may sometimes ask you not to spend any money right now because cash is tight.
Although this book focuses on increasing your financial intelligence in business, you can also apply what you’ll learn in your personal life. Consider your decisions to purchase a house, a car, or a boat. The knowledge you’ll gain can apply to those decisions as well. Or consider how you plan for the future and decide how to invest. This book is not about investing, but it is about understanding company financials, which will help you analyze possible investment opportunities.
Cash as presented on the balance sheet means the money a company has in the bank, plus anything else (like stocks and bonds) that can readily be turned into cash. Really, it is that simple. Later we will discuss measures of cash flow. For now, just know that when companies talk about cash, it really is the cold, hard stuff.
Imagine the shock on your boss’s face if you made a case for a raiseand part of your case included a detailed analysis of the company’s financial picture, showing exactly how information technology has contributed.
Far-fetched? Not really. Once you read this book, you’ll know how to gather and interpret data such as the following:
- The company’s revenue growth, profit growth, and margin improvements over the past year. If the business is doing well, senior managers may be thinking about new plans and opportunities. They’ll need experienced peoplelike you.
- The company’s remaining financial challenges. Could inventory turns be improved? What about gross margins or receivable days? If you can suggest specific ways to better the business’s financial performanceand show how information technology can support that improvementboth you and your boss will look smart.
- The company’s cash flow position. Maybe you’ll be able to show that your company has lots of free cash flow for raises for its hard-working employees.
The same goes for when you apply for that next job. The experts always tell job seekers to ask questions of the interviewerand if you ask financial questions, you’ll show that you understand the financial side of the business. Try questions like these:
- Is the company profitable?
- Does it have positive equity?
- Does it have a current ratio that can support payroll?
- Are revenues growing or declining?
If you don’t know how to assess all these, read onyou’ll learn.
This is an excerpt from Financial Intelligence for IT Professionals: What You Really Need to Know About the Numbers by Karen Berman, Joe Knight, and John Case, published by Harvard Business School Press, January 2008. Copyright 2008 Business Literacy Institute. All rights reserved.