To many students, the scariest single feature of a business master’s degree program is any class with a name like "Financial Management."
"A lot of people are intimidated by financials," says Gary Vaughan, who works in the Venture Center at Fox Valley Technical College and teaches classes in the Master of Business Administration program at Concordia University Wisconsin in Appleton. "Looking at finances, it’s kind of like a foreign language. If you’re a manager or a C-level executive, you want to make good decisions based on financials."
"There’s non-financial people who actually work doing numbers — they use a little bit of their savvy to make it," says Kevin Parins, who teaches financial management in the Master of Science in Management and Organizational Behavior program at Silver Lake College. "And you see it in the classroom too."
The reason managers need to become, if not "numbers people," then at least able to understand financial reports, is obvious.
"It’s easy to find a business owner who has a great product idea, or maybe they have a great marketing idea, but they don’t have the ability to track their numbers or the ability to track through how something will work in the marketplace," says Bill Lepley, who teaches in the Master of Management program at the University of Wisconsin–Green Bay. "It’s not that’s always that way — you can find people who can wear many hats — but when you think of someone with a new product, you think of someone who has technical expertise. That doesn’t necessarily mean they have the background to think through the dollar implications of their supposedly great idea."
Of course, business owners have the option of simply hiring outside financial help.
"It gets back to the conundrum of do I do this myself, or do I hire an expert?" says Lepley. "I really think that everybody who’s in business should try to acquire some basic level of knowledge in finances, even if down the road they decide they need to hire an expert. The problem is down the line you may hire an expert and then find out that you didn’t really hire an expert."
People who don’t consider themselves "numbers people" can learn and understand finances at a basic level at least.
"The idea is to be able to understand what that financial statement is telling you," says Vaughan, to allow managers to apply information to strategic decisions. "At the end of the day, you get the consequences, good or bad, from your decision."
"When you talk to a financial person, they use a lot of jargon and complicated words," says Parins. "I try to keep it basic, and I try to stick to real-world situations."
Managers at some point will deal with employees who are either completely risk-averse or will give the manager an overoptimistic recommendation. Being able to decipher financial reports allows the manager to discern which of the two points of view, or a point of view in between, makes sense.
"Students are planning on being an executive, a senior-level manager, so they have to be able to read financial statements and interpret them and analyze them as well so they can make sound decisions when they’re managing," says Parins.
Many managers experience finances for the first time when they are named to a manager position.
"When you’re going in there, you don’t know what you don’t know about finances," says Vaughan. "But I have to be competent at finances so I can make decisions. If I’m going to become a business owner or have responsibility for a specific business or a division of, I don’t have much experience with cash flow or a balance sheet."
The accounting principle behind financial reports is the "going concern principle" — simply, whether, based on the numbers, a company will be able to continue as a business in the future.
There are three basic financial reports to learn — income statements, also known as Profit and Loss (or P&L) statements; cash flow statements; and the balance sheet of assets against liabilities.
"We key on two big words in finance: cash flow," says Lepley, specifically how to create cash flow and what eats up cash flow. He also focuses on "what does the balance sheet mean in the day-to-day operations of the company, and vice versa."
The challenge in interpreting financial reports comes when reports on the same business contradict each other.
"Let’s suppose you have a nice fat net income figure," says Lepley. "It can mean more than one thing; it can mean all the good things that come along with a growing and profitable business. Sometimes that nice fat net income figure can appear when there’s danger on the horizon — if, for instance, a company is too liberal in giving credit to customers. The sales are booked, but the balance sheet may show a lot of accounts receivable, and if you don’t collect, it’s not going to do the company any good."
Vaughan believes managers need to understand the relationship among P&Ls, cash flow and the balance sheet, and "how do those three link together."
"Cash flow is a symptom," says Vaughan. "The real root cause is something else, which is, I’m not managing the business correctly."
Parins adds a fourth financial report, the statement of retained earnings, the portion of a company’s net profits that are not going to shareholders as dividends, to the list of financial reports to learn. He also advocates understanding how financial reports are put together, including double-entry accounting, and how a "trial balance is put together, and then creating financial statements" from the trial balance.
"You also need to learn how they’re interrelated and how all four financial statements have to be put together to make sound decisions, instead of looking at just one financial statement," he says.
Vaughan also follows ratios, and advocates determining industry benchmarks and then determining how a business’ finances compares with its industry benchmarks.
Another challenge is in interpreting pro forma statements, income statements that do not include unusual or one-time occurrences such as company restructuring costs or adjustments to previous balance sheets that occurred during the reporting period. Pro forma income statements are built on assumptions of a company’s income had the unusual occurrences not happened. Another variation is a pro forma business plan with projected cash flow and P&L statements.
"You’ve really got to be careful" about pro forma statements, says Lepley. "You don’t have to be a mathematical wizard or a CPA, but it does require the ability to be honest and realistic with yourself about whether it’s really possible."
Understanding finances allows business owners to not just make better decisions, but allows them to focus more on their business than on business operations.
"They make better decisions at the front end, which means I’m putting out fewer fires, which means I have more time to focus on the business," says Vaughan. "I can’t be working in my business 90 percent of the time and on my business 10 percent of the time. I have to be futuristic — I have to be proactive and not reactive."
Next: Cost management, in Marketplace Nov. 4.